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| 52014SC0030 | |
| COMMISSION STAFF WORKING DOCUMENT IMPACT ASSESSMENT Accompanying the document Proposal for a Regulation of the European Parliament and of the Council on structural measures improving the resilience of EU Credit Institutions and the Proposal for a Regulation of the European Parliament and of the Council on reporting and transparency of securities financing transactions /* SWD/2014/030 final */ | |
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| TABLE OF CONTENTS | |
| 1............ Introduction. 5 | |
| 1.1......... Policy
context 5 | |
| 1.2......... Procedural
aspects. 6 | |
| 1.2.1...... Consultation
of stakeholders. 6 | |
| 1.2.2...... Impact
Assessment Steering Group and Impact Assessment Board (IAB) 7 | |
| 2............ Problems
related to the corporate structure of large, complex, and trading-intensive EU
banking groups 8 | |
| 2.1......... Problem
driver: The unrestricted co-existence of core banking functions and trading
activities within large banks. 10 | |
| 2.1.1...... Problem 1:
Impediments to resolution and supervision. 11 | |
| 2.1.2...... Problem 2:
Distorted incentives for banks. 12 | |
| 2.2......... Manifestation
of problems during the financial crisis. 17 | |
| 2.3......... Reform
efforts to date and complementarity of bank structural reform.. 18 | |
| 2.4......... How
would the situation evolve without EU action (baseline scenario) 22 | |
| 2.5......... The
EU's right to act and justification for acting. 24 | |
| 3............ Objectives
of reforming bank structures. 25 | |
| 3.1......... General
objectives. 25 | |
| 3.2......... Specific
or microeconomic objectives. 25 | |
| 3.3......... Operational
objectives. 25 | |
| 4............ Reform
options. 26 | |
| 4.1......... Activities
to be separated. 26 | |
| 4.2......... Strength
of separation. 29 | |
| 4.3......... Preventing
the risks emanating from shadow banking. 31 | |
| 4.4......... Structural
reform options. 33 | |
| 4.5......... Issues
related to implementation. 34 | |
| 4.5.1...... Institutional
scope. 34 | |
| 4.5.2...... Role of
supervisors. 36 | |
| 4.5.3...... Timeline for implementation. 36 | |
| 5............ Impact
and comparison of reform options. 37 | |
| 5.1......... Comparison
criteria. 38 | |
| 5.2......... Social
versus private benefits and costs. 38 | |
| 5.2.1...... Social
benefits. 39 | |
| 5.2.2...... Social
costs. 40 | |
| 5.2.3...... The impact
on economic growth of reducing implicit public subsidies. 41 | |
| 5.3......... Assessment
of reform options based on subsidiarisation according to stricter rules. 42 | |
| 5.3.1...... Social
benefits. 43 | |
| 5.3.2...... Social costs. 51 | |
| 5.3.3...... Conclusion. 52 | |
| 5.4......... Assessment
of reform options based on ownership separation. 52 | |
| 5.4.1...... Social
benefits. 53 | |
| 5.4.2...... Social
costs. 55 | |
| 5.4.3...... Conclusion. 56 | |
| 5.5......... Assessment
of retained reform options. 58 | |
| 5.5.1...... Effectiveness. 58 | |
| 5.5.2...... Efficiency. 63 | |
| 5.5.3...... Coherence. 63 | |
| 5.5.4...... Conclusion. 64 | |
| 5.6......... Retained
options aimed at increasing the transparency of shadow banking. 64 | |
| 5.7......... Complementary
aspects. 65 | |
| 5.7.1...... Quantitative
assessment of some benefits and costs. 65 | |
| 5.7.2...... International
aspects. 67 | |
| 5.7.3...... Institutional
scope. 68 | |
| 5.8......... Impact
on stakeholders. 70 | |
| 5.8.1...... Impact on
bank customers (investors, borrowers, etc.) and market liquidity. 71 | |
| 5.8.2...... Impact on
bank employment 75 | |
| 5.8.3...... Impact on
bank shareholders and unsecured creditors. 76 | |
| 5.8.4...... Impact on
regulators and supervisors. 76 | |
| 5.8.5...... Impact on
EU banking industry. 77 | |
| 6............ Monitoring
and Evaluation. 80 | |
| LIST OF ANNEXES | |
| A1. Overview of structural reforms and
reform proposals | |
| A2. Summary of replies to the stakeholder
consultation | |
| A3. Assessing the complementarity of
structural separation with the current reform agenda | |
| A4. Implicit subsidies | |
| A4.1 Implicit subsidies: Drivers,
Distortions, and Empirical Evidence | |
| A4.2 Estimating the size and determinants
of implicit state guarantee for EU banks | |
| A5. Analysis of possible incentives towards
trading activities implied by the structure of banks’ minimum capital
requirements | |
| A6. Qualitative assessment of benefits and
costs of separating banking activities from deposit-taking entities | |
| A7. Strength of separation | |
| A8. Trading activities and functional
structural separation: possible definitions and calibration of the
institutional scope | |
| A9. Summary of the main findings in
literature on economies of scale and scope in the banking sector | |
| A10. Quantitative estimation of a part of
the costs and benefits of bank structural separation | |
| A11. Impact on private costs – bank
responses | |
| A12. Economy-wide impact of structural
separation | |
| A13. Shadow banking – Securities finance
transactions and transparency | |
| A14. Glossary | |
| 1.
Introduction
1.1.
Policy context | |
| Since the start of the financial crisis, the
European Union (the "EU") and its Member States have engaged in a
fundamental overhaul of bank regulation and supervision. This exercise has to a
large extent been based on the reforms to strengthen global financial markets,
agreed upon by global leaders at the G20 summits in London in April 2009 and
thereafter and implemented in cooperation with the Financial Stability Board ("FSB")
and the Basel Committee of Banking Supervisors ("BCBS"). | |
| In the area of banking, the EU has
initiated a number of reforms to increase the resilience of banks and to reduce
the impact of potential bank failures, the objectives being to create a safer,
sounder, more transparent and responsible financial system that works for the
economy and society as a whole (see in particular the new Capital Requirement
Regulation and Directive ("CRR"/"CRDIV") as well as the
proposed Bank Recovery and Resolution Directive ("BRRD").[1] | |
| In line with these objectives several EU
Member States (Germany, France, Belgium and the United Kingdom ("UK"))
as well as third countries (United States ("U.S.")) have taken a step
further and introduced, or are in the process of introducing, structural
reforms of their respective banking sectors to address concerns related to
financial institutions that are too-big-to-fail ("TBTF")[2]. Structural reform
measures have also been suggested in reports published in the Netherlands. See
Annex A1 for an overview and summary of the main legislative initiatives. | |
| Also international institutions such as the
FSB, the Bank for International Settlements ("BIS"), the
International Monetary Fund ("IMF"), and the Organisation for
Economic Cooperation and Development ("OECD") have been working on a
number of initiatives to improve the resilience of the financial sector and not
long ago called for a broad and global debate on bank business models, which
includes a review of bank structural measures. This review of structural
measures was called for because of the continued growth of TBTF banks in
relation to the size of the financial system, as well as because of the adoption
or planned adoption of structural measures in several jurisdictions (e.g.
separation of activities into different legal entities, intra-group exposure
limits, etc.). | |
| In this context, Commissioner Barnier
announced in November 2011 the setting up of a High-level Expert Group
("HLEG") with a mandate to assess the need for structural reform of
the EU banking sector and, with the objective of establishing a safe, stable
and efficient banking system serving the needs of citizens, the EU economy and
the Internal Market, to make relevant proposals for further action at EU level.
In agreement with President Barroso, he appointed Erkki Liikanen, Governor of
the Bank of Finland as chairman of the HLEG.[3] | |
| The HLEG presented its report to the
Commission in October 2012 (Liikanen (2012)). It concluded that the existing
and on-going regulatory reforms do not address all the underlying problems in
the EU banking sector, as these reforms do not fully correct incentives for
excessive risk-taking, complexity, interconnectedness and intra-group
subsidies. The HLEG stated that reforming the structure of banks is necessary
to complement the existing and on-going banking reforms and recommended the
mandatory separation of proprietary trading and other high-risk trading activities
into a separate legal entity within the banking group. The HLEG envisaged that
this separation would be mandatory only for banks where the activities to be
separated amounted to a significant share of the bank’s business.[4] | |
| Following a public consultation on the HLEG
recommendations, the College of Commissioners debated bank structural reform in
early 2013. President Barroso concluded the debate by noting a: “broad
consensus in favour of an approach at European level, while stressing that the
impact analysis would provide essential clarification.” The President
called for an impact assessment to: “examine the various possible options
and their implications”.[5] | |
| On 3 July 2013, the European Parliament
("EP") adopted an own initiative report called "Reforming the
structure of the EU banking sector"[6]
with a large majority. The EP welcomes the Commission’s intention to bring
forward a proposal for structural reform to tackle problems arising from banks
being TBTF in order to provide greater resilience against potential financial
crises, restore trust and confidence in banks, remove risks to public finances
and deliver a change in banking culture. The EP calls on the Commission to: (i)
provide for a principles-based approach to structural reform of the European banking
sector and to that end stresses e.g. the need to reduce risk, complexity and
interconnectedness; (ii) ensure the continuity of retail activities; (iii)
ensure that trading activities reflect underlying risk and do not benefit from implicit
public subsidies; and (iv) ensure that the separated entities have different
sources of funding, with no undue or unnecessary shifting of capital and
liquidity between these entities and activities. The EP also calls for further
measures to strengthen bank governance and promote competition. | |
| 1.2.
Procedural aspects
1.2.1.
Consultation of stakeholders | |
| During the process of considering
structural reform of banks, stakeholders have been consulted on a number of
occasions. The HLEG met with a variety of stakeholders during its mandate (e.g.
different types of banks, bank investors, large corporates, SMEs, retail client
associations, supervisors and European and international regulators) and held a
public consultation targeting banks, corporate customers and retail clients and
their associations.[7]
The HLEG received 83 responses, the large majority of which were from banks and
other financial institutions, followed by retail customers and their
associations and, lastly, corporate customers. | |
| The Commission also held a public stakeholder
consultation after receiving the HLEG final report in October 2012.[8] Out of the 89
replies received, almost half came from the banking industry. | |
| Structural bank reform has also been
subject to discussions with Member States in the Financial Services Committee
on 14 November, in the Economic and Financial Committee on 23 November and at
the ECOFIN meeting on 4 December. The need for a coordinated action at EU level
was clearly highlighted. | |
| As part of preparing this Impact
Assessment, the Commission services held an additional public stakeholder
consultation during the course of spring 2013 based on a consultation paper.
Amongst others, the consultation invited banks to model the impact of different
types of structural reforms.[9]
Annex A2 summarises the replies. | |
| The Commission services received 540
replies. These responses came from the expected type of respondents: banks and
other financial institutions, corporate clients, investors, public authorities,
and consumer associations and individuals. The number of responses from
individuals (439) and consumer associations (11) stand out. | |
| The consultation responses highlight a clear
distinction between the responses of banks, on the one hand, and consumers and
non-bank financials on the other hand. The former are to an overwhelming extent
against structural separation (with the exception of some cooperative banks).
The latter are largely in favour. The views of other categories are more
balanced. Corporate customers, while acknowledging the need to address TBTF,
express opposition, based on the potential impact of such reforms on their cost
of financing. | |
| Regarding the type and strength of
structural measures and what activities to separate diverging views show up
again. A large portion of banks express a strong opposition to structural
reform or endorse only the plain separation of proprietary trading from deposit
taking. Consumer associations and individuals on the other hand argue that
separation of proprietary trading and market making activities along the recommendations
of the HLEG was the minimum effective, and expressed a preference for either
separating all investment banking activities from deposit taking or prohibiting
credit institutions from carrying out any investment banking activity. | |
| 1.2.2.
Impact Assessment Steering Group and Impact
Assessment Board (IAB) | |
| An Inter-service Steering Group on bank
structural reform was established in March 2013 with representatives from the
Directorate Generals COMP, ECFIN, EMPL, ENTR, JUST, MARKT, SG, SJ, TAXUD and
the JRC. The Impact Assessment Steering Group met in March 2013, April 2013 and
September 2013 and supported the work on the Impact Assessment. | |
| The draft Impact Assessment was submitted
to the Impact Assessment Board (the “IAB”) of the Commission on 19 September
2013 and discussed with the IAB on 16 October 2013.The IAB initially issued a
negative opinion and provided its recommendations for improvement on 18 October
2013. The main recommendations were (i) to improve the problem description and
baseline scenario, (ii) to better describe and explain the reform options,
(iii) to better assess impacts and better demonstrate the effectiveness of the
retained reform options, (iv) to better present stakeholder views, and (v) to
add a glossary. The Commission Services resubmitted a revised Impact Assessment
on 18 December 2013, alongside with a separate document explaining to the IAB
how the IAB recommendations had been incorporated. The IAB subsequently issued
a positive opinion on 15 January 2014, whilst providing further recommendations
for improvement, asking in particular to strengthen the analysis of the
justification, alternative reform options, impact, and stakeholder views with
respect to the transparency measures that had only been introduced in the
resubmission of the impact assessment. The IAB also recommended further
strengthening the structural reform options presentation and the assessment of the
impact and effectiveness of the retained reform options. The current, final
version of the impact assessment has significantly expanded the analysis of the
transparency reform measures and has further elaborated on the other two IAB recommendations. | |
| 2.
Problems related to the corporate structure of
large, complex, and trading-intensive EU banking groups | |
| Banks play an important role in channelling
funds from savers to borrowers. This intermediation role is particularly
important in Europe, as reflected in the absolute and relative size of the EU
banking sector compared to those in other major economies (Table 1 and Chart 1).[10] | |
| Table 1: Size of EU, US and Japanese banking
sectors (2010) | |
| || EU || USA || Japan | |
| Total bank sector assets (€ trillion) || 42.9 || 8.6 || 7.1 | |
| Total bank sector assets/GDP || 349% || 78% || 174% | |
| Top 10 bank assets (€ trillion) || 15.0 || 4.8 || 3.7 | |
| Top 10 bank assets/GDP || 122% || 44% || 91% | |
| Notes: Top 6 banks only for Japan. Source:
European Banking Federation (2011). | |
| The EU banking system is also a highly
diversified eco-system made up by around 8000 banks that operate according to
different business models and different ownership structures. However, over
time the market evolved to produce a few very large, complex, interconnected
banking groups that offer a diversified set of services such as commercial
banking, traditional investment banking, asset and wealth management services, and
capital market activities such as market making, brokerage services,
securitisation and proprietary trading.[11] | |
| Chart 1: Size of selected EU banks (2012 assets
in € billion and as % of national GDP) | |
| Source: SNL Financial (total assets), Eurostat (GDP) | |
| Several of these banking groups have
weathered the crisis well, helped by extraordinary and unprecedented
sector-wide state support. Without state support (which in some cases is
on-going) the EU financial system would have faced a far worse banking crisis
(European Commission (2011, 2012)).[12] The (contingent) taxpayer support to date that benefit the EU
banking sector amounts to 40% of EU GDP (€5.1 trillion in parliamentary
committed aid measures) and has undermined the solidity of several Member
States' public finances.[13] | |
| The on-going reforms including the BRRD and
Single Resolution Mechanism (“SRM”) will undoubtedly ensure that the vast
majority of banks will in the future be fully resolvable. The resolution of the
largest and most complex banking groups may nevertheless involve specific
challenges that could place a significant burden on both creditors and public
the safety net. Moreover, to the extent that market expectations remain that
government support may be forthcoming in a future systemic crisis, in
particular for the largest and most complex banks, the latter may continue to
benefit from an implicit public subsidy. Empirical analyses typically confirm
that implicit subsidies exist and in most cases are significant with subsidies
amounting to billions of euros annually. For example, JRC estimates that implicit
public subsidies enjoyed by the largest European banks that jointly represent
60-70% of EU assets amount to approximately EUR 72-95 billion and EUR 59-82
billion in 2011 and 2012 respectively.[14] | |
| Section 2.1 of this Impact Assessment argues
that several of the problems that have materialised in the EU banking sector
can be traced back to the unrestricted co-existence of core banking activities
with trading activities within large and complex banking groups. This problem
driver has contributed to banks growing, becoming TBTF and also too complex to
fail ("TCTF") and too interconnected to fail ("TITF"). As
further elaborated upon in section 2.2, the financial market activities of
banks have contributed to the failure of major banks in Europe. These problems
have not been fully addressed by current reforms, as outlined in section 2.3.
As a result, section 2.4 highlights that several Member States have filled this
gap by pursuing national structural reforms. While these national reforms share
the same objectives, they differ in several respects, notably as regards the activities
subject to separation and the strength of separation. Such divergences create
tensions in the internal market. There is therefore a case for action at the EU
level to ensure effective, efficient and coherent reforms (section 2.5). | |
| 2.1.
Problem driver: The
unrestricted co-existence of core banking functions and trading activities
within large banks | |
| Large European banks typically combine
retail and commercial banking activities and wholesale and investment banking
activities in one corporate entity[15] or in a combination of closely connected entities with limited restrictions
on transactions between them.[16] The unrestricted co-existence of activities gives rise to the
following two main problems, as visually summarised in the “problem tree” in
Chart 2, and as discussed below: | |
| ·
Problem 1: Impediments to effective
resolution and supervision; | |
| ·
Problem 2: Distorted incentives for banks: the implicit public safety net generates moral hazard and leads to excessive
trading and balance sheet growth, misallocation of resources, distortions of
competition, management and monitoring problems, and the combination of
activities within a deposit taking entity can lead to conflicts of interest and
flaws in bank culture and standards. | |
| Chart 2: Corporate structure related problem
driver, problems and consequences | |
| 2.1.1.
Problem 1: Impediments to resolution and
supervision | |
| Intra-group links arise through, for
example intragroup cross-shareholdings, trading operations whereby one group
entity deals with or on behalf of another group entity, central management of
short-term liquidity within the group, and guarantees and commitments provided
to or received from other companies in the group. Amongst others, these
economic links are put in place to promote group business activities, to enable
the group to operate on an integrated basis across different legal entities, or
to ensure competitive financing terms to the entire group (BCBS (2012)). | |
| Intra-group links complicate the resolution
and recovery process in the event of failure. They can also impede effective
supervision and resolution efforts and increase contagion risk across the group.
The financial crisis has highlighted the problems of resolving large banking
groups in bad times; the sheer complexity of banks' organizational structures
and business models with economic functions and business lines spanning
multiple legal entities make it extremely difficult to quickly isolate the
problematic and non-viable elements of a banking group. As a result, resolution
has up to date been disorganized, involved entire banking groups (as opposed to
only the non-viable parts) and has relied significantly on public support. More
simplicity in terms of organizational and business structure could therefore lead
to easier and more effective supervision and also resolution. Anticipating
public intervention in resolution leads to the so-called implicit subsidy which
in turns distorts incentives of banks and other relevant stakeholders. | |
| In addition, impediments to resolution can arise from banking
groups being highly connected to each other through interbank borrowing and
lending and derivatives markets. This is primarily because when highly complex
banks are “interconnected” it may not only be difficult
for the supervisor/resolution authority to gain insight into the operations of
the group but also because it may be difficult to isolate banking groups (or
parts of them) that are so connected and resolve them safely and quickly without
destabilizing the entire financial system. JRC also finds that banks which are
more interconnected are likely to benefit from a higher implicit guarantee (see
Annex A4.2). | |
| 2.1.2.
Problem 2: Distorted incentives for banks | |
| Deposit taking-banks are by nature exposed
to potentially damaging depositor runs. Therefore public safety nets in the
form of deposit insurance and lender of last resort facilities (as well as
bail-outs) have been introduced. Despite these safety nets, deposit-taking banking
groups are currently largely unrestricted in the type of banking activities they
undertake and benefit significantly from the explicit and implicit public
safety nets. The public safety nets distort incentives by encouraging banks to
take excessive risks which in turn give rise to excessive trading and balance
sheet growth, misallocation of resources, distortions of competition,
management and monitoring problems, conflicts of interests and culture shocks
as well as flaws in banking standards. | |
| Moral hazard, excessive trading and
balance sheet growth and misallocation of resources: Deposit-taking banks are by nature exposed to potentially damaging
depositor runs. Therefore public safety nets in the form of deposit insurance
and lender-of-last-resort facilities have been introduced.[17] However, the public safety nets also have the effect of incentivising
banks to expand and take excessive risks with the funds available to
them (the so-called "moral hazard" problem) because monitoring
and market discipline is muted when risk is not appropriately priced. For
example, insured depositors do not lose part of their investment upon a bank’s
failure. As a result, they have no incentives (let alone the ability) to
monitor the actions of the banks to which they lend. More generally, explicit
and implicit public safety nets reduce disciplining incentives of depositors
and/or bank creditors and lower a bank’s funding cost. This allows banks to expand
and increase their debt issuance and hence to leverage up more quickly, in
particular if they are not restricted to relationship-oriented banking activities.
High leverage in combination with limited liability incentivises excessive
risk-taking by banks even further given the asymmetric payoffs to bank
managers and shareholders as upside gains are being privatised, whilst downside
losses are being socialised.[18] Even a bank manager that is entirely unaware of the existence of the
implicit public subsidy will take advantage of it by assuming high levels of
artificially cheap debt and by assuming risky positions that are expected to
benefit his shareholders. | |
| Residential real estate bubbles and crashes
illustrate that wholesale and investment banking activities do not necessarily
have to be more risky than retail and commercial banking activities. However, it
is difficult to separate the real estate bubbles from the role of financial
innovation, including securitisation of mortgages and derivatives to structure
these products for distribution to investors. Moreover, the recent real estate
crises, unlike most in history, imperilled sovereigns because sovereigns have
been obliged to bail out not only traditional deposit banks, but also banking
groups and activities that they should not have had to bail out. Targeting the
safety net to those core banking activities that deserve subsidisation and
protection because they address a market failure reduces the scope of the
public safety net. The nature of the banking activity is what matters the most.
The ability to take risks will depend on whether the activity is
relationship-oriented or transaction-oriented. Whereas relationship-oriented
retail and commercial banking activities are difficult to scale up quickly
and easily, market-based and transaction-oriented wholesale and investment banking
activities can to the contrary be scaled up more easily.[19] Genuine relationship-oriented banking activities are time-consuming
to build and maintain, whereas transaction-oriented banking activities are more
deal-oriented and can be replicated more easily. | |
| In addition, JRC analysis points to the
possible existence of an incentive for banks towards trading and away from
lending activities as a result of the current minimum capital requirements.
Such an incentives bias is found not be (fully) eliminated by the Basel III
minimum capital requirements reform (see Annex A5). | |
| Bank balance sheets in the EU, particularly
those of the largest banking groups, grew significantly in the years leading up
to the financial crisis (see charts 3 and 4 below).[20] Much of the balance sheet growth that took place was driven
by intra-financial-sector borrowing and lending, rather than real economy
lending. For the EU aggregate bank balance sheet, loans to households and
non-financial corporations only make up 28% of total assets (March 2012). A
significant part of banks' explicit and implicit taxpayer-subsidised pre-crisis
activity consists in inter-group financial borrowing and lending. | |
| The increasing
dominance of intra-financial business is also reflected in global currency and
derivatives markets developments, where large (“broker-dealer”) banks’ trading
with non-financial customers (e.g. corporates, governments) has decreased
substantially over time both for foreign exchange and interest rate derivatives
(BIS (2013)). Recent OECD research raises important concerns about derivative
trading giving rise to excessive leverage, interconnectedness, and conflicts of
interests (Blundell-Wignall et al. (2012, 2013)). The notional value may not be
informative about the riskiness of the derivative positions. Chart 5 Plots the
“gross credit exposure” of derivatives positions for the biggest systemically
important banks. First, the Gross Market Value (GMV) measures what it would
cost to replace all trades at current market prices. It is typically
significantly smaller than the notional value. While the notional value of global
derivatives was 586 trillion USD in December 2007, the GMV at the same time was
only 16 trillion USD. Even when valued at GMV, derivatives will still be important
as a proportion of the balance sheet. Second, financial firms have offsetting
positions that can be netted and banks expressly hedge most of their positions.
The GMV minus netting is the Gross Credit Exposure (GCE). It is against the GCE
that collateral is held. It amounted to 3.3 trillion USD in December 2007,
against which 2.1 trillion USD was held. The final global open exposure hence amounted
to 1.2 trillion USD. Changes in volatility may shift the GMV quickly and
netting provides no protection against such shifts in market risks, because
netting is about settlement amounts using prices at the point of close out.
When the crisis hit in 2008, the GMV more than doubled from 15.8 trillion USD
to 35.3 trillion USD, the GCE increased from 3.3 trillion USD to 5 trillion USD
and the estimated collateral had to rise from 2,1 trillion USD to 4 trillion
USD. Banks faced significant margin calls in a highly risky environment. | |
| Chart 3: Evolution of liabilities 1998-2012 (euro area, € billion) || Chart 4: Evolution of assets 1998-2012 (euro area, € billion) | |
| || | |
| Notes: Customer deposits are deposits of non-monetary financial institutions excluding general government. Source: ECB data. || Notes: Customer loans are loans to non-monetary financial institutions excluding general government. Source: ECB data. | |
| Chart 5: The gross credit exposure (gross
market value minus netting) of derivatives and collateral | |
| Source: BIS, ISDA,
OECD | |
| Research also suggests that the deepening
of financial markets in the last 10 to 15 years has fundamentally destabilised
banks by introducing a trading and fee-based culture in large banking groups.
As a percentage of total assets, smaller banks tend to engage more in
traditional commercial banking business, resulting in a balance sheet that has
more loans (chart 6) and fewer assets held for trading (chart 7) compared to
larger banks. These average figures hide significant variations between banking
groups, though (chart 8). | |
| Chart 6: Importance of loan making for EU banks (2011) || Chart 7: Importance of trading activity for EU banks (2011) | |
| || | |
| Source: ECB consolidated banking data. || Source: ECB consolidated banking data. | |
| Chart 8: Assets held for trading, share of
total assets (2012) | |
| | |
| Source: SNL
Financial | |
| The implicit public safety net also leads
to a misallocation of resources. The expectation of public support artificially
increases the size of the financial sector in aggregate and hence diverts
resources away from other sectors of the economy. According to academic
research, the benefits of more banking activity may not always compensate for
increased financial stability risks and other disadvantages. Cecchetti and
Kharroubi (2012) empirically find that the enlargement of the financial
system beyond a certain size is associated with reductions in real productivity
growth. In part this may be due to the financial sector competing with the
rest of the economy for scarce resources. Arcand et al. (2012) also find
that there can be “too much” finance. When private credit reaches 80% to 100%
of GDP (which is largely exceeded for several crisis-affected EU Member States
such as Cyprus, Denmark, Ireland, the Netherlands, Portugal, Spain and the UK)
further private credit is found to be negatively associated with GDP growth.
The hypothesis is that excessively large financial systems may reduce economic
growth because of the increased probability of a misallocation of resources,
the increased probability of large economic crashes[21], or the endogenous feeding of speculative bubbles. Philippon (2008)
observes that outstanding economic growth was achieved in the 1960s with a much
smaller financial sector.[22] | |
| Competition distortions: Implicit public subsidies distort competition in the market place and
raise barriers to entry to the extent that: (i) small and medium-sized banks are
less likely to benefit from such subsidies to the same extent as the large ones
and are therefore being disadvantaged; and (ii) weak banks in strong Member
States are more likely to enjoy a good support rating[23] and are not disciplined by the market place. These findings have
been confirmed by the work undertaken by JRC (see Annex A4.2) as well as other
papers (Schich and Lindh (2012) and De Grauwe and Ji (2013)). | |
| Managing and monitoring problems: The financial crisis has highlighted the problems associated
with the complexity of banks' businesses and the scope of their operations. There
are increasing signs that investors shun this complexity[24] and find it difficult to monitor and therefore understand the
underlying risks.[25] | |
| Banks with a variety of activities also
require more complex management and are more difficult to regulate.[26] More simplicity in terms of corporate structure could lead to
easier and more effective management and regulation. The prudential regulation
of banks is also difficult for investors to understand. Accordingly, investors
do not fully exercise the “watch-dog” monitoring function granted to them under
Basel's “pillar 3” (market discipline).[27] | |
| Conflicts of interests, bank culture shocks and flawed standards: There are significant cultural divides within banking
groups. In general, conflicts of interest are more likely to materialize when
an institution provides multiple financial services. The main concern is that
the bank uses the informational advantage it gains from conducting different
activities to its own advantage, instead of seeking to meet the best interest
of customers and investors. Whereas regulation and self-regulation aim to
address such conflicts of interest, it is difficult to monitor and control the
flow of information within large banks. Recent and large-scale events such as the
rigging of the Libor benchmark rate – legal fines to date amount to more than
USD6bn[28] – and ongoing investigations by several regulators relating to trading
on global foreign exchange markets illustrate the limited effectiveness of
softer forms of governance separation (e.g. Chinese walls). It is also
illustrative of how banks have increased their profits to the detriment of
their customers by exploiting proprietary customer information to their own
benefit. | |
| 2.2.
Manifestation of problems during the financial
crisis | |
| The problems highlighted in section 2.1 are
at the root of the financial crisis. Capital market-based activities have
contributed to the failure of major banks in Europe. The majority of the large
and complex EU financial institutions that received state support in 2008 and
2009 had trading income to total revenue ratios that were relatively large. For
example, having analysed a sample of large and complex EU banking groups, IMF
research suggests that almost 80% of all supported banks that received official
support in 2008/2009 traded significantly more than average (Chow and Surti (2011)). | |
| Deeper markets have allowed banks to trade
more and take larger trading positions with higher associated profits in the
good times. However, the higher profitability comes with higher risks, which
may compromise bank stability in the bad times. Analysis by the JRC allows disentangling
the return on assets (ROA) by type of activity (see also Annex A5). Chart 9
below illustrates the higher profitability and volatility of trading
activities. | |
| Chart 9: Average return on assets of
European banks as a percentage of total assets by type of activity | |
| Source: SNL and
JRC. See Annex A5. | |
| The shift towards a transaction-oriented
banking model and the corresponding excessive trading also contributed to boost
the size of bank balance sheets. The expansion of bank balance sheets outpaced
GDP growth and hence could not be funded by retail funding sources which are
more tightly linked to GDP growth and increasingly pushed large banking groups
towards short term wholesale funding (repo, money market funds, interbank
borrowing, etc.). As a result of their trading activities and increasingly
transaction-oriented banking model, banks such as RBS and Allied Irish Bank had
significant exposures to structured credit and securitised assets. Also, the capital
market activities of TBTF banks effectively enabled other banks to inappropriately
rely upon short-term wholesale funding to finance their activities (e.g. Spanish
cajas). If Lehman Brothers or any large European bank would have been less
connected to deposit taking banks, the impact of their failure would have been
less disruptive (see also section 5.8). | |
| As a result, governments would have a
smaller incentive to resort to bail out policies, as concerns on contagion and
on the continuity of business for deposit banks concerns would be more
contained. | |
| 2.3.
Reform efforts to date and complementarity of
bank structural reform | |
| The EU has already initiated a number of
reforms to increase the resilience of banks and to reduce the probability and
impact of bank failure. These reforms include measures to strengthen banks'
solvency (the capital and liquidity requirements part of the CRR/CRDIV
package); measures to strengthen bank resolvability (the proposed BRRD);
measures to better guarantee deposits (the revision of the Deposit Guarantee
Schemes directive (the "DGS"); measures to improve transparency and
address the risks of derivatives and to improve market infrastructures
(European Market Infrastructure Regulation (the "EMIR") and related
revisions to the Markets in Financial Instruments Directive
("MiFID")). Additionally, in order to break the negative feedback
cycle between the sovereign and banking risks and to restore confidence in the
euro and the banking system, the European Commission has called for further
development of a Banking Union, building on the single rule book that will be
applicable to all banks in the entire EU. This will include a Single
Supervisory Mechanism (“SSM”) and a Single Resolution Mechanism ("SRM),
which will be mandatory for members of the euro area but open to voluntary
participation for all other Member States. | |
| Despite this broad-ranging reform agenda further
measures are needed to reduce the probability and impact of failure of TBTF
banks. Such measures have global support, as evidenced by recent statements by
G20 leaders and ministers.[29] | |
| As regards the probability of failure,
the business of credit intermediation is inherently unstable and prone to
liquidity and solvency shocks. Banks are therefore required to put in place
adequate shock absorbers, in the form of liquid assets that can be sold without
loss to meet unexpected cash outflows ("liquidity buffers") and in
the form of sufficient own funds to absorb potential losses ("solvency
buffers"). The CRR/CRDIV reform package has increased the quantity and
quality of such funds and will thus enable banks to absorb more losses before
defaulting. | |
| However,
capital requirements are not a panacea and there are limits to what they can
achieve. More specifically: | |
| ·
Addressing remaining TBTF problems by means of
higher capital requirements would not address the fundamental inconsistency of
on the one hand "taxing" systemic risk and excessive trading with
high capital requirements while at the same time allowing these activities to
be performed by entities that enjoy explicit coverage of public safety nets; | |
| ·
Irrespective of the changes to the market risk
capital requirements that increase the amount of capital that is required,
banks could still have significant incentives for engaging in trading
activities given the particularly substantial profits of such activities (see
Annex A5). This has induced a broad-based shift towards these activities, at
the expense of traditional activities, with an increase in systemic risk being
the consequence (Boot and Ratnovski (2012)); | |
| ·
The ratio of risk weighted assets to total
assets is significantly lower for TBTF banks, which typically have an important
trading book, than for other banks (see chart 10).[30] In addition, the risk-based capital requirements based on value-at
risk ("VaR") model calculations can still be small compared to the
size of trading assets.[31] Standard setters at both international and European level are currently
critically assessing the consistency and accuracy of the risk-weighted asset
approach;[32] | |
| ·
Whereas nominal, non-risk weighted capital
buffers could be considered to address these risks, such buffers are blunt and
also distort adequate risk-taking incentives. They would have to be set at a
high level to fully off-set the remaining incentives in favour of trading.
Introducing such additional buffers would also further complicate the
prudential framework. This complexity also stems from the
increased variety and complexity of bank activities that have required much
more complex capital standards (Hoenig and Morris (2011)). These complex standards are difficult to monitor and understand
for banks, supervisors, and the market.[33] Structural reform may help to simplify supervision and enforcement
of capital requirement regulation; | |
| ·
Capital requirements also do not address several
problems referred to above, such as conflicts of interest and a misalignment
between a commercial banking and an investment banking culture within a single
“unstructured” banking group; | |
| Chart 10: RWA to total assets: G-SIFI banks
versus Non G-SIFI banks | |
| | |
| Source: Bloomberg, OECD, Blundell-Wignall
et al. (2013) | |
| While capital requirements are a major
instrument in reducing the probability of failure, it would appear unwise to
rely on one instrument only to address the TBTF problem. Structural bank
reforms complement the reforms related to capital requirements by imposing
direct constraints on specific activities, as opposed to capital requirements
that depend on the riskiness of the individual entity and/or of the
consolidated group. Structural reform would also be a more direct way of making
sure that insured deposits are not used freely throughout integrated groups to
fund transaction-oriented activities that are not customer-oriented and hence
should not benefit from the implicit government support. It could also
complement the systemic risk charges for systemically important banks by adding
another disincentive towards banks excessively expanding their risky trading activities,
thus putting a break to the main source of unsustainable bank growth in recent
years. | |
| As regards impact of failure,
implementation of the BRRD will pave the way for the orderly
resolution of normal EU banks and thus significantly reduce the impact of
failure of such banks on public finances.[34] The resolution powers will be challenging
to exercise for TBTF banks, given their particularly large, complex and
integrated balance sheets and corporate structures. As a result, while the
potential for eventual public support is certainly reduced, it may still not be
eradicated if the powers are not in all instances fully applied. The impact of a failure of a large and complex bank may still be significant.
Structural reform will increase the options available to authorities when
dealing with failing banking groups. By increasing orderly resolution
credibility, it will also improve market discipline and bank balance sheet
dynamics ex ante. | |
| The resolution planning offers a vehicle to
address potential impediments to resolution. However, it is built on judgement
by authorities in individual cases. In the absence of a more clearly structured
corporate group structure, it might be extremely difficult for a supervisory
authority to exercise its discretionary judgment and impose e.g. a divestment of
a part of a large and complex diversified banking group, especially if other
competent authorities are not responding with similarly harsh measures in
comparable cases.[35] All this may explain market perceptions of remaining implicit
subsidies and call for further clarity as regards potential additional
structural measures.[36] | |
| Structural reforms could help the orderly
resolution of TBTF banks. It could make the newly granted powers in BRRD more
effective for TBTF banks, as resolution authorities would deal with separate,
segregated and simpler balance sheets. This would make it easier to monitor and
assess the different entities of a banking group and it expands the range of
options at the disposal of resolution authorities. Additional measures for TBTF
banks would be in line with the BRRD’s proportionality principle. | |
| Structural reform can potentially curtail
contagion by clearly mapping and controlling intra-financial sector exposures.
If left uncontrolled, bail-in may give rise to undue contagion (as bail-in
related losses may create losses and distress at other linked financial
institutions). As a result, the credibility and effectiveness of the bail-in
tool may be hampered. | |
| Ex ante structural reform would also complement
the available preventative powers of the BRRD that imply a more institution-specific
reorganisation of selected banking groups and which have a narrower resolution
objective only. Combining structural reform legislation with the BRRD could
over time lead to a greater alignment between business lines and legal
structures. | |
| Banking Union is meant to reduce the
inappropriate links between sovereigns and their banks. However, by doing so,
implicit subsidies and the corresponding problems of moral hazard, aggressive
balance sheet expansion, and competition distortions discussed in section 2.1.2
become even more prominent. As a result, Member States may be reluctant to
mutualise (future) risks through Banking Union, in the absence of structural
reform and credible orderly resolution mechanisms. Targeting the safety net to
those core banking activities that deserve subsidisation and protection because
they address a market failure reduces the scope of the public safety net and
will be a catalyst for the willingness of EU Member States to push ahead with
Banking Union. | |
| Chapter 4 develops different forms that
structural separation could take. These different reform options are then
assessed and compared in chapter 5. That comparison demonstrates in both
qualitative and quantitative ways that structural reform has value added in
further addressing the problems of TBTF banks. While the exact impact depends
on the specific design of the reform option in question (e.g. range of
activities to be separated, strength of separation), in general structural
reform along the lines outlined in chapter 4 would increase the private cost of
engaging in excessive trading activities of primarily intra-financial nature,
thus leading to a contraction of such activities as banks adjust to the new
reality and hence, other things being equal, a reduction in bank size. It would
thus contribute to a better deployment and allocation of resources towards the
real economy. It would also facilitate the task of resolution authorities,
which in times of stress would imply lower costs related to bank failures. This
would benefit the EU economy, as public finances would no longer need to be imperilled
to support failed banks. Targeting the safety net to those core banking
activities that deserve subsidisation and protection because they address a
market failure reduces the scope of the public safety net. At the same time,
depending on the scope of activities to be separated and strength of
separation, a degree of efficiency might in principle be lost owing to notably
reduced economies of scope (see Annex A9). As stated above, the magnitude of
these benefits and costs depend on the specific reform option chosen. | |
| 2.4.
How would the situation evolve without EU action
(baseline scenario) | |
| As a response to these concerns, several EU
Member States (Germany, France, Belgium and the UK) as well as third countries
(U.S.) have introduced or are currently in the process of introducing
structural reform measures applying to their respective banking sectors. The
reforms in France, Germany, Belgium, the UK and the U.S. all have in common
that they prescribe the separation of selected banking activities from a
deposit taking entity (for banks above certain thresholds in all countries
except the U.S.). Structural reform measures are also under consideration in the
Netherlands (Annex A1). | |
| Given the fundamental freedoms set out in
the Treaty of the Functioning of the European Union (the "TFEU")
divergent national legislation may affect capital movements and establishment
decisions of market participants. Under the freedom to provide services, banks authorised in one Member State can freely provide all banking
services in other Member States. Under the freedom of establishment, banks can
either open a branch or a subsidiary in other Member States. The rights and
obligations linked with the two differ. Branches are legally dependent parts of
the credit institution. As such, they continue to be supervised as a part of the
whole bank by the home Member State supervisory authority. A subsidiary is an
independent legal part – and considered as any other legal entity – and becomes
subject to supervision in the Member State where it is established, which is
thereby considered its 'home'. National structural reforms can accordingly only
apply to institutions that are headquartered in that Member State – and their
branches in other Member States – as well as locally incorporated subsidiaries
of banks from other Member States. Local branches of banks from other Member
States are not affected. | |
| This means that under national structural
reform, banks operating in the same national market would be subject to
different rules depending on whether they are subsidiaries (subject to reform)
or branches (not subject to reform).[37] National reforms accordingly run the risk of becoming ineffective,
if locally incorporated banks were to relocate and branch back in (for local
banks subject to reform) or switch from subsidiary to branch status (for banks
from another Member State).[38] However, the effects could also be more pervasive in the sense that
banks, rather than relocating by legal means, could relocate in "economic"
terms and thus avoid national rules by moving particular activities (by e.g.
booking certain transactions in another part of the banking group located in
another Member State). | |
| Regulatory arbitrage could over time, and
to the extent it became material, compound some of the underlying problems. Divergent
national legislation may also undermine efforts to achieve a single rulebook
applicable throughout the Internal Market. This is a general problem, as the financial
crisis has highlighted that the single financial market does not work optimally
if national legislation is significantly different from one country to the
other. It can also create specific problems regarding supervision, notably for
the future SSM, where the ECB would have to supervise banks subject to
different legislation regarding bank structure, thus undermining the
establishment of a single rulebook within the EU. Divergent legislation would also
make the management of cross-border institutions more difficult and costly,
notably in terms of ensuring compliance with divergent and possibly
inconsistent rules. It would also lead to safety net distortions, as the DGS of
the Member State subject to relocation would face a heavier burden. In sum, if
not all Member States address TBTF banks in a roughly consistent way, not all
relevant TBTF banks would be subject to reform.[39] Moreover, even those banking groups subject to national reforms
would be able to circumvent the rules thanks to the Treaty freedoms, their
existing cross-border network of branches and subsidiaries and their right to
transfer capital and liquidity across EU borders. Conversely, those arbitrage
opportunities would be closed if common rules were to be adopted at EU level. In
sum, addressing TBTF banks in an effective manner requires a coordinated EU
approach (chart 11). | |
| Chart 11: Potential problems and
consequences of uncoordinated national reforms | |
| The default option for this Impact
Assessment is to take no policy action as regards structural bank reform at the
European level. This represents the baseline against which the
incremental impact of structural bank reform options will be evaluated. That
baseline includes the non-structural reform elements of the current reform
agenda, notably CRR/CRD, BRRD and the first two pillars of the Banking Union
(SSM, SRM). The incremental impact will be measured by means of relevant social
benefits and costs of the different reform options (see Chapter 5). | |
| 2.5.
The EU's right to act and justification for
acting | |
| In accordance with the principles of
subsidiarity and proportionality set out in Article 5 of the TFEU, the Union shall act only if and in so far as the objectives of the
proposed action cannot be sufficiently achieved by the Member States, while the
content and form of Union action shall not exceed what is necessary to achieve
the objectives of the Treaties. | |
| In this case, only
EU action can ensure that EU banking groups, many of which operate in several
Member States, are regulated by a common framework for structural reform. If
the EU does not provide a common framework, divergent national legislation have
the potential to distort the Internal Market for the reasons highlighted above.
Uniform rules on bank corporate structure are needed to enhance financial
stability, facilitate the orderly resolution and recovery of the group, enhance
cross-border provision of services and the establishment in other Member
States, and prevent regulatory arbitrage. | |
| Common rules on bank structural reform are
particularly important for an effective Banking Union. Different national rules
would make the task of the ECB in its capacity as a single supervisor
difficult, as it would have to supervise banks subject to different, and
potentially inconsistent, national rules. Similarly, the future SRM would have
to resolve banks subject to potentially different national requirements
regarding their organisational and operational structure. The advantage of
uniform rules are particularly clear for TBTF banks in Banking Union
participating Member States by (1) making supervision easier, by providing for
one set of rules that would over time contributing to simpler and more
transparent group structures with clearer delineation of business lines; (2)
facilitating the task of the Single Resolution Mechanism; and, (3) limiting the
risks to be insured by a future EU DGS subject to risk mutualisation (and hence
increased implicit subsidies). | |
| The objective of an EU initiative on
structural reform would be to adopt uniform measures which have as their objective
the establishment and functioning of the Internal Market in financial services.
The appropriate legal basis is Article 114 of the TFEU. Article 114 leaves the
choice of legal instrument open (either directive or regulation). The advantage
of using a regulation is that it would be directly applicable to relevant
institutions and create legal certainty as opposed to a directive which would
require national implementing legislation that could well be divergent. With a
regulation institutions would know when and how the rules apply and be ensured
that they apply in a similar fashion to all banks across the EU. A regulation
is particularly important for the SSM and SRM for the reasons elaborated upon
above. | |
| 3.
Objectives of reforming bank structures | |
| The objective of bank structure
reform is to address the problems and underlying problem drivers highlighted in
Chapter 2. To that end, Chapter 3 distinguishes macroeconomic (Section 3.1),
specific or microeconomic objectives (Section 3.2), and operational objectives
(Section 3.3). | |
| 3.1.
General objectives | |
| Reducing the risk of systemic instability
– reducing the risks of banks becoming or wanting to become TBTF, TCTF and TITF: A key objective of structural reform is to make banks that provide
essential services to the real economy more resilient in the event of
endogenous or exogenous shocks but also more resolvable in the event of a
failure, thus reducing the severity of future financial crises. | |
| Reducing Single Market fragmentation: Many of the banks that will be affected by structural reform
legislation operate across borders and seek to benefit from the opportunities
created by the single financial market. A common legislative framework on structural
reform would prevent the fragmentation of the Internal Market and increase the
effectiveness of the future SSM and SRM. | |
| 3.2.
Specific or microeconomic objectives | |
| The objectives of structural reform should
be to address the problems highlighted in chapter 2. Accordingly, the different
options outlined in chapter 4 will be assessed on the extent to which they
achieve the following micro-economic objectives: | |
| (1)
Facilitate bank resolution and recovery; | |
| (2)
Facilitate management, monitoring and
supervision; | |
| (3)
Reduce moral hazard; | |
| (4)
Reduce conflicts of interest, improve bank
culture and standards; | |
| (5)
Reduce capital and resource misallocation; and | |
| (6)
Improve competition. | |
| 3.3.
Operational objectives | |
| On the basis of the above, the operational
objectives of structural reform would be to reduce the magnitude of the
problems currently encountered. The following set of quantifiable operational
objectives would form the base of future evaluations: | |
| (1)
Reduce the size of implicit public subsidies,
i.e. reduce the artificial funding cost advantage of TBTF banks (after
controlling for bank characteristics such as size, risk-taking, etc.); | |
| (2)
Reduce excessive trading by TBTF banks; increase
the lending to non-financial customers as a percentage of total assets. | |
| 4.
Reform options | |
| This
chapter develops the policy options that will be subject to further assessment.
In particular, sections 4.1, 4.2, 4.4, and 4.5 introduce options regarding (i)
the scope of activities to be separated; (ii) the strength of separation; and,
(iii) the institutional scope of separation, and considers the timeline for
implementation. As each of the examined options may lead to a situation whereby
certain banking activities may migrate away from regulated banking groups
towards “shadow banks”, the structural reform options must necessarily be
accompanied by measures improving transparency and data reporting of the shadow
banking activities (section 4.3). | |
| 4.1.
Activities to be separated | |
| The Single Market has brought significant
benefits to EU Member States. It contributes to solid economic growth and
supports employment (ECB (2012)). Integration in the markets for banking and
other financial services is one key element of the Single Market. Among other
benefits, financial integration has contributed to the convergence of and
decline in financing costs for corporations and households and the opening up
of investment and diversification opportunities across Europe. | |
| Financial integration in Europe had
progressed significantly in the years prior to the crisis, in particular in the
wholesale markets. The adoption of the euro and, shortly afterwards, the
Financial Services Action Plan were major milestones in this integration
process. | |
| Financial institutions and banks in
particular have adapted to this new economic reality by expanding in scale,
reach and scope of activities. This has led to the emergence of large financial
"one-stop shops" combining within one entity or group the provision
of a diverse set of services. Moreover, in their quest for economies of scale
and scope, banks have also consolidated; first within national borders, then
beyond. This process has allowed banks both to provide a broader range of
services to their clients, as well as serving clients operating across borders.
This process was particularly pronounced in the EU, given the Single Market and
enshrined treaty freedoms. This has enabled banks to respond to the
increasingly sophisticated needs of their global clients. The financial crisis
has clearly illustrated the impact on financial stability arising from an ever more
global and integrated financial system with ever larger units of financial
service providers. | |
| As a result, the banking activities
undertaken by large EU banking groups today range from retail and commercial
banking (RCB) activities to wholesale and investment banking (WIB) activities.
Examples of RCB activities include, amongst others, insured deposit taking,
lending to households and SMEs, and the provision of payment system services.
Examples of WIB include, amongst others, underwriting, market making, brokerage
services, and proprietary trading. | |
| Notwithstanding the benefits highlighted
above, the financial crisis has clearly illustrated the impact on financial
stability arising from an ever more global and integrated financial system with
ever larger units of financial service providers. Therefore, the basic
rationale of structural reform is to separate certain risky trading activities
in order to facilitate the resolvability of banks and to ensure that these
activities do not endanger bank activities that are regarded as critically
important for the real economy. In the national structural reform efforts to
date, the separation has been applied at different “locations” between and
within the range of RCB and WIB activities. Depending on the strength of
separation and the scope of targeted activities, separation leads to different
degrees of restrictions on some banks’ ability to provide certain services. | |
| Accordingly, concrete options to separate
banking activities logically end up between, at one end of the spectrum, a
narrow trading entity and a correspondingly broad deposit-taking entity and, at
the other end, a broad trading entity and a correspondingly narrow deposit
entity. In the first case, relatively few activities are being separated from
the deposit entity (funded by guaranteed deposits in contrast to the trading
entity), and it accordingly remains relatively free to provide a broad set of trading
and capital market activities. In the latter case, a much broader set of
activities is separated, and the deposit entity is accordingly much more
constrained in the activities it can engage in. | |
| ·
“Narrow” trading entity and “broad” deposit entity: A first polar case is that in which only relatively few trading
activities are being separated from a broad deposit entity, namely those types
of trading activities where traders are speculating on markets using the bank’s
capital and borrowed money, for no purpose other than to make a profit and
without any connection to trading on behalf of customers (i.e., proprietary
trading). Proprietary trading is the purchase and sale of financial instruments
for own account with the intent to profit from subsequent price changes. The
importance of dedicated proprietary trading desks has decreased over time and
currently appears to be of relatively limited importance for many large EU
banking groups. Internal hedge funds are similar in spirit. This would also
involve trading in physical commodities.[40] In this polar case, the set of activities to be separated from the deposit
entity would roughly correspond to the French banking law and the German law
(where the separation largely takes place within the group), as well as the
Volcker rule in the US (where the separation amounts to a prohibition and a
banning of the activity from the group altogether). See Annex A1. | |
| ·
“Medium” trading entity and “medium” deposit
entity: A second case is one in which market making
(and possibly more) is added to the above set of activities to be separated
from the deposit entity. Separating customer-related market-making, proprietary
trading and selected similar activities is roughly aligned with the proposals
made by the HLEG. | |
| In general terms, market making is the purchase
and sale of financial instruments (government bonds, corporate bonds, equities,
derivatives, etc.) for own account at prices defined by the market maker, on
the basis of a commitment to provide market liquidity on a regular and on-going
basis. Market makers provide "immediacy" to clients and investors by
facilitating their requests to buy and sell quickly and, arguably, in a
cost-effective way for them. For example, an investor anxious to sell an asset
relies on a market maker's standing ability to buy the asset for itself
immediately. Likewise, an investor who wishes to buy an asset often can call on
a market maker to sell the asset out of its inventory. By doing so, market
makers can instil greater investor confidence in the functioning of financial
markets and encourage investors to trade confidently. Market making makes up a
significant part of large banking groups' trading revenues. Without market
makers, customers would face higher transaction costs, and security prices
would be more volatile. However, from a legal and economic point of view,
market making (and the securities inventory used to facilitate customer
trading) is difficult to distinguish from proprietary trading, in particular
for “outsiders”. A market maker acquires a position at one price and then lays
off the position over time at an uncertain average price by providing liquidity
to customers. The ultimate goal is to "buy low, sell high". In order
to accomplish this goal on average over many trades, with an acceptable level
of risk for the expected profit, a market maker relies on its expectation of
investors’ needs and the future path of market prices. Although traders
involved in the actual trade are able to identify any given transaction as
being of a market making or proprietary trading nature, such a distinction no
longer is simple from the perspective of an outsider such as a manager,
regulator, supervisor, creditor, or judge. Indeed, a market maker might
legitimately choose to take a long position in an asset either in anticipation
of client demand to allow the order to be fulfilled quickly or to facilitate a
quick sale by a client of an illiquid asset. | |
| While it is possible for institutions other
than banks (such as funds) to take on a similar role to market makers, banks do
have a natural advantage in acting as market makers because of the fact that
banks have a variety of other relationships with the clients who want to make
trades and the fact that acting as a market maker for a security is often a
natural follow-on activity for securities underwritten by the banking group. | |
| The most active market makers in financial
markets today are high frequency traders, many of whom trade as voluntary
market makers with no obligations to maintain markets. According to several
academic studies, high frequency market making is a profitable enterprise and,
more importantly, market quality has improved alongside the growth in
algorithmic trading. These results are frequently interpreted as support for a
structure where participants supply liquidity because it is a profitable and
viable activity on its own (see Anand and Vankatamaran (2013) for a more
in-depth analysis). Several important market makers are not taking any
deposits, suggesting that market making is a viable activity on its own. | |
| ·
“Broad” trading entity and “narrow” deposit entity: This case corresponds to a relatively broad range of activities being
separated from the deposit entity and is one in which all wholesale and
investment banking activities are to be separated. In this stylised option, trading
entities would perform activities such as underwriting[41], advisory services, brokerage services, derivatives transactions, investing,
sponsoring and structuring activities related to certain securitisation
activity[42], in addition to proprietary trading and market making (See Annex A6
for a more elaborate description and assessment of these additional WIB
activities). Separating a broad range of investment banking activities will
result from the UK structural reform. The US also organises banking groups as
bank holding companies that perform core banking activities and other banking
activities through different affiliates. | |
| In determining which activities should be
subject to separation, the Commission services have considered: (i) the extent
to which losses related to an activity would impact a bank’s balance sheet; (ii)
the extent to which an activity gives rise to market or counterparty risk; (iii)
the importance and potential impact of the activity on systemic risk; (iv) the customer-oriented
nature and usefulness of an activity for financing the real economy, and (v)
the extent to which the banking activity resolves a market failure (such as
asymmetric information) in the economy. The application of these criteria
leaves a narrow range of wholesale and investment banking activities that
require further analysis, e.g. proprietary trading, market making, underwriting,
investing, sponsoring and structuring activities related to certain securitisation
activity, and derivatives transactions. The focus on wholesale and investment
bank activity is consistent with the significant increase in trading and
market-based activities, documented in Chapter 2. | |
| There are certain activities, however, that
are critically important for the continuity of a banking group (i.e. the taking
of deposits and provision of retail payment services). Those activities would
under any of the options outlined above always reside with the deposit-taking
entity. | |
| 4.2.
Strength of separation | |
| When determining the strength of
separation, a starting point is to consider three broad forms of separation:
(i) accounting separation; (ii) subsidiarisation; and (iii) ownership
separation, i.e. prohibition of certain business lines. These forms of
separation display a varying degree of severity and intrusiveness in banks’
business structure. They are not mutually exclusive but build on each other.
For example, subsidiarisation presupposes a degree of accounting separation.
Furthermore, subsidiarisation can coexist with prohibition (ownership
separation) of certain activities. | |
| (a)
Accounting separation: The lightest degree of intervention is accounting separation. This
would require banks that provide integrated financial services to make separate
reports for their different business units and make them publicly available. A
certain degree of accounting separation already exists in the EU. Accounting
separation would increase transparency, as it would lead to banks having to put
more information in the public domain, thus in theory facilitating market
monitoring and supervision. However, it would not significantly affect economic
incentives. For example, it would not impose any restrictions on intra-group
legal and economic links, and it is thus unlikely to be sufficient to address
the major policy objective of this exercise. Accordingly, it would not
contribute to addressing the TBTF problem. Even so, while insufficient to
address the main objectives, a degree of stronger separation of accounts by
business lines would, by construction, follow from – and be necessary for –
more ambitious forms of separation. | |
| (b)
Subsidiarisation:
A second form of separation is to require subsidiarisation, i.e. to require
banking groups to separate the activities of different business units into
separate legal entities ("subsidiarisation"). Subsidiarisation could
also require these entities to maintain separate capital structures, i.e. for
the business units to become “ring-fenced” subsidiaries with their own capital
and funding and with rules on how the different subsidiaries deal with each
other (e.g. limits on intra-group capital flows and arm's length pricing). | |
| Importantly,
under subsidiarisation, universal banking groups could continue to provide
their clients with a diverse set of banking services. However, they would have
to structure their group differently with some of the services provided in legal
entities separated from the other parts of the group (“structured universal
banking”). | |
| Subsidiarisation
can take many forms. Under subsidiarisation, there will still be links of
legal, economic, operational and governance nature between the banking group
and the functionally separate legal entities. As a result, choices need to be
made as regards the degree of independence of the subsidiary. More
specifically: | |
| ·
As regards legal separation, one could
limit oneself to requiring the setting-up of a separate legal entity to which
the relevant activities could be separated for banks that fall under the
institutional scope of the regulation. Given the activities under
consideration, that entity would most likely be an investment firm. Or, one
could consider options that would provide a stronger degree of legal separation
by governing also the ownership links between this new entity and the rest of
the group. For example, one could consider rules limiting certain
parent-subsidiary ownership structures (e.g. whereas the group could continue
engaging in a universal set of activities, the trading entity of the group
could not own the group’s deposit bank); or rules prohibiting direct ownership
links between deposit banks and trading entities, thus calling for a group
holding company on top; | |
| ·
As regards economic separation, the
separate legal entity would normally have to respect the CRD/CRR requirements
related to capital, liquidity, leverage, and large exposures on an individual
basis. To provide a stronger degree of economic separation, further rules could
be considered for the relations between the separated entities and other group
entities, such that intra-group transactions could be on arm's length basis;
whether certain restrictions on exposures, funding pattern and activities
should be introduced to further isolate the deposit taking entity from
(international and financial-system originated) shocks. In addition, one could
consider whether the subsidiary would have to raise funds separately; | |
| ·
As regards governance separation, one
could consider the degree of independence of the board of the separated
entities (e.g. degree to which directors should be independent from rest of
group), as well as whether or not the separated entities should have their own
risk management structures even if currently reserved for “significant”
institutions by CRD. Also one could require the management body to uphold the
objectives of structural reform; | |
| ·
As regards operational separation, one
could consider the degree to which infrastructure related to payment systems
and IT and data could be shared among group entities, or whether it would also
need to be separated. | |
| The reforms
pursued to date have chosen different combinations along these separation dimensions,
even though there is a large degree of complementarity (see Annex A1). | |
| (c)
Ownership separation: The most intrusive degree of structural intervention is ownership
separation. Under this form of separation, there would be separate ultimate
ownership of assets supporting different activities. Accordingly, those
services would have to be provided by different firms with different owners
that are not in any way affiliated with each other. | |
| This was the
approach followed by the 1933 Glass-Steagall Act.[43] The justifications for this strong type of separation were to: (i)
prevent inherent conflicts of interest; (ii) reduce the financial power of
depository institutions; (iii) reduce depository institutions' ability to
engage in risky securities activities; and (iv) prevent managers of depository
institutions – focused on prudence – to enter markets that are focused on
risk-taking. | |
| For the reasons stated under point A)
above, accounting separation will not be subjected to further assessment in
this Impact Assessment. | |
| Three degrees of separation will be subject
to consideration in the remainder of this Impact Assessment, two based on
different forms of subsidiarisation (given the wide range of specific
subsidiarisation rules) and one based on ownership separation. A first separation
option would contain a limited degree of subsidiarisation in legal and economic
terms. It would require the creation of a separate legal entity, but would
limit itself to the degree of economic and governance separation that currently
follows automatically from such an obligation. A second “moderate separation”
option would include an additional, stricter degree of legal, economic, and
governance separation, whereas a final “complete separation” option would be
equivalent to full ownership separation, as described above, i.e. effective
prohibition of certain activities. More specifically: | |
| (1)
Subsidiarisation with intra-group links
restricted according to current rules (“SUB”): in
terms of legal separation, this option would require a separate legal entity.
In terms of economic separation, it would restrict itself to the economic and
governance requirements that currently result from this degree of legal
separation. That entity should be subject to the CRD/CRR prudential
requirements in terms of capital, liquidity, leverage and large exposures on an
individual basis. This would result in a degree of economic and governance
separation, depending on whether these requirements would be waived or not; | |
| (2)
Subsidiarisation with tighter restrictions on
intra-group links (“SUB+”): in order to more
effectively address intra-group funding subsidies, this option would require a
more significant degree of subsidiarisation in legal and/or economic terms. In
terms of legal separation, it may include rules on ownership links between
separated entities within the group. This option may also require a stricter
degree of economic separation, such as separate funding for the two entities.
It also includes stricter economic separation, notably by considering rules on
intra-group relations (e.g. requirements that intra-group transactions be on
third party, commercial terms; ensuring that current large exposure
restrictions are not waived and possibly apply stricter requirements; providing
limits on intra-group guarantees (deposit-taking entity would not support
trading entity); and, stipulating a higher degree of governance separation
(e.g. limits on cross-use of board directors within the group); or | |
| (3)
Ownership separation: under this option, banking groups would not be allowed to engage
in certain activities. They would accordingly have to divest or wind down any
such activities that they currently engage in. | |
| 4.3.
Preventing the risks emanating from shadow
banking | |
| As each of the examined options may lead to
a situation whereby certain banking activities may migrate away from regulated
banking groups towards shadow banks where there may be less scope for control
by supervisors (whether or not located with the EU). To that end, each of these
options must necessarily be accompanied by measures improving transparency and
data reporting of the shadow banking activities. | |
| The work done by the FSB has highlighted
that the disorderly failure of shadow banking entities can carry systemic risk,
both directly and through their interconnectedness, with the regular banking system.
The FSB has also suggested that, as long as such entities remain subject to a
lower level of regulation and supervision than the rest of the financial
sector, reinforced banking regulation could drive a part of banking activities
beyond the boundaries of traditional banking and towards shadow banking. The
European Commission has recently adopted a Communication setting-out a roadmap
for tackling the risks inherent in shadow banking. In line with the 2013 FSB
Recommendations endorsed at the St-Petersburg G20 Summit, the measures foreseen
in this roadmap include, among others, measures aimed at strengthening
transparency and data availability in the shadow banking area. | |
| Because of its size and close links to the
regular banking sector, the shadow banking sector poses a systemic risk. The
first factor is size. The latest studies indicate that the aggregate shadow
banking assets are about half the size of the regulated banking system. Despite
the fact that shadow banking assets have decreased slightly since 2008, the
global figure at the end of 2012 was €53 trillion[44]. In terms of geographical distribution, the biggest share is
concentrated in the United States (around €19.3 trillion) and in Europe
(Eurozone with €16.3 trillion and the United Kingdom with around €6.7
trillion). The second factor which increases risks is the high level of
interconnectedness between the shadow banking system and the regulated sector,
particularly the regulated banking system. Any weakness that is mismanaged or
the destabilisation of an important factor in the shadow banking system could
trigger a wave of contagion that would affect the sectors subject to the
highest prudential standards. | |
| To prevent that banks shift parts of their
activity in the less regulated shadow banking sector, it is necessary to ensure
that any structural separation measure be accompanied by measures improving the
transparency of shadow banking. Due to their size and close links with the
banking sector securities financing transactions (SFTs) such as repurchase
agreements, securities lending, other equivalent financing structures and
re-hypothecation are a particularly relevant issue to address. SFTs display structural similarities with banking activities as they
can lead to maturity and liquidity transformation and increased leverage,
including short-term financing of longer-term assets. | |
| As explained in detail
in Annex A13, when assessing the transparency of the SFTs markets and
rehypothecation, three main themes emerge: (1) the monitoring of the build-up
of systemic risks related to SFT transactions in the financial system; (2) the
disclosure of the information on such transactions to the investors whose
assets are employed in these transactions; and (3) reducing the uncertainty
about the extent to which assets have been rehypothecated. EU regulatory
authorities lack the necessary data to better monitor the use of SFTs and the
risks and the vulnerabilities for the stability of the financial system that
they imply. At the same time the investors are not properly informed whether
and to what extent the investment fund, in which they have invested or plan to
invest in, has encumbered or intends to encumber investment assets by means of
engaging in SFTs and other financing structures that would create additional
risks for the investors. Finally, there is a lack of transparency about the
extent to which clients' and counterparties' assets can be rehypothecated, or
about the risks posed by rehypothecation. | |
| Because the risks resulting from a
migration from the banking sector toward the shadow banking sector are not
directly related to the decision that is retained as regards the degree of the
structural separation, the options aimed at increasing the transparency of the
shadow banking sector will be assessed separately. The assessment of the
impacts for the structural separation is not linked to the assessment of the
impacts for the shadow banking transparency, and inversely. However every
decision that is taken on the structural separation aspect will have an impact
on the shadow banking sector, therefore Annex A13 analyses the potential
response to that threat for the financial stability. | |
| The following section presents the nine
reform options for the structural separation whereas the Annex A13 presents and
assesses the potential options aimed at increasing the transparency of SFTs.
For each of the three main themes that have been identified, a series of policy
options have been identified and assessed. The reform options on the structural
separation are aimed at credit institutions whereas the options on shadow
banking are aimed at each financial counterparty that performs SFT activity.
This difference in scope is necessary because the entities acting in the shadow
banking universe are diverse in nature. A targeted approach would not have
achieved a level playing field between all actors. | |
| These elements will notably allow
supervisors to better identify interconnectedness between deposit taking
entities and some shadow banking entities and will shed more light on some of
their funding operations. It will also allow both market participants and
supervisors to better evaluate possible risk exposures of shadow baking
entities, leading to better-informed investment decisions by the former and
better-targeted and timely actions by the latter. Annex A13 provides for
details about the impact of introducing more transparency in securities
financing transactions. | |
| 4.4.
Structural reform options | |
| The combination of the different range of
trading and capital markets activities to be separated and strengths of
separation (see sections 4.1 and 4.2) yields nine stylised reform options, as
visualised in matrix form in Table 2. In the remainder of this Impact
Assessment, we will refer to the different reform options, according to the
labels in Table 2 (reform option A, reform option B, etc.). To the extent
possible and for illustration purposes only, the Commission services have
mapped the different national and expert group structural reform proposals and/or
legislative initiatives into the matrix of stylised reform options. See also
Annex A1 for a more elaborate discussion of these reform initiatives. | |
| Table 2: Overview of options | |
| Activities strength || Functional separation 1 (SUB) Current requirements || Functional separation 2 (SUB+) Stricter requirements || Ownership separation Ownership separation | |
| Narrow trading entity/ broad deposit entity E.g. Proprietary trading + exposures to HF (PT ) || Option A || Option B [≈ FR, DE baseline, BE] || Option C [≈ US Volcker] | |
| Medium trading entity/ medium deposit entity E.g. PT + market-making (MM) || Option D || Option E [≈ HLEG; ≈ FR, DE if wider separation activated] || Option F | |
| Broad trading entity/ narrow deposit entity E.g. all investment banking activities || Option G || Option H [≈ US BHC; ≈ UK] || Option I [≈ Glass-Steagall] | |
| The reform options listed in the first
column (A, D and G) all have in common that they require setting up separate
subsidiaries for trading and deposit entities (“subsidiarisation” requirement) without
strengthening the regulatory rules and requirements that are currently in
place. The effectiveness of all three of these options thus depends on whether
the social benefits are effectively achieved with a separation according to
current rules. However, under current rules and regulations, some of the above
prudential requirements can be waived in certain circumstances, notably upon
approval from the domestic supervisor. Moreover, the current regulatory
framework does not regulate legal, economic and governance links and
interconnections between separate entities within a group to a significant
extent. For example, large exposure rules for intra-group entities are optional
(can be waived) and Member States have discretion on their level. Implicit public subsidies arising from the public safety net could
accordingly continue to flow freely within integrated groups. Taken together,
these options have a very limited effectiveness. The
Commission services will therefore not further assess these reform options. | |
| Selected structural reform initiatives have
been mapped into Table 2 for illustration purposes only and according to the
understanding of Commission Services of the latest proposals and (draft) laws. The
conceptual mapping inevitably is a simplification of reality. National
initiatives differ from the stylised options and the mapping does not
necessarily do justice to the different national initiatives. See Annex A1 for
more details on the respective national initiatives. | |
| 4.5.
Issues related to implementation | |
| The social benefits and costs of the options
outlined in table 2 will be compared against each other and against the “no
policy change” scenario in the next chapter. Irrespective of the preferred
options that will arise as a result of that comparison, there are three more
specific implementation issues that need to be addressed in any structural
reform option. The first implementation issue concerns the scope of banks that
would be subject to structural reform. The second implementation issue concerns
the role of supervisors in structural reform implementation, and the third
implementation issue relates to the structural reform implementation timeline. | |
| 4.5.1.
Institutional scope | |
| Irrespective of choices related to
activities and strength, given the focus on TBTF banks identified in chapter 2,
a structural reform initiative in principle targets large banks only. Hence, it
only applies to a small subset of the more than 8000 banks incorporated in the
EU. It would in particular not concern the vast majority of local and regional
banks, such as small cooperative and savings banks, which put relatively large
proportions of their balance sheet at risk to serve the local real economy as
well as the banks that primarily focus on customer-related lending. The latter
banks are more likely to be resolvable than larger and more trading intensive
and interconnected banks. | |
| In light of the focus on TBTF banks, an
approach should be found to limit the scope for structural reform to banks that
either are very large and/or engage in significant trading activity. To that
effect, the HLEG recommended that only banks with significant trading
activities should be subject to structural separation. However, the definition
of trading activities underpinning the thresholds recommended by the HLEG,
which is based on the aggregation of broad accounting categories and includes
available for sale assets, has been criticised for being a poor proxy of risky
trading activities. | |
| Many financial institutions, as well as public
authorities, that responded to the Commission’s public consultation about the
options considered in this Impact Assessment also favoured the use of a risk-based
threshold to determine the appropriate scope of banks for structural
reform (See annex A2). Under a risk-based approach, the threshold would be
based on a measure of banks’ trading risk. A risk-based threshold would
accordingly have the benefit of clearly linking structural separation to
existing measures of the risk associated with trading. The most logical source
for such a risk-based threshold would be the risk-weighted assets for market
and counterparty credit risk, as these are the prudential measure of banks’
trading books. However, such a risk-based approach has certain drawbacks. First,
risk-weighted data is not always publicly available. In the absence of
verifiable and consistent public data, the delineation of the appropriate
threshold and hence scope becomes less transparent. Second, there are concerns
about risk-based approaches that would rely on risk weighted assets given the
reported inconsistencies between banks when presented identical stylised
portfolios of assets. Furthermore, both European and international standard
setters are currently reviewing the RWA approach. Both concerns led the HLEG to
reject using such measures for threshold and initial scope delineation purposes. | |
| Another alternative is to apply structural
separation to banks that are designated as systemically important by
competent authorities. This was also highlighted as an alternative by some
respondents to the stakeholder consultation. This approach would have the advantage
of linking separation to one of the main drivers of implicit public subsidies.
It also has the operational advantage of linking it to a readily available
measure of systemic risk that has been translated into European law by the
CRDIV. Moreover, analysis by the Commission services (Annex A8) indicates that
nearly all banks that are of global systemic importance engage in significant
trading activity. However, the systemic risk measure may not be a perfect proxy
for significant levels of trading activities, as the analysis carried out by
the Commission services also highlight that banks beyond the current G-SII list
engage in significant trading activity. So, whereas the list of G-SII may be
useful as a starting point, it may not necessarily include all banking groups
that may require closer scrutiny. Also, while the provisions related to
systemically important institutions have been laid down in the CRDIV, the
definitive list of G-SIIs has not yet been finalised. Accordingly, using this
approach as a sole base for determining the banks subject to separation would
not yield clarity in the short term. | |
| For the above reasons, the Commission
services on balance recommend retaining the HLEG recommendation for an accounting-based
approach. It is likely to be more effective than
the other two alternatives referred to immediately above. It would be
transparent and would provide for a higher degree of legal certainty for banks
and market participants as regards the scope of banks subject to structural
reform. While the Commission services do not consider
risk-weighted assets to be an appropriate base for setting the institutional
scope, they consider that the systemically important institution-approach
should be included explicitly in the sample of banking groups that require
further examination. Thresholds should further identify banks with significant
trading activities. Accordingly, in addition to banks designated as G-SIIs
should, banks that are captured by the accounting-based trading activity
threshold, in principle should be subject to the provisions of the reform.. | |
| The Commission services have therefore
assessed and reviewed the recommendations of the HLEG with a view to consider
in particular the suggested examination threshold levels and definition of
trading activity to be taken into account (see Annex A8). The Commission
services have assessed four options in that respect: | |
| (1)
Using the HLEG definition (Assets held for
trading and available for sale); | |
| (2)
A more narrow definition that account for the
current reform agenda by excluding securities held for liquidity purposes under
Basel III, and/or a share of derivative assets that are likely to become cleared
by Central Counterparties (CCPs); | |
| (3)
A definition focused on the gross volume of
trading activities, as this is likely to focus on proprietary traders and
market-makers; or | |
| (4)
A definition focused on net volumes, which is
likely to only capture those that have a higher share of unbalanced risk
trading (proprietary traders). | |
| Preference for either of these approaches
accordingly depends on which of the reform option outlined in Table 2 is being pursued.
The assessment of the reform options carried out in Chapter 5 is accordingly
done on the assumption that any structural reform would apply to a limited
subset of TBTF banks only. A comparison of the alternatives for a threshold
stated above will accordingly be carried out following the comparison of the
options in Table 2. | |
| 4.5.2.
Role of supervisors | |
| Irrespective of the choice of threshold, a
separate issue is whether supervisors should retain some discretion in
reviewing the scope of institutions, the activities subject to potential
separation as well as whether separation would need to materialise. As regards
the institutional scope, any threshold may not always capture the right
institutions. As regards the activity scope, there may be a case for allowing
flexibility for supervisors in how to address particular activities in light of
e.g. local market circumstances (e.g. market-making provisions by banks may be
regarded as more useful where public markets are particularly illiquid). Finally,
as regards the decision of whether separation would automatically materialise, specific
characteristics of banks may be such that the objectives of structural reform
are not put at risk or that diseconomies of scale and scope do not arise.
Therefore supervisors may want to exempt them from separation requirements. There
is therefore an a priori case for a degree of supervisory discretion. | |
| However, this needs to be constrained for
both practical and legal reasons. First, structural separation decisions go
beyond simple prudential matters and ultimately reflect societal and economic
choices as regards the reach of the public safety net. Such policy decisions
accordingly need to be taken at political level. Second, supervisory discretion
cannot be unlimited if the intention is to ensure consistent outcomes across
the Internal Market. Third, unconstrained supervisory discretion reduces legal
certainty. For all those reasons, structural separation decisions should be
anchored at political level with only a degree of carefully framed powers
granted to supervisors. | |
| The ways of designing and framing
supervisory powers will be assessed after the comparison of the different reform
options as outlined in Table 2. | |
| 4.5.3.
Timeline for implementation | |
| The HLEG called on the Commission to
consider a sufficiently long implementation and transition period. There are a
number of rationales for considering the time dimension. First, structural
separation, no matter how beneficial to society, will yield private costs. Imposing
restrictions on the structure of a banking group will by construction limit
bank flexibility to freely allocate capital and liquidity within the banking
group. Moreover, improved market discipline and more credible resolution will
get reflected in higher funding costs at unchanged balance sheet size, in
particular for the trading entity. To the extent that bank shareholders and/or
bank employees do not shoulder this cost, banks may pass the costs on to borrowers
or may not provide the activity at all, which in principle could reduce economic
growth depending on whether other alternative actors step in (see section 5.2
for a more in-depth discussion of the social costs and benefits of structural
reform). Furthermore, the transfer of existing assets and liabilities to a
potentially new separate legal entity requires time and involves one-off costs,
the level of which would depend on the timeline available for implementation. The
implementation will also depend on the role of supervisors in reviewing the
scope of institutions as well as the activities subject to potential
separation. Finally, the EU has adopted or will soon adopt several initiatives
in related areas, including Basel III, BRRD and the SRM that will not become
fully applicable until 2018 or 2019. Accordingly, in order to allow
institutions subject to these related legislative initiatives to implement them
in a coordinated manner and to gradually absorb related transition costs, it is
appropriate to provide for a similar transition period to implement a future
structural reform initiative. The latter should not become applicable before 2019. | |
| 5.
Impact and comparison of reform options | |
| The previous chapters list the problems
with respect to the current corporate structure of the large, complex and
trading-intensive EU banking groups (Chapter 2), describe the corresponding
objectives of structural bank reform in trying to resolve the identified
problems (Chapter 3), and outline the range of policy options under
consideration to achieve the stated objectives (Chapter 4). | |
| This chapter assesses and compares in
qualitative terms the relevant reform options under consideration (the two last
columns of Table 2). The chapter should allow understanding the rationale,
objectives and viability of the preferred structural reform options. The
benefits and costs of the different structural reform options will be compared,
qualitatively and where possible quantitatively. | |
| Stakeholder views on different reform
options will be considered, bearing in mind the clear divergence of opinion between
the responses of the banks on the one hand (against any separation and
especially any option going beyond separating proprietary trading) and consumer
associations and individuals on the other hand (in favour of full ownership
separation, and strong subsidiarisation of all wholesale and investment bank
activities as second best) highlighted above and beyond those generally held
views, the limited degree of more detailed views on different reform options. | |
| Section 5.1 presents the different criteria
used to assess and compare the different reform options' effectiveness, efficiency,
and coherence). Section 5.2 discusses the different benefits and costs used to assess
and compare the different bank reform options according to the retained
assessment criteria. It also stresses that the assessment needs to consider
social, rather than private, costs and benefits. Section 5.3 assesses the
options based on subsidiarisation according to strict rules (options B, E and H
of Table 2); and section 5.4 assesses and compares the reform options related
to ownership separation (options C, F and I of Table 2). The assessment in
these two sections leads to most options being discarded and a limited number being
retained for further assessment and comparison. Section 5.5 assesses the
retained options against each other and suggests possibilities to further
increase their effectiveness and efficiency. 5.6 discusses the retained options
aimed at increasing the transparency of shadow banking. Section 5.7 discusses complementary
aspects related to (i) the quantitative estimation of costs and benefits and
its difficulties, (ii) international aspects such as territorial scope and
impact on international competitiveness, and (iii) institutional scope aspects
such as thresholds and the role of supervisors. Section 5.8 further discusses the
qualitative impact on the different stakeholder groups of implementing the
preferred reform options and responds to arguments raised against structural
bank reform. | |
| 5.1.
Comparison criteria | |
| Three key criteria are applied for the
purpose of comparing the different reform options within this Impact Assessment. | |
| (1)
“Effectiveness”
measures the extent to which the specific or microeconomic reform objectives
are being met, i.e. the extent to which social benefits, i.e. benefits to
society as a whole, are achieved, notably facilitated resolution and recovery
in the bad times, facilitated management, monitoring and supervision in the
good times, reduced moral hazard, reduced conflicts of interest, reduced
capital and resource misallocation and reduced trading culture contamination
across the banking group, and improved competition (see section 3.2); | |
| (2)
“Efficiency”
assesses the social costs, i.e. costs to society as a whole, incurred when
implementing the respective reform options (mainly foregone economies of scope);
and | |
| (3)
“Coherence” measures
the alignment of the reform options with the Commission’s overall policy
objectives in general and the degree to which they are complementary to
on-going banking reforms. | |
| In the remainder of this Impact Assessment,
greater social benefits should be taken to imply greater effectiveness, and
vice versa. Greater social costs in turn will imply lower efficiency. Structural
reform needs to effectively and efficiently target and address the root
problems in the corporate structure of large, interconnected, complex, and
trading-intensive banking groups, to the extent that the latter remain TBTF,
even after taking into consideration other complementary regulatory measures. As
regards the third “coherence”
criterion, the Commission services take the view
that the objectives and impact of all options considered are consistent with and
supportive of the broad EU policy agenda and the relevant policy initiatives of
the financial reform agenda, and thus in general fulfil the conditions for
coherence (see e.g. section 2.3 and Annex A3 as regards complementarity with
other policy initiatives in the field of banking). Consequently, this criterion
has not been part of the initial assessment of the relevant reform options (sections
5.3 and 5.4). However, the extent to which the implementation of the retained
options would rely on supervisory judgement may have an impact on the degree of
coherence with broad policy objectives (e.g. the need for a single rulebook,
the need to limit the potential for regulatory arbitrage, the desirability of
legal certainty, etc.). The options that have been retained as a result of the
initial analysis and comparison are thus subject to an assessment in terms of
coherence in section 5.5. | |
| 5.2.
Social versus private benefits and costs | |
| When analysing the impact of structural
reform, it is important to distinguish “private” (i.e. stakeholder-specific) benefits
and costs from “social” benefits and costs (i.e. benefits and costs for society
as a whole).[45] Whereas private costs and benefits focus on the impact on banks,
bank shareholders, bank employees, or the EU banking sector, the latter is
broader in scope and targets total or aggregate welfare more generally by incorporating
the impact on all stakeholders in society, including bank customers (e.g. depositors,
borrowers and consumers of financial services), bank creditors, and taxpayers (i.e.
the public finances of governments). | |
| Structural reform is expected to result in
increased private funding costs for the banking group, in particular for the
trading entity which is being separated from the deposit entity and hence no
longer benefits to the same extent from being implicitly linked to the public
safety net. Those funding costs are recurrent private costs. However, they do
not necessarily result in any social cost, as the increased funding cost merely
reflects the shift of bank risk and contingent liability away from the
taxpayer and toward the unsecured debt bank creditors that should, in
principle, bear the risk (and be properly remunerated for being exposed to it).
The increased private funding cost for the bank reflects and is being offset by
a decreased (implicit) public subsidy to the benefit of taxpayers. In sum, the
increase in the private funding cost due to the removal of the implicit public subsidy
should not be considered as a social cost.[46] | |
| 5.2.1.
Social benefits | |
| The social benefits retained in this Impact
Assessment correspond to the microeconomic objectives of the structural reform:
facilitate resolution and recovery in the bad times, facilitate management,
monitoring and supervision in the good times, reduce moral hazard, reduce
conflicts of interest, reduce capital and resource misallocation, and improved
competition. | |
| With respect to the latter, evidence
suggests that competition in the internal market can be distorted as i) larger
banks and ii) banks headquartered in countries with a strong sovereign rating
are more likely to benefit from implicit public subsidies (see Annex A4.1 and
A4.2). Structural reform can therefore contribute towards restoring a level
playing field across small and large banks and across EU Member States. | |
| Social benefits are not only static.
Dynamic social benefits are also important, as reduced moral hazard also reduces
aggressive balance sheet expansion. Structural reform aims to reduce the undue
or artificial promotion or subsidisation of specific excessively risky
activities, in particular those that are scalable and transactions-oriented, as
opposed to relationship-oriented. Hence, the private cost increase may
negatively affect specific banking activities, which is welcome and desirable
(despite a corresponding funding cost increase) to the extent that these
activities, on balance, have a negative impact on the real economy and society
as a whole. | |
| 5.2.2.
Social costs | |
| The costs to society of structural reform
need to be defined carefully. They will mainly consist in reduced genuine
economies of scale and scope and increased supervisory costs to monitor and
implement the reform. | |
| It cannot be excluded that structural
reform will give rise to the loss of genuine scale and scope economies. Combining
different activities within one institution may give rise to genuine economies
of scope related to risk diversification, revenue economies of scope, and cost
economies of scope. There may also be genuine economies of scale as an
increased scale may allow spreading fixed costs which can reduce average costs.
However, economies of scale are activity-specific and are likely to be
relatively small given that only large banks would be subject to structural
reform and that empirical evidence on economies of scale for large banks is
weak (see Annex A9 for a literature review). There could be however some
genuine economies of scope. For example, as explained in chapter 4, integrated banks
do have a natural advantage in acting as market makers because of the fact that
banks have a variety of other relationships with the clients who want to make
trades and the fact that acting as a market maker for a security is often a
natural follow-on activity for securities underwritten by the banking group.
This may allow integrated banks to perform this activity more efficiently than
other market players, thus better serving clients and/or contributing to
enhancing market liquidity. This can lead to some recurrent private costs. Such
effects should be weighed against potential benefits that could flow from
structural separation, as discussed elsewhere in this Impact Assessment. | |
| Related to the notion of risk
diversification and economies of scope are also the regulatory capital
compliance costs. Regulatory capital compliance costs refer to the fact that
banking groups are under an obligation to separate capital to comply with
regulatory requirements on an individual and consolidated basis. As a result banking
groups are expected to need to hold more capital in the aggregate than without
separation, as diversification across activities may reduce the capital needed
to meet capital requirements, which represents a loss of economies of scope. This
is a recurrent private cost. | |
| Operational costs are costs that banking
groups incur from having to operate through separate subsidiaries. Operating with
separate stand-alone management boards will be operationally more costly than
operating through a single management board. Administrative systems may also
have to be separated. These operational costs are recurrent or equilibrium
costs. Operational costs as defined
above refer to costs borne by banks. | |
| In the remainder of this Impact Assessment,
implementation costs will refer to costs borne by regulators and supervisors when
writing up and monitoring the compliance of banks with the new regulatory
framework on an on-going basis. | |
| There may also be additional transitional
or one-off costs related to the setting up of the new legal entities, related
to transfers, sales or the winding down of business units, client migration,
and corresponding administrative structure changes. | |
| On the other hand, at least some economies
of scale and scope may get exhausted when a bank reaches a certain level of
assets. Diseconomies of scale such as complexity, conflicts of interest, increased
private or systemic risk may dominate. In any case, economies of scale and
scope should be evaluated after correcting for the funding advantage that
arises from banks being TBTF. After such correction, the literature suggests
that economies of scale and scope are exhausted at relatively low levels of
bank balance sheet size.[47] Those levels are significantly lower than the balance sheet size of
the vast majority of banks that would exceed the threshold levels considered
for the potential application of structural separation (section 5.7.3.1).[48] | |
| In sum, the literature suggests that
genuine foregone synergies between relationship banking and trading activities
are exhausted at a fraction of the balance sheet size for some affected banking
groups. From a private cost perspective however, funding cost increases will be
unavoidable for the trading entity at unchanged balance sheet size and in fact reflect
the objective of structural reform to reduce implicit public subsidies for
certain trading activities (increased market discipline, reduced competition
distortions, no artificial balance sheet growth). Operational costs will be
inevitable as well, but seem modest in comparison to the other costs and in
comparison to the social benefits. Regulatory capital compliance costs should
also not be exaggerated given the strong international push for more and better
capital and the recent academic literature (Admati and Hellwig (2013)). | |
| 5.2.3.
The impact on economic growth of reducing implicit
public subsidies | |
| Most, if not all, banking activities are
valuable and useful to the real economy. But, just like most activities in a
market economy, many should not be promoted or subsidised by the taxpayer
unless there is an appropriate justification. | |
| Subsidising an activity is a form of
government intervention that is justified if it directly addresses a genuine
market failure, such as when the activity resolves an information asymmetry
(e.g. funding SMEs), avoids negative externalities (e.g. avoiding financial
instability), provides a public good (e.g. market liquidity or financial
stability) or addresses a market power concern (e.g. due to switching costs or
network effects). | |
| It has been argued above that the increased
funding costs are the mirror image of reduced implicit public subsidies for the
bank. The literature review on implicit public subsidies in Annex A4.1 and
related own research in Annex A4.2 concludes that implicit public subsidies are
in particular enjoyed by larger banks and are significant compared to their
annual profitability. | |
| Is lowering these subsidies justified and
would economic growth be affected? To answer this question, it is necessary to
determine to what extent the activities that benefit from these implicit public
subsidies address genuine market failures, are underprovided, or are not
overprovided due to excessive subsidies. Some activities may justify being
subsidised but may exceed the optimal level. | |
| At one extreme, there is lending to
households and SMEs funded by deposits, where regulatory intervention in the
form of explicit deposit insurance is warranted to avoid bank runs. At the
other extreme, proprietary trading is a banking activity that is not
customer-oriented or related to another core banking function, but only aims at
generating profits for the bank. Therefore, it seems hard to justify that implicit
public subsidies are channelled toward such activities by allowing
deposit-taking banks to perform such activities. | |
| In between, there may be more ambiguous cases.
One example is activities related to secondary trading of sovereign debt (e.g.
market-making). The potential reduction of market liquidity in secondary
markets may to some extent depress primary market government bond prices. The
risk of a corresponding yield increase, however limited in comparison to
government bond yield levels, may not be desirable at this current juncture.
Accordingly, when separating a particular activity, exemptions for sovereign bonds
could be considered in light of this uncertainty. Such an exemption would be consistent
with the zero risk weight currently assigned to sovereign bonds in the CRDIV. At
the same time, an exemption could lead to distortions (e.g. crowding out of private
debt issuance), would increase concerns with respect to the accumulation of sovereign
debt risks, and the zero risk weight for sovereign bonds is currently under
discussion. Given the uncertainty concerning the market response in terms of
liquidity and sovereign bond yields, this impact assessment does not propose
specific recommendations on this matter that involves a large degree of
political judgement. See also section 5.8 for further discussion of the
potential impact of structural reform proposals on market liquidity more
generally. | |
| 5.3.
Assessment of reform options based on
subsidiarisation according to stricter rules | |
| Options B, E and H (column 2 in Table 2)
are reform options that roughly correspond to reforms
currently being pursued by EU Member States or being recommended by the HLEG. | |
| As regards strength of separation, these
options would all foresee additional restrictions being imposed on the
economic, legal, and operational linkages between the deposit and trading
(sub-consolidated) entities to ensure the integrity and effectiveness of the
separation.[49]
The restrictions aim to effectively address intra-group funding subsidies. In
terms of legal separation, it includes restrictions on ownership links between
separated entities within the group. This would provide for a stricter degree
of economic separation (e.g. separate funding). Irrespectively, this includes
stricter economic separation in its own right, notably by considering rules on
intra-group relations (e.g. requirements that intra-group transactions be on
third party, commercial terms; ensuring that current large exposure
restrictions are also imposed intra-group and possibly applying stricter
requirements for large exposures of deposit entities; providing limits on
intra-group guarantees (deposit-taking entity would not support trading
entity), and stipulating a higher degree of governance separation (e.g. limits
on cross-membership of board directors within the group). | |
| In terms of scope of activities, the reform
options differ: | |
| ·
Reform option B foresees
the mandatory separate subsidiarisation of proprietary trading and
bank-internal hedge funds within a banking group; | |
| ·
Reform option E foresees
the mandatory separate subsidiarisation of a larger set of trading activities
within a banking group, notably proprietary trading (including bank-internal
hedge funds), market making, investing, sponsoring, and structuring activities
related to “complex securitisation”[50],
and structuring, arranging or execution of “complex derivative transactions”[51]. However, subject to
supervisory approval, the deposit entity would under this option still be allowed
to engage in amongst others underwriting[52],
investing, sponsoring, and structuring activities related to “simple
securitisation”, lending to large corporates, and maintaining exposure to
private equity or venture capital funds. The latter activities may be
underprovided from a social point of view if they are no longer allowed to
benefit from the implicit state support and are more of a relationship-oriented
nature. They accordingly do not raise similar concerns with respect to
introducing a trading culture within the deposit entity. Furthermore, these
activities may be of greater importance to the real economy and their separation
would accordingly come with a degree of cost to society. Proprietary trading,
market making, and complex securitisation, and complex derivatives are more
easily scalable and more transaction-oriented in nature; | |
| ·
Reform option H requires the subsidiarisation of
all wholesale and investment banking activities. | |
| Stakeholder views differ on the merits of these
reform options. According to the responses from consumer associations and
individuals, this degree of separation could be acceptable, provided that it
includes a sufficiently broad range of activities. According to those
responses, option E would be the minimum acceptable reform option to be
effective. Support is to some extent echoed by some institutional investors
that call for separation so as to address excessive risk-taking and reduce moral
hazard. Bank respondents, on the other hand, highlight the costs in terms of
foregone efficiency associated notably with subsidiarising a broader activity
range such as in options E and H. Bank respondents, as well as corporate respondents,
also argue that market-making in their view is a socially useful activity, the
provision of which may be hampered by reform along the lines of E or H. | |
| 5.3.1.
Social benefits | |
| Options B, E and H are likely to be
effective in facilitating resolvability and monitoring, reducing moral hazard,
reducing conflicts of interest, reducing resource and capital and resource
misallocation, and improving competition, albeit to different degrees and
depending on the specific subsidiarisation rules. | |
| 5.3.1.1.
Facilitate recovery and resolution | |
| In terms of resolvability, subsidiarisation
into a simpler group structure with further restrictions to separate the different entities should facilitate the assessment
and allocation of losses, while making constituent entities that fail smaller
and provide authorities with additional options to orderly resolve parts of or
entire banking groups. It should enhance the credibility of the application of
any resolution tool, and hence of the process of orderly resolution of failing
banking groups | |
| Separating proprietary trading, market
making, complex securitisation activity, and complex derivative activity all facilitate
recovery and resolution in the bad times for the following reasons. | |
| Proprietary trading potentially gives rise
to large open positions subject to market risk and counterparty risk (risk that
the counterparty to the investment will fail to pay) as well as
interconnectedness between institutions. Conversely, having to unwind less
large open positions and not being interconnected with other banking groups to
the same extent will facilitate the recovery and resolution of the deposit entities.
The potential opaqueness, complexity and interconnectivity of proprietary
trading represent important impediments to orderly and swift resolution. Following
separation the balance sheet of the trading entity is also expected to shrink
as the risks associated with its activities are fully priced. This will induce
better market discipline and reduce resolvability impediments. | |
| Note that the impact of subsidiarising proprietary
trading on the resolvability of the bank may currently be relatively limited as
most banks claim that they do not engage in proprietary trading to any
significant extent. However, evidence suggests that the extent of proprietary
trading activities has gone down substantially since the start of the crisis.[53] Absent specific restrictions on proprietary trading activities
there is no safeguard that would prevent banks from expanding such risky
activities in the (near) future. Moreover, the limited data that does exist
typically tend to measure only dedicated proprietary trading desk activity.[54] | |
| Individual trading positions are treated
the same way in resolution whether they result from client-driven market making
or proprietary trading. Given the relative importance of market making and the
quantity of positions needed to be resolved, and given the fact that market
makers are typically interconnected with other large banking groups, a
separation of market making activities could also have significant social
benefits in terms of facilitating resolvability. | |
| Complex forms of securitisation and
derivatives allow for opaqueness and complexity which impede swift resolution
and recovery. Complex securitisation also allows for significant growth in
short-term debt between financial intermediaries and leads to financial
intermediaries becoming intertwined. | |
| The stricter the rules on subsidiarisation,
the more resolution and recovery will be facilitated as the separated trading
entity will have been run and organised on a more autonomous basis. This
provides authorities with more options for swift and orderly resolution in a
scenario in which parts of the group (or the group as a whole) need to be
resolved. Moreover, the relevant trading activities would not be provided on
the same scale as the separated trading entity would be subject to more
effective market discipline. | |
| All three reform options facilitate
resolvability, but options E and H arguably more than option B, given the
limited importance of proprietary trading and the broader activity scope. | |
| Underwriting is not as easily scalable as
pure market making. Given that underwriters typically retain a significant
fraction of issued securities in their inventories and play an active market
making role immediately after the issuance, resolution may be improved by
separating underwriting from deposit taking, as the inventory of relatively
illiquid assets will be smaller. However, underwriting does not give rise to
similar interconnectedness across financial institutions, as is the case with
market making. All in all, underwriting is a more relationship-oriented
activity and less scalable as market making. The additional benefits in terms
of banking group resolvability of moving from option E to option H are hence
limited. | |
| Box 1: Interaction and consistency of structural
reform with the single point of entry and the multiple points of entry
resolution strategies | |
| The BRRD requires banks to submit recovery
and resolution plans to the competent resolution authority. The FSB guidance,
published in July 2012, indicates that large global banks will be forced to
choose between two “resolution mechanisms”, which will dictate how they
restructure themselves and ensure that crucial banking functions – payment
systems, trade finance and deposit taking – can continue, no matter what
happens to the larger group. These two stylised approaches are known as the “single
point of entry” (SPE) resolution, in which resolution powers are applied to the
top of a group by a single national resolution authority (for banks such as
Goldman Sachs and JPMorgan that operate as an integrated group) and the “multiple
point of entry” (MPE) resolution in which resolution tools are applied to
different parts of the group by two or more resolution authorities acting in a
coordinated way (for banks such as Santander and HSBC, that operate as locally
capitalised subsidiaries). | |
| Which type of resolution strategy (SPE or
MPE) is better for a particular group will depend on the structure of the
group, the nature of its business, and the size and location of the group’s
losses. In either case, for bail-in to be the chosen resolution tool there
needs to be sufficient loss absorbing capacity in the relevant legal entities. | |
| From the perspective of banks the preferred
resolution strategy will depend on their structure, jurisdiction and the
attitude of the supervisors and regulators. Some banks may find it
prohibitively expensive to raise local capital for the MPE strategy, and will
opt for the SPE whenever possible. However, regulators may oblige putative SPE
banks to hold significantly more capital at the group level, inducing other
banks to opt for the MPE method. Either way, investors stand to benefit from
more public disclosure, from both regulators and the banks, of what will happen
in the event of a crisis. | |
| The obstacles to resolution will differ
between resolution strategies. In SPE strategies, obstacles may arise from the location
of primary loss absorption capacity; debt instruments governed by foreign law;
and inadequate management information systems that do not support rapid
valuation of losses. In MPE strategies, obstacles include legal, financial and
operational dependencies within a group. Obstacles relevant to both strategies
include immediate rights of exercise of termination clauses in contracts held
by a bank’s counterparties and the exercise of cross-default clauses. | |
| Under subsidiarisation with additional
restrictions reform options (SUB+), the trading entity needs to be separately
capitalised and funded and therefore will always be identified as a “point of
entry”. Thus it should have sufficient loss absorbing capacity (“LAC”) to cover
its likely losses in resolution and those of subsidiaries below it for which a
separate resolution is not planned. Alternatively, it should be capable of
being wound down without affecting the rest of the group. Debt is likely to be
issued by operating subsidiaries to third parties, with the consequence that
the use of resolution powers to convert debt to equity may result in a change
of ownership, loss of control by the top parent or holding company and,
potentially, separation from the group. The resolution strategy should address
how such change of ownership and separation from the group can be implemented
without disruption to the entity’s critical operations. The bank holding
company can hold equity in the trading entity but only at arm’s length and
constrained by large exposure limits. Thus losses at the level of the trading
entity (or its subsidiaries) cannot be up streamed to the parent company, by
recapitalising the trading entity with excess capital from the parent or from
any of the non-ring fenced deposit taking entities. The bank holding company
may still opt for an SPE approach for non-ring fenced subsidiaries. | |
| The interaction between structural reform and
resolution strategies under BRRD will need to be discussed between the supervisor
and the resolution authority, subject to consultation procedure to be
established. | |
| 5.3.1.2.
Facilitate monitoring, management, and supervision | |
| Subsidiarisation with further restrictions
will materially improve market discipline and increase transparency in the
stand-alone performance of the different parts of the group. The reason is that
restricted interconnections will no longer allow shifting profits and losses
within the group and will render rules related to governance more effective. | |
| Separating proprietary trading, market
making, complex securitisation, and complex derivative activities facilitates
monitoring, management, and supervision. | |
| Increased market discipline on the trading
entity facilitates the latter’s supervision, even without factoring in the
likely reduction in proprietary trading, market making, complex securitisation,
and complex derivatives that result from enhanced market discipline. | |
| The nature of proprietary trading hinders
the ability of regulators, supervisors and bank managers to properly understand
and thereby calibrate the risks taken, in particular tail risk (i.e., the risk
that an investment will perform significantly worse than expected). It is
equally complex to apply the correct capital treatment so that banks have
sufficient resources to absorb losses if these occur. Proprietary trading can
also be a high-frequency activity that may result in thousands of daily
transactions. As a result, snapshots of the positions of these activities may
have limited predictive value for future positions. This rapid movement in
underlying positions significantly raises monitoring costs for the management
of the banks and for market participants (such as bank creditors and
shareholders). | |
| Bank management and external monitoring by
the market and supervisors will be facilitated, as the activities that are most
scalable and hence difficult to monitor would be located in separate subsidiaries
with their own separate governance. Subsidiarisation with restrictions would
yield stronger benefits in this regard, given the stronger degree of governance
separation. The additional restrictions applied to the respective entities will
ensure that it becomes easier to assess the stand-alone performance of the
different entities. | |
| All three reform options facilitate
management and monitoring, but options E and H arguably more than option B,
given their broader activity scope. As the additional activities to be
separated under reform option H are not as significant and scalable as market
making, the additional benefits in terms of facilitated monitoring of moving
from option E to option H are correspondingly small. | |
| 5.3.1.3.
Reduce moral hazard | |
| Separate funding requirements and
restricted interconnections between sub-consolidated entities will impose a significant
increase in market discipline on the trading entity. As a result, depositors would
be better shielded from risk-taking originating from subsidiarised trading
activities, also because intra-group large exposure rules would apply (can no
longer be waived). | |
| Separating proprietary trading, market
making, complex securitisation, and complex derivative activities will reduce excessive
risk taking. Through subsidiarisation, these activities would not benefit (to
the same extent) from the implicit public subsidies which would also help to
re-align private and social interests. The resulting increased funding cost
would reflect the inherent riskiness of the activity (although systemic risk
may still not be adequately reflected in the institution-specific funding
cost). As a result, moral hazard in the trading entity will be reduced. | |
| Proprietary trading is an inherently risky
banking activity that is by definition not customer-oriented. It has the
ability to produce “tail risk” or systemic risk and is easily scalable (in
comparison to more relationship-based activities such as lending). When part of
a larger banking group, traders benefit from lower funding costs and as a
result have the ability and incentive to take significant risks, even without
having access to liquidity (through short-selling positions). Separating
proprietary trading from the deposit entity allows shielding depositors from
this type of risk-taking. | |
| When facilitating client business through
market making, a bank is likely to try and hedge most of its risks. Hence,
genuine market making is generally considered to entail limited market risk.
However, the actual exposure to risk may vary depending on the liquidity of the
instruments, on changes in market volatility and on significant variation in
the sizes of positions that market making clients may wish to acquire or
liquidate. Moreover, there may be a mismatch between the position and the hedge
(basis risk) and the hedge will need to be rebalanced over time as market moves
alter risk profiles. Furthermore, market makers are still exposed to high
counterparty risk and the concrete functioning of market making can vary in
relation to different financial instruments and market models. | |
| Given its importance as a share of trading
revenues, market making entails significant risk and separating it from the deposit
entity could significantly reduce moral hazard, excessive risk taking, and
artificial balance sheet expansion. | |
| In terms of reduction of moral hazard and
excessive risk taking, the legal, economic, and governance requirements to be
imposed under the stricter form of subsidiarisation of options B, E, and H would
reduce risk taking incentives by forcing the trading entity to internalise the
true cost of its risk taking and to more strictly separate it from the public
safety net associated with insured deposits through (possibly sharpened)
intra-group large exposure rules. | |
| By separating banking activities from core
deposit-related activities, the funding of these activities would become more
risk-sensitive. As a result, banks would have less of an incentive to engage
excessively in these activities. The extent to which funding becomes fully risk
sensitive depends on the degree of separation. Accordingly, subsidiarisation
with restrictions that give rise to a stronger degree of economic and legal
separation will result in more effective market discipline compared to
subsidiarisation as such. | |
| Prudential regulatory requirements, aimed
at promoting the stability of financial institutions currently apply at the
consolidated group level (and at the individual level, but only if they are not
waived). At the core of these prudential standards are the requirements for
banks to hold buffers of capital and liquidity to absorb losses (in the case of
capital) and to provide emergency funding (in the case of liquidity). A
structural separation would entail different entities holding separate capital
and liquidity buffers, thereby aligning the cost of regulation more closely
with the risk. This promotes market discipline. It would also mean that the
entities would have separate funding requirements, ending the risky
cross-subsidy of trading activities with deposits. | |
| All three reform options reduce moral
hazard, but options E and H arguably more than option B, given their wider
activity scope. Underwriting is not as easily scalable as pure market making.
The scope for moral hazard reduction is still significant, but smaller than for
market making. Market making as a follow-on activity of underwriting does imply
that significant securities and derivatives inventories are being built up, and
hence that risks are potentially significant, but hedging instruments exist and
risks can in principle be monitored and managed. The scope for additional moral
hazard reduction when shifting from option E to option H is accordingly limited. | |
| 5.3.1.4.
Reduce conflicts of interest | |
| Subsidiarisation with further restrictions
will address conflicts of interest, to the extent that governance rules reach
further than outlined in the CRDIV, and especially if there is a duty on the
banking group to uphold the integrity and objectives of the separation. The
restrictions allow safeguarding the separation objectives and ensure that a short-term
trading culture will not continue to unduly influence the relationship-oriented
deposit entity. | |
| Separating proprietary trading, market
making, complex securitisation, and complex derivative activity reduces the
scope for conflicts of interest and avoids that a short-term oriented trading
culture gets installed within a deposit entity. | |
| Proprietary trading is particularly prone
to conflicts of interests because the bank in its role of proprietary trader no
longer is a service provider to its client, but becomes a potential competitor
and hence faces interests that are no longer aligned with those of its clients.
The bank can make improper use of client-related information to increase its
own profits. The commercial bank department may have private information about
the likely bankruptcy of a firm it has granted a loan and may buy credit
protection against the default of the firm from the unsuspecting public,
thereby reducing its own credit risk whilst earning a fee. | |
| In theory, genuine market making aims at
facilitating client business and hence bank interests are supposed to be
aligned with customer interests. However, principal-agent problems need not to
be confined to proprietary trading given that market making and proprietary
trading activity are difficult to disentangle for outsiders to the actual
transactions. | |
| In general, if markets are opaque, such as
is the case in over-the-counter markets, and if market makers have superior
access to information, collusion and exploitation of conflicts of interests may
occur. The origin of the problem is an inherent conflict of interest. Banks
possess (asymmetric) information in the form of customer trade details,
including the number and size of trades to be executed. And they have knowledge
that their own proprietary positions could be harmed without (or could benefit
with) trader intervention. The banks allegedly act on that knowledge, against
their customer’s best interests and in favour of their own, as evidenced in
recent banking scandals, related to front running, FX bid rigging, Libor
benchmark rate setting, etc.[55] | |
| Stricter rules of subsidiarisation, for
example on governance separation, would provide further checks. | |
| All reform options reduce conflicts of
interests, but options E and H arguably more than option B, given their wider
activity scope. | |
| Separating underwriting will reduce the
scope for conflicts of interests, as the interests of the bank as underwriter
and as loan provider are typically not aligned.[56] Within a large and
diversified banking group, the commercial bank department may have private
information about the likely bankruptcy of the firm it has granted a loan and
may hence encourage the underwriting department to sell bonds or issue shares
to the unsuspecting public, thereby reducing its own credit risk whilst earning
a fee. Banks have an incentive to hedge their risk as underwriters,
guaranteeing the proceeds of the share issue, but this may potentially have an
adverse impact on their clients’ share price. Alternatively, a bank’s lending
division may feel pressured to provide bank loans to a firm whose shares have
been issued by the bank’s underwriting division, even though such loans would
not be granted absent any such in-house pressure. Some studies indicate that earnings
forecasts and stock recommendations provided by an analyst working with the
lead-underwriter are on average inaccurate and positively biased, and
unaffiliated analysts perform better and provide higher long-run value to their
customers.[57]
The main concern is that the bank uses the informational advantage it gains
from conducting different activities to its own advantage, thereby misleading
customers and investors. | |
| Having said that, evidence does not suggest
that there are obvious conflicts of interests between underwriting and loan
making.[58]
In fact, it suggests that bonds underwritten by commercial banks default less
often than bonds underwritten by investment banks. However, the conflicts of
interest seem more severe and more likely to exist in a universal bank that has
an underwriting division together with an asset management division. These
studies seem to support the view that asset management divisions may feel
pressured by the bank’s underwriting division to buy and hold poorly performing
issues to make a customer satisfied, even though this may be unwise. | |
| Next to internal monitoring and controlling
procedures, there is outside regulation (for example with respect to insider
trading and market manipulation in the context of the Market Abuse
Directive/Regulation)) and the rule of law to contain the exploitation of
possible conflicts of interests. In principle, the market can also respond to
apparent conflicts of interests, thereby constraining their scope. The market
can penalize the service provider if it exploits conflicts of interest in the
form of a higher funding cost or lower demand for its services even to the
point of forcing the provider into bankruptcy. The market can also promote new
institutional means to contain conflicts of interest by generating a demand for
information from non-conflicted specialized organizations. | |
| However, the market is likely to be unable
to contain the incentives to exploit the conflicts of interests. For the market
to be able to do this it needs to have information on whether exploitation
might take place. Sometimes, such information is simply not available or would
require the revealing of proprietary information that would benefit a firm's
competitors, thus reducing the incentives to reveal this information. Sometimes
when corporate governance is poor, even the top management of the firm is not
aware of the conflicts of interest and mala fide opportunistic individuals are
able to capture the firm's reputational rents. | |
| All in all, the above suggests that reform
option H may be superior to option E as regards reducing the scope for
conflicts of interests. | |
| 5.3.1.5.
Reduce capital and resource misallocation | |
| Depending on the separation restrictions and restrictions
on intra-group pricing policies, trading activities will no longer enjoy
cross-subsidies to the same extent and will de facto be distanced more from public
safety net coverage (and its corresponding benefits). Hence, trading activities
no longer are artificially promoted to the same extent. | |
| Subsidiarisation rules impose limits on shifting
excess capital within the wider corporate group, which reduces the incentives
for the parent/trading entity to encourage the allocation of capital and human
resources to trading and away from lending activity. | |
| Separating proprietary trading, market
making, complex securitisation, and complex trading activity reduces capital
and resource misallocation. | |
| The traditional raison d’être of
deposit-taking banks is to be a financial intermediary between savers and
investors (and thereby competing with capital markets that play a similar
role). In comparison to capital markets, who intermediate more directly between
savers and investors, deposit-taking banks are relatively good at: (i)
monitoring and knowing their customers, i.e. resolving information asymmetries;
(ii) providing insurance against idiosyncratic liquidity risks faced by
households and firms; (iii) pooling risks efficiently; and (iv) performing
risk-return tranching services to customers. None of these roles is fulfilled
by proprietary trading. As such, bank capital and human resources are being
misallocated to the extent that they are put at work in proprietary trading
rather than in engaging in loan making and other core banking services. | |
| The inherent riskiness of trading attracts
and requires people who are good at taking short-term risks rather than lenders
with a long-term perspective. Absent separation, a short-term return oriented culture
may arise within the entire banking group, given the relatively high profitability
(without adjusting for the riskiness, that is) associated with trading. | |
| Academics have argued that market makers
hamper the development of securities markets (Zingales (2012)). Large universal
banks are currently accused of having protected their indispensable position in
the global credit default swaps ("CDS") market through control of a
trading body and information provider, which vetted whether new exchanges
should be licensed. The alleged harm consists of exchanges being blocked from
bringing part of the over-the-counter CDS transactions onto public exchanges,
which would have resulted in lower transaction costs for their
investor-customers, as well as in less financial instability as over-the-counter
("OTC") markets are more opaque and involve more counterparty risk. | |
| To the extent that the additional restrictions
reduce the implicit public subsidies and introduce effective market discipline
on the trading entity, the latter will no longer be able to artificially and
aggressively expand to the detriment of the deposit entity. Hence, this will
result in fewer distortions away from lending and towards trading activities. | |
| All three reform options reduce capital and
resource misallocation, but options E and H arguably more than option B, given
their broader activity scope. Given that underwriting is also a
relationship-based activity, not easily scalable and may be underprovided when
distanced from the public safety net, the justification for mandatory
separation of underwriting to enhance capital allocation is weak. Reform
options E and H can be deemed equivalent in this respect. | |
| 5.3.1.6.
Improve competition in the EU banking sector | |
| To the extent that implicit public subsidies
to TBTF banking groups will be reduced in the reform options that require
subsidiarisation of trading entities with further restrictions, competition
distortions will also be reduced and the level playing field between banks in
the Internal Market (large versus small but also across Member States) restored. | |
| To the extent that the restrictions introduce more
effective market discipline on the trading entity, competition on the merits
between small, medium-sized and large banks will be promoted. Smaller and medium-sized
banks will benefit as they currently do not enjoy equally high implicit
subsidies (see Annex A4.1 and A4.2). Also competition
among banks subject to subsidiarisation would be placed on a more equal playing
field as there would be less scope for some banks benefiting more from implicit
support due to a given Member States' perceived ability, willingness and
incentive to intervene. Similarly banks that are less interconnected with other
banks and banks that are better capitalised would also benefit as they tend to
benefit less from implicit subsidies thank other banks (see Annex A.4.2). In that respect, separating proprietary trading,
market making, complex securitisation, and complex derivatives (option E) or
even all wholesale and investment banking activities (option H) would improve
competition in the EU banking sector more than just separating proprietary
trading (option B). | |
| Options E and H will both significantly
improve the competitive environment of EU banking. Arguably, given that option
H is more prescriptive as to the mandatory separation of banking activities,
option E will result in greater diversity in EU bank business models and hence
be preferred over option H. | |
| 5.3.2.
Social costs
5.3.2.1.
Foregone economies of scale and scope | |
| Economies of scope consist in risk
diversification, cost economies of scope, and revenue economies of scope. All
three reform options maintain the universal banking model but introduce varying
degrees of structure as to how activities should be grouped together and as to
which activities are allowed to be performed by a deposit entity that enjoys
access to a public safety net. The reform options aim to (partially) retain the
potential economies of scope, whilst eliminating the potential diseconomies of
scope (i.e. achieve the social benefits). | |
| Given the limited importance of proprietary
trading the corresponding risk diversification economies of scope are likely to
be immaterial. Therefore there should not be significant risk diversification
benefits lost in option B. | |
| Genuine economies of scope related to lost risk
diversification opportunities are possibly non-negligible for market making
given the importance of market making for a bank’s revenues. However, given
that the activities are not banned from the group altogether (no prohibition,
just subsidiarisation), the risk diversification economies of scope are
partially retained within the group for reform options E and H. | |
| Risk diversification costs are particularly
pronounced for reform option H as it foresees the mandatory separation of all
WIB activities, including activities that are of great importance to the real
economy and which deserve more to be linked to the public safety net (and hence
enjoy certain subsidies), given that they address genuine market failures.[59] However, option H may
score somewhat better in terms of cost economies of scope as it mandates
underwriting and market making to be grouped together within the trading
entity. This avoids costly duplication between underwriting and follow-on
market making and secondary market making activities. | |
| In option B, however, the main lost economy
of scope may arise from the fact that separating proprietary trading from
market making may give rise to important infrastructure duplication and hence
lost cost economies of scope. The lost cost economies of scope may be
significant for option B, given that traders will need to make use of separate
infrastructure, depending on whether they engage in proprietary trading or
market making. Options E and H score better than B in that respect, as they
keep trading activity together in a single trading entity and hence avoid
costly infrastructure duplication. | |
| 5.3.2.2.
Operational costs | |
| All three reform options require the
establishment of separate legal entities to conduct either proprietary trading
related activities (option B), a broader set of activities (option E), or all
wholesale and investment banking activities (option H), whereby specific
additional legal, operational and economic restrictions between the respective
trading and deposit entity should be introduced, monitored, and enforced. | |
| Although these costs cannot be avoided they
are likely to be relatively modest compared to the potential benefits that can
be reaped from these reforms (see e.g. ICB (2011) and HM Treasury (2013)). Moreover,
costs can be minimised by giving banks a sufficiently long phase-in period. | |
| 5.3.3.
Conclusion | |
| Among the three retained reform options
that require separate subsidiarisation of a deposit and trading entity with
additional regulatory restrictions, the Commission services consider that
implementing reform option E is the best way forward in the EU context and
would represent a significant improvement over the no policy change
alternative. | |
| The bulk of the benefits of the universal
banking model are retained in all three reform options. However, option E
yields significantly greater social benefits compared to reform option B. The
separation of proprietary trading, market making, complex securitisation and
complex derivative activity limits banking groups’ ability to take excessive
risks through easily scalable trading activities and avoids that a short-term
oriented trading culture contaminates the more traditional banking activities.
It also achieves greater resolvability in the bad times and monitoring in the
good times. It ensures (or, better, allows) that those and only those activities
that would otherwise be underprovided benefit from the implicit state support. The
separation in option B appears to yield lower social benefits due to its
significantly narrower activity scope (proprietary trading is currently not
performed by large EU groups to a significant extent). Whereas option E will
give rise to greater social costs compared to option B, as the scope for risk
diversification is also lowered correspondingly, these social costs are capped
because subsidiarisation allows transferring (excess) capital from the trading
entity to the deposit entity, as long as minimum regulatory requirements are
met. In sum, option E yields greater net social benefits than B. | |
| Option E is also deemed preferable by
Commission services compared to reform option H, as it achieves similar
benefits whilst, in principle, being less prescriptive and exhaustive as to the
set of activities to be mandatorily separated. However, the mandatory
separation of the entire set of wholesale and investment banking activities
from banking groups in the EU may be preferable conditional on the specific
circumstances of national banking systems, in particular where banks operate
within a large financial system and can be heavily exposed to international
financial markets. In any event, in light of the uncertainty as to the impact
of the relatively broad structural reform options it may be desirable to err on
the side of caution as regards the location of the fence and to leave
discretion to the banks, subject to supervisory approval and constraints, which
bundle of activities they would like to place in addition to the trading entity
mandated activities in the trading entity. Recall that option E is also
preferred over option H by the High Level Expert Group chaired by Erkki Liikanen | |
| 5.4.
Assessment of reform options based on ownership
separation | |
| Options C, F and I foresee the ownership
separation of respectively proprietary trading (C), proprietary trading and
market making (F), and all wholesale and investment banking activities (I). The
banking groups concerned would accordingly be prohibited from engaging in
certain activities. These reform options are hence the most intrusive ones of
all the reform options in Table 2 and would remove the separated activities
from the perimeter of the regulated and supervised banking group. This section again
first assesses the social benefits and costs of ownership separation and then assesses
the social benefits against costs of the three options in light of the
different activity scope. | |
| The options based on ownership separation are
the ones that get the strongest support from consumer associations and
individual respondents to the stakeholder consultation. Together with some
non-bank financial respondents, they stressed that these options, and in particular
option I, would be the simplest and most effective options in the long term.
Bank respondents, as well as corporates, on the contrary highlighted the
significant costs that in their view arise from ownership separation compared
to other reform options. | |
| 5.4.1.
Social benefits | |
| All reform options based on ownership
separation would lead to social benefits. Typically these benefits would
increase with the scope of activities subject to such separation, although the
nature of the specific activity obviously will also matter. | |
| 5.4.1.1.
Resolution | |
| Ownership separation facilitates resolution
of the banking group mainly because the risks linked to the prohibited
activities no longer feature on the balance sheets of the financial
institution. As a result, the remaining banking groups would become less
complex and smaller in size. | |
| All three reform options facilitate
resolvability in this respect, but options F and I arguably more than option C
given the limited importance of proprietary trading relative to other wholesale
and investment banking activities and relative to its pre-crisis size. However,
evidence suggests that the extent of proprietary trading activities has gone
down substantially since the start of the crisis[60] and absent specific restrictions on proprietary trading activities
there is no safeguard that would prevent banks from expanding such risky
activities in the (near) future. The limited data that does exist typically
tend to measure only dedicated proprietary trading desks (see also section
5.5.1.1 on implementation challenges).[61]
Moreover, speculative proprietary trading can take place alongside customer-related
trading and be performed elsewhere within the banking group (for example,
treasury management and market making). Given the alleged currently low activity
level now may be an opportune moment to address the potential future risks of
proprietary trading and to prevent a renewed surge in the future within large
and complex banking groups. | |
| 5.4.1.2.
Monitoring, management and supervision | |
| Monitoring, managing and supervision would
be facilitated as the activities that are most scalable and complex and
consequently difficult to monitor would be located outside the financial
institution. Ownership separation would yield stronger benefits in this regard
compared to the subsidiarisation options assessed in section 5.3. | |
| All three reform options facilitate
management and monitoring, but options I and F arguably more than option C
given their broader activity scope. However, as the additional activities to be
separated under reform option I (notably underwriting) are not as significant
and scalable as market making the additional benefits in terms of facilitated
monitoring of moving from option F to option I are correspondingly small. | |
| In addition, as explained below, the Commission
has recently issued a roadmap for tackling risks inherent in shadow banking
thus mitigating the risk that the separated activities would shift to shadow
banking. | |
| 5.4.1.3.
Moral hazard | |
| An important advantage of ownership
separation is that, while intrusive, it is a pure “structural” reform which
after implementation would significantly alleviate the need for continuous
enforcement and supervision of the separation.[62]
Ownership separation should effectively and significantly reduce the implicit
state subsidy (expected bail out) enjoyed by financial institutions that are taking
insured deposits and from that perspective remove the moral hazard linked to safety
net coverage. | |
| All three reform options reduce moral
hazard, but options F and I arguably more than option C, given the broader activity
scope. Again, underwriting is not as easily scalable as pure market making and,
hence, the scope for moral hazard reduction will be significant, but smaller
than for market making. Market making as a follow-on activity of underwriting
does imply that significant securities and derivatives inventories are being
built up, and hence that risks are potentially significant. However, hedging
instruments exist and risks can in principle be monitored and managed. All in
all, the scope for additional moral hazard reduction when shifting from option
F to option I is limited. | |
| Option C is a superior way to address the
moral hazard associated with proprietary trading compared to option B, as it
protects retail banking activities more effectively from the risks stemming
from this activity. However, given that most banks claim that they currently do
not engage in significant proprietary trading activity, the impact of ownership
separation of proprietary trading will primarily be to have a preventive effect
going forward. | |
| 5.4.1.4.
Conflicts of interest | |
| Ownership separation is the cleanest and
most effective way to eliminate conflicts of interest arising from engaging in
certain activity combination. This would be particularly valuable for proprietary
trading (option C), as it is particularly prone to conflicts of interests (see
section 5.3 and Annex A6). It is also valuable for underwriting, as the
interests of the bank as underwriter and as loan provider are typically not
aligned. The benefit would be less pronounced for market making even though
principal-agent problems may arise there as well, particularly in more opaque
OTC markets. | |
| All reform options accordingly reduce
conflicts of interests but to a varying degree. Option C has the narrowest scope
but nevertheless addresses the activity where conflicts of interest and
potential bank culture contamination are the most significant. | |
| 5.4.1.5.
Capital and resource misallocation | |
| With the most risky trading activities no
longer on its balance sheet, a financial institution is able to entirely focus
on and allocate more resources to its core and traditional role of lending to
the real economy and acting as an intermediary between savers and borrowers. | |
| All three reform options reduce capital and
resource misallocation, but options F and I arguably more than option C given
their broader activity scope. Even so, given that underwriting does not give
rise to a trading culture and may be underprovided when distanced from the
public safety net, the justification for ownership separation of underwriting
to enhance capital allocation is weak. | |
| 5.4.1.6.
Competition | |
| Ownership separation eliminates implicit
cross-subsidies and ensures effective market discipline on the trading entity.
Competition on the merits between small, medium-sized and large banks and
across Member States is accordingly promoted. Smaller and medium-sized banks
benefit, as they currently are not likely enjoying equally high implicit public
subsidies (see Annex 4.1 and A4.2). In that respect, the ownership separation of proprietary trading, market making, and complex
securitisation (option F) or even of all wholesale and investment banking
activities (option I) improve competition in the EU banking sector more than
just separating proprietary trading (option C). However, given that those
options are far-reaching (prohibiting the concerned EU banking groups from
engaging in many or all WIB activities) option C would be easier to reconcile
with the significant diversity in EU bank business models. | |
| 5.4.2.
Social costs | |
| Ownership separation would in general lead
to more significant losses of economies of scope compared to options based on subsidiarisation
reform options. It would also trigger a migration of certain activities toward
non-bank credit intermediaries (so-called "shadow banking entities"). | |
| 5.4.2.1.
Foregone economies of scale and scope | |
| Ownership separation is the most intrusive
form of separation as it results in the elimination of economies of scale and scope
(while for example under subsidiarisation economies of scale and scope can be maintained
to a significant extent). Whereas all other reform options maintain the
universal banking model and merely intend to introduce more structure into the
group, ownership separation reform options are no longer compatible with the
universal banking model as it exists today in the EU, in particular when
considering a broader set of activities, such as in F and I. | |
| Ownership separation would eliminate the
extension to the prohibited activities of the implicit subsidy resulting from
the safety net. Those activities would accordingly become more costly, which
would, other things being equal, lead to a reduction in the scale of those
activities and by extension a reduction in the systemic risk. | |
| As a result of ownership separation, the
loss in economies of scope (and to a certain extent scale), would be greater
than for other options (subsidiarisation without or with additional rules and
restrictions) and would have the highest effect in terms of increased private
funding and capital costs. These costs tend to increase with the strength of
separation for the entities that include the most risky activities. If some of these activities perform an important role in the
economy these additional costs may have further efficiency effects in other
segments of the economy. | |
| However, social costs appear relatively limited
for ownership separation of proprietary trading (option C). A prohibition of proprietary
trading is unlikely to lead to a significant loss of efficiency for large
banks, as proprietary trading comprises a relatively small part of those banks'
activities, and the social cost is in any case limited given that the activity
can be and is performed by non-banks. Given the size of proprietary trading,
there would be no lost economies of scale, as at very large asset levels
economies of scale are likely to be exhausted (see Annex A9). One type of
economies of scope loss is the loss of diversification benefits (of capital and
profits). Channelling of profits and capital between the bank and the proprietary
trading activities would no longer be possible and therefore diversification
benefits between proprietary trading activities and banks' remaining activities
would be lost. It is doubtful that such scope for diversification would be very
substantial for the remaining bank, given that larger banks do not engage
substantially in proprietary trading activities. Furthermore, given the very
risky nature of proprietary trading and the low complementarity of proprietary
trading with other traditional activities of banks, proprietary trading
activities would rather lead to diseconomies, rather than economies, of scope
through excessive complexity, risk taking and even systemic risk. However,
there would be lost cost economies of scope as separating proprietary trading
from market making activities may lead to some duplication of infrastructure. | |
| Genuine economies of scope related to lost risk
diversification opportunities are possibly non-negligible for market making,
given the importance of market making for a bank’s revenues (option F). | |
| Risk diversification costs are particularly
pronounced for reform option I as it foresees the ownership separation
of all WIB activities, including activities that are of great importance to the
real economy and which would deserve to be linked to the public safety net (and
hence enjoy certain subsidies), given that they address genuine market
failures.[63]
Given that the activities would be banned from the group completely, the risk
diversification economies of scope would be entirely lost under options F and
I. | |
| For those reasons option C leads to
substantially less social costs compared to options F and I. | |
| 5.4.2.2.
Operational costs | |
| Ownership separation is unlikely to create
high operational costs for the banking group under consideration. It would
actually lead to lower operational costs from the perspective of the bank, as
once separated there would no longer be any costs associated with running that
activity within the banking group (e.g. separate boards, risk management,
monitoring, etc.). Naturally, from a societal point of view, there would still
be operational costs associated with running the company carrying out the
separated activities, but operational costs associated with continued
coexistence within the group would no longer arise. These findings hold for all
three options as a whole without any meaningful variations in importance. | |
| 5.4.3.
Conclusion | |
| Ownership separation has the potential to
be the most effective set of options in terms of achieving the specific
objectives of facilitating resolution and limiting moral hazard, conflicts of
interest and capital and resource misallocation. However, it is also the set of
options that may come with the highest social costs in terms of foregone
economies of scope and it would remove the separated banking activities from
the perimeter of the regulated and supervised banking group into the shadow
banking sector (see Annex A13). | |
| In general, the broader the scope of
activities concerned, the stronger the potential benefits and costs. Whether
the costs appear proportionate to the benefits achieved in addressing the
objectives of facilitated resolution and reduced moral hazard, conflicts of
interest and capital and resource misallocation differ between the options. As
regards option C, the potential benefits would be pronounced, given the risks,
complexity and interconnectedness associated with proprietary trading. Proprietary
trading is also the activity that is most prone to conflicts of interest, given
that it is the most distanced from client, real economy oriented activity. Even
if banks currently engage in modest levels of proprietary trading compared to
earlier years, ownership separation of proprietary trading ensures that a
potential new surge will not materialise within the largest and most complex EU
banking groups. Ownership separation would accordingly facilitate resolution
and reduce moral hazard, conflicts of interest and misallocation of capital and
resources to a significant extent within the largest and most complex EU
banking groups. Proprietary trading activities do not provide substantial value
added to the economy, can and is performed by non-banks, and foregone economies
of scope seem limited. Hence, the social benefits associated with option C
clearly outweigh the social costs. Moreover, given that option C delivers
stronger benefits than option B with little additional marginal cost and with
similar implementation difficulties, option C is superior to option B. | |
| A significant positive balance between
benefits and costs is more difficult to argue for options F and I. Whereas the
separation of market-making (option F) would indeed yield substantial social benefits,
the social benefits associated with other wholesale and investment banking
activities (e.g. underwriting) are less pronounced. Ownership separation would
also yield higher social costs in that regard, given that these activities can
not all be performed by non-banks and that stand-alone investment banks may not
be in a position to readily step in as a substitute. As highlighted above, market
making and underwriting are activities that can and do contribute to the
financing of the real economy, notably by providing liquidity to secondary
markets, although the latter may require qualification given the financial
crisis experience (see section 5.8 below as well as Annex A6). Market making
and underwriting are perceived as socially useful activities. Being socially
useful does not imply that they need to be artificially promoted by benefiting
from being performed by the deposit entity enjoying access to the public safety
net. However, it does imply that the ownership separation of investment banking
activities –effectively eliminating economies of scope such as risk
diversification – may be less obvious to justify for activities other than
proprietary trading. | |
| At this stage of economic knowledge and
evidence and given the relatively high uncertainty, cautiousness as regards the
activity scope for ownership separation seems appropriate. Ownership separation
with a wide activity scope would limit the flexibility to cater for cultural
and structural differences within and across national banking systems and risks
reducing the current diversity in successful business models across the EU. Given
the potential social costs associated with ownership separation, there is a
strong imperative to be cautious as regards ownership separation of a broader
set of activities at this current juncture. Ownership separation as per option
F and I are likely to generate social costs, uncertainty and unintended
consequences that would be disproportionate to the benefits, in particular as the
preceding analysis has highlighted that a less intrusive reform option (E)
delivers similar benefits at significantly lower social cost. Moreover, ownership separation of all wholesale and
investment banking activities may effectively give rise to an
under-provisioning of selected core and relationship-oriented banking
activities (in particular those oriented at SMEs) and as such does not seem
coherent with the overall policy objective of promoting growth and jobs. | |
| Hence, the Commission services believe that
only option C with ownership separation of a relatively narrow activity scope
provides a good net balance of social benefits and social costs and is worth
exploring further. | |
| 5.5.
Assessment of retained reform options | |
| Table 3 summarises and
collects the qualitative assessments of the different reform options. The
result of the assessment and comparison of the different options result in
reform option E being found superior to all other options, with reform option C
being superior to other reform options, except for option E. Whereas option E
yields higher social benefits than option C, it comes at a higher social cost,
such that on balance option C is still worthwhile retaining. | |
| Table 3: Overview of options | |
| || Reform options | |
| || No policy change || A || B || C || D || E || F || G || H || I | |
| EFFECTIVENESS || || ≈ || ≈/+ || + || ≈ || ++ || ++ || ≈ || ++ || ++ | |
| Facilitate resolution || 0 || ≈ || + || + || ≈ || ++ || ++ || ≈ || ++ || ++ | |
| Facilitate management || 0 || ≈ || + || + || ≈ || ++ || ++ || ≈ || ++ || ++ | |
| Reduce moral hazard || 0 || ≈ || ≈/+ || + || ≈ || ++ || ++ || ≈ || ++ || ++ | |
| Reduce conflicts of interest || 0 || ≈ || ≈/+ || + || ≈ || +/++ || ++ || ≈ || ++ || ++ | |
| Reduce capital and resource misallocation || 0 || ≈ || ≈/+ || + || ≈ || ++ || ++ || ≈ || ++ || ++ | |
| Improve competition, retain diversity || 0 || ≈ || ≈/+ || + || ≈ || ++ || ++ || ≈ || +/++ || ++ | |
| EFFICIENCY || || ≈ || ≈/- || ≈ || ≈ || - || - - || ≈ || - - || - - | |
| Reduced economies of scale and scope || 0 || ≈ || ≈/- || ≈ || = || - || - - || ≈ || - - || - - | |
| Increased operational costs || 0 || ≈ || - || ≈ || ≈ || - || - || ≈ || - || - | |
| Note:
++: strongly positive; +: positive; - -: strongly negative; -: negative;
≈: marginal/neutral; ?: uncertain; | |
| n.a.: not applicable. | |
| This section accordingly
compares these two options in terms of effectiveness (social benefits),
efficiency (social costs) and coherence. | |
| 5.5.1.
Effectiveness | |
| Option C foresees the
complete ownership separation of proprietary trading, which accordingly would
have to be divested from the banking group altogether (or wound down). This is
a stronger degree of separation compared to option E, as option E leaves
proprietary trading within the group. However, it is also a more narrow option
in terms of activity scope, as it would not separate other wholesale and
investment banking activities, such as market making, complex securitisation and
complex derivatives. | |
| Overall, the benefits
of the stronger degree of separation of option C have to be weighed against its
narrower activity scope. Accordingly, all risks associated with those
additional activities (e.g. market-making, complex securitization and complex
derivatives) that are affected under option E would be left unaddressed by
option C. This is quite relevant, as existing evidence suggests that large
banks currently engage in limited proprietary trading but do engage in
significant market making, securitisation, and derivatives activities. Option C
is therefore less effective in delivering the identified social benefits for TBTF
banks compared to option E (see sections 5.3 and 5.4). Its main benefit would
therefore be to prevent any future expansion of such activity and the
corresponding concerns in terms of impediments to resolution, excessive risks,
conflicts of interests and inappropriate implicit safety net coverage. | |
| The effectiveness of
option C is furthermore handicapped by potential difficulties related to
implementation, notably as regards defining proprietary trading and objectively
distinguishing it from market-making. | |
| In order to make an
informed choice between the two retained options requires taking into account
(1) potential fundamental implementation problems, and (2) possibilities to improve
reform effectiveness through tailored and framed supervisory action. | |
| 5.5.1.1.
Implementation problems | |
| Option C appears particularly challenging
in terms of implementation, given the need to distinguish proprietary trading
from market making, which is not a concern that arises when implementing option
E. Nevertheless, option E is not immune to its own implementation challenges,
given that it requires a subsidiarisation that upholds the integrity of the
separation objectives. More specifically: | |
| ·
Challenges of implementing option C: The main problems arise from the need to define and distinguish proprietary
trading from market making and hedging, given that such a distinction seems to
rely on the private intent of the trader. As regards the definition, France,
Germany and the U.S. have proposed to adopt a restriction of proprietary trading
activities which excludes market making activities. None of these countries,
except for the U.S., have yet defined proprietary trading in an operational
way. In the definition of proprietary trading special importance should be
given to the way definitions can be operationally and legally enforced and
supervised. | |
| Distinguishing proprietary trading from
market making is difficult both in theory and
practice.[64] Although traders involved in the actual trade are able to identify
any given transaction as being of a market making or proprietary trading
nature, such an intent-driven distinction is not easy from the perspective of a
manager, regulator, supervisor, creditor, or judge.[65] Indeed, a market maker might legitimately choose to take a long
position in an asset either in anticipation of client demand to allow the order
to be fulfilled quickly or to facilitate a quick sale by a client of an
illiquid asset. Therefore, a proprietary trade and a trade pursuant to market
making are indistinguishable based solely on the objective and observable features
of the trade itself. | |
| The precise definition of proprietary trading
versus market making would also have an impact on the ability of banks to
effectively perform market making activities. Market makers require substantial
discretion in their ability to buffer unexpectedly large supply and demand
imbalances in order to provide immediacy to their customers and to effectively
perform their activity. As a result, a narrow definition of market making
activities may constrain the ability of market makers of a banking group to
service heightened demands for immediacy given the limits they would have to
comply with. | |
| Proprietary trading is also difficult to distinguish
from treasury management operations.[66] In particular, these difficulties arise when considering the
hedging activities that banks can engage into to mitigate the risk of their
commercial activities. If banks are no longer able to perform such hedging
activities they would be deprived of engaging in efficient risk management. For
this reason, the U.S., France, Germany and UK have made exemptions for
risk-mitigating hedging activities. However, such exemptions may well raise
implementation problems as well as monitoring/supervision problems.[67] In addition, banks may also by-pass the ban on proprietary trading
through such hedging activities by masking their positions as simply hedges of
permitted trades, though in reality such hedging positions are their real
purpose. | |
| In sum, it would therefore be feasible to ban
dedicated proprietary trading activities that are clearly disconnected from any
customer-related transaction. However, for a broader definition, genuine proprietary
trading may look like market making, and genuine market making may in fact look
like proprietary trading. Therefore in any broad definition there is scope for
"type I and type II errors".[68] | |
| ·
Challenges of implementing option E: Whereas option E at first sight seems easier to implement as it
avoids distinguishing proprietary trading from market making, option E is still
left with the complexity to ensure that proprietary trading does not take
place alongside other permitted activities (notably treasury and liquidity
management) in the deposit-taking entity. Whereas the supervisory burden is
lighter than for option C (as proprietary trading and market making are treated
similarly), the implementation concerns are therefore not avoided altogether. | |
| Given the difference in separation strength,
option E faces the implementation challenge to design and enforce the
separation, triggering greater compliance costs. The activities would
remain within the group and regulation and supervision would have to be
established to govern the economic, legal, governance and operational links
that would remain in order to uphold the separation objectives over time. | |
| Option E also faces the challenge that the
reform may be (perceived as) less effective, in particular in crisis times, due
to informational and reputational contagion.[69] Even if the separation would be fully effective in crisis times,
customers and creditors may not be convinced and may retreat from engaging with
both entities if only one gets into significant difficulties. | |
| Overall, the challenges of defining and
distinguishing proprietary trading from other activities such as market-making
and risk hedging are significant. However, banning dedicated proprietary
trading desks is of course feasible, albeit easy to circumvent and less
effective (e.g. London whale incident at JP Morgan). The main challenge
associated with option E is to set up, enforce, and maintain the integrity of
the separation over time. | |
| 5.5.1.2.
Improving effectiveness through tailored and
framed supervisory action | |
| Option C suffers from an effectiveness gap
compared to E, especially if the implementation problems considered above and a
more modest ambition of merely banning dedicated proprietary trading desks are
taken into account. There are nevertheless ways of raising the limited
effectiveness of option C. It could for example be complemented by a procedure
for separating additional trading activities either without further supervisory
discretion (ex ante) or following further supervisory review (ex post). These
two variations are examined in turn. | |
| ·
Option C combined with ex ante separation of market-making
(“C+ex ante”): The first option would be to combine
a prohibition of proprietary trading with an ex ante separation of other
trading activities (effectively combining options C and E). Given the analysis
in section 5.3 that highlighted the benefits of option E, the logical
consequence would thus be to separate notably market making, complex
securitisation and complex derivatives. Such a combined reform option would
resemble the current state of play in the US, where a Volcker rule prohibition
is being imposed on bank holding companies in which the deposit taking
commercial bank arm face activity restrictions that are largely similar to E
and where the economic links of that entity with other group affiliates that
perform other investment bank activities are subject to quantitative limits and
qualitative restrictions. The commercial bank arm of a bank holding company can
engage in dealing and underwriting (subject to caps and conditions and
depending on type of securities), certain derivatives, and securities brokerage
(see box 2 below); | |
| ·
Option C combined with ex post separation of market-making
following a framed decision by the relevant supervisor (“C+ex post”): Another option is to combine a prohibition of proprietary trading
with a potential ex post separation of market making, complex securitisation
and complex derivatives if certain metrics are exceeded. Under this approach,
the supervisor would have the possibility to require the subsidiarisation of market
making, complex securitisation and complex derivatives after careful scrutiny
and analysis. To ensure a consistent application of the procedure throughout
the Internal Market and create legal certainty for banks and other stakeholders,
this procedure would need to be framed. It would thus rely on a framework of
assessment under which the supervisor would have to review market making,
complex securitisation and complex derivatives (and possibly other trading
activities) for the banks under consideration and take further action should
specific relevant and well-defined criteria be fulfilled. In particular, a
rebuttable presumption can be created according to which if such criteria are
fulfilled then subsidiarisation should result. This latter rebuttable
presumption bridges the gap between ex ante and ex post subsidiarisation. A
two-step procedure is thus created: (1) a mechanism is created that triggers an
obligatory review by supervisors of market making, complex securitisation and
complex derivatives; in combination with (2) guidance provided to supervisors
to ensure that subsidiarisation according to certain rules is triggered when
certain criteria are fulfilled. The criteria and corresponding thresholds
and triggers need to be elaborated by the EBA and agreed with the Commission as
the guardian of the Treaty and Internal Market. | |
| The trigger mechanism for the review by
supervisors would be based on a reporting requirement imposed on relevant
banks. Information to be reported could include amongst others the relative
size of trading activities, the leverage of trading assets, whether the trades
are being triggered by customer demand or not, trading book exposures, relative
importance of capital requirements for counterparty and market risk as a
percentage of total regulatory capital requirements, identification of trading
account, trading units, activities and changes in activities,
compensation/bonus allocations for staff in different trading and other
business lines as well as the interconnectedness of the bank. | |
| The value added of this complement compared to option
C and to existing legislation is that it would set a uniform standard across
the EU for if and how to review trading activities, under what circumstances
subsidiarisation of market making, complex securitisation and complex
derivatives should be mandatory, and how that subsidiarisation should be
implemented. It would also create legal certainty for banks and other
stakeholders, as they would know when and how the rules would apply and be
ensured that they are applied in a similar fashion to all banks concerned
across the EU. For these reasons this framework would also complement and
provide a value added to the other tools supervisors already have through CRDIV
and BRRD to impose structural measures on banks (see more in Section 2
and Annex A3). | |
| With regard to activities other than market
making, complex securitisation, and complex derivatives (such as underwriting,
private equity, venture capital, etc.), the supervisor would have discretion
whether to require separation and if so, in what form (subsidiarisation and/or
additional restrictions).[70] However, the foreseen framework would also include a more general
provision providing supervisors with the specific right to intervene, and
require separation as appropriate, when there are concerns that activities
would involve or result in a material conflict of interest, when there are
concerns about distorted incentives such as, for example, moral hazard as a
result of the implicit subsidy, and when there may be a serious concern that
the activities of the bank would pose a systemic threat to the financial
system. | |
| The advantage of the above is that it would
only apply to those banks that represent the greatest risk to the financial
system because of resolvability concerns or distorted incentives. By clearly
framing the supervisory powers as per above, risks about geographical arbitrage
and fragmentation across the internal market are reduced. | |
| The above complements
to option C would reduce (ex post) or eliminate (ex ante) the gap in
effectiveness compared to option E and would ensure that banks whose trading
activities do not pose significant risks are not subject to (socially
undesirable) subsidiarisation. | |
| 5.5.2.
Efficiency | |
| In terms of foregone economies of scale
and scope, option E, by virtue of its broader activity scope, has a larger
effect on foregone economies of scope, in particular through reduced risk
diversification benefits, although risk diversification is being partially
retained within regulatory limits. A similar potential loss of economies of
scope would not materialise in C, given the currently limited importance of
proprietary trading activities. However, the mandatory separation of
proprietary trading would result in higher cost of duplication of trading
infrastructure compared to E (as such infrastructure can no longer be shared
between proprietary trading and market making activities in option C). As
proprietary trading and market making are kept together under option E, such a
duplication of infrastructure would not be required under E. | |
| There are ways of reducing the potential
efficiency cost associated with option E should that cost be considered
excessive. This could be done by for example exempting from the separation
requirement certain instruments where existing markets are particularly shallow
and/or illiquid; i.e. reform option "E-". | |
| In terms of operational costs,
option E compared to option C and from the banking group’s perspective would
result in greater on-going operational costs associated with running the separated
trading entity within the group. Although, from a social point of view, the
proprietary trading activities to be banned still need to be housed elsewhere,
operational costs will be higher under option E. Whereas option E- will not
trigger additional operational costs compared to E, option C+ will require
significant regulatory energy to frame and elaborate the decision whether and
when to subsidiarise certain trading activities, to take the subsequent
decision after implementing the ex post process, and in following up the potentially
divergent outcomes across banking groups. For the banks that require
subsidiarisation, the operational costs of complying with the separation will
apply. All in all, C+ will lead to the highest operational costs of all
retained options and variations thereof. | |
| 5.5.3.
Coherence | |
| Reform options relying more on ex post
separation subject to supervisory judgement (option C+ex post) in principle may
give rise to divergent outcomes to banks sharing the same characteristics but
subject to different supervisors, if the framing of such decisions is weak and
therefore allows for flexibility. If so, banks can try to exploit such
divergences by relocating activities (see section 2.4) to Member States where
the supervisor has taken a more lenient approach. Such an effect would not be
coherent with the overall ambition of the Commission following the financial
crisis to reduce the potential for regulatory arbitrage. Furthermore, wide
divergences of de facto application of EU rules would run counter the efforts
to establish a Single rulebook. | |
| Conversely, reform options with higher
degree of ex ante separation and more limited reliance on supervisory judgement
(option E-, option C+ ex ante) would not be associated with the same level of
risk, given that separation will be more firmly set out in primary law and that
less room will be granted for supervisors to exercise judgement. | |
| Even so, there are ways of reducing the arbitrage
risks associated with differing supervisory judgements. The process for
carefully framing the guidance should aim to ensure as consistent an
application as possible throughout the internal market. Furthermore, in
practice the potential for wide divergences is limited by the de facto very
limited number of supervisory authorities involved. The banking groups that on
the basis of historical data look likely to be required to separate would in
the majority of cases be headquartered in a Member State that will participate
in the Single Supervisory Mechanism.[71] The remaining banks come from two other Member States (UK, SE). | |
| Accordingly, while the problem of potential
differences of application is a bigger issue for options with a larger ex post
supervisory judgement element, the risk can be limited by the possibility to
frame the subsidiarisation decision (in particular by creating a rebuttable
presumption for subsidiarisation) and the de facto very limited number of
supervisors concerned. | |
| 5.5.4.
Conclusion | |
| Because of its significantly broader
activity scope, option E delivers greater social benefits compared to option C
and hence may be deemed more effective, at limited additional efficiency cost. However,
there are a number of variations to option C and E that can be considered as
roughly equivalent. | |
| The ex post complement to option C could reduce
the effectiveness gap with option E, especially if that process was clear,
transparent and predicable in terms of result (i.e., the more supervisory
discretion is framed in terms of when and how it would be exercised the closer
to E). It would nevertheless raise significant operational costs for
supervisors to elaborate and implement the required framework to take
bank-specific subsidiarisation decisions. The combination of C with E or E- ,
i.e. “option C+ex ante” above, would also be effective. | |
| The “option C+ex post”,
“option C+ex ante”, and E, albeit not identical either in terms of
effectiveness, efficiency and coherence can be considered to be preferable to
no intervention when balancing the net benefits in terms of improved financial
stability (due to increased resolvability, reduced moral hazard, reduced
conflict of interests, increased competition and diversity, an adequate culture
geared towards better serving the interests of the real economy and spur growth,
etc.) against the increased costs in terms of foregone efficiencies. However,
beyond a largely qualitative economic analysis other considerations of a more
political nature, such as timing of the reform, expected views and position of
co-legislators etc., need to be taken into consideration before making a choice
between these acceptable and justifiable options. As a result this report does
not state a preference between the three options. | |
| In conclusion, the final balance between
the additional benefits in terms of improved ex ante financial stability
(due to increased resolvability, reduced moral hazard etc.) versus the
increased costs in terms of foregone economies of scale and scope and
operational costs in this instance is more a matter of political choice than
technical ranking. | |
| 5.6.
Retained options aimed at increasing the
transparency of shadow banking | |
| As indicated previously, the decision to
separate the banking entities entail risks that parts of the banking sector
shift to the less regulated shadow banking sector. To make sure that this risk
is properly monitored, a series of options have been assessed in Annex A13. A
combination of options has been retained that will complement the options
retained on the structural separation aspect. | |
| Transparency towards regulators: Counterparties to SFTs will be required to report the details of
such transactions to trade repositories. The reporting obligation will cover
all market participants, regulated or unregulated. This reporting will lead to
a substantial increase in the transparency of securities financing markets which
a key sources of liquidity. This will also facilitate regulators' access to market
data and avoid the need to compile unstandardized and dispersed information
from different regulators. It would allow for complete and timely information
to be reported (e.g. principal amount, currency, type and value of collateral,
the repo rate or lending fee, counterparty, haircut, value date, maturity
date), therefore making it possible for regulators to perform a well-timed
comprehensive monitoring of the market developments. The periodic publication
of aggregate data by TRs can be an additional benefit as it will improve the
overall data available to investors but also for research projects. The FSB has
already recommended the collection of frequent SFTs data with high level of
granularity. Meanwhile, the ESRB has concluded in a paper that 'trade
repository collecting transaction data based either on trade-by-trade data or
exposure data is likely to be ideal for a comprehensive assessment of risks'. | |
| Transparency toward fund investors: Fund managers will be required to disclose in their periodical
reports (semi-annually and annually) the use they make of SFTs and other
financing structures to their investors. They will also be required to notify
in the pre-contractual documents such as the prospectus the limits they will
apply as regards their intended use of SFTs. This new information will give
insight to the investors on the transactions that the fund has been involved in
over the previous reporting period. It is a means for the investors to check
the performance of the fund and other indicators regarding the risks or costs.
More generally, it gives the possibility to verify that the fund's investment
strategy has evolved as announced in the prospectus. Investors will also have
knowledge, prior to their investment, on whether SFTs form part of the
investment strategy pursued by a fund. They will be able to measure the
expected risk and reward profile linked to this activity. Their ability to
compare the investment proposition of different investment funds will increase.
In addition, investors will receive increased assurance that managers will not
use to a greater extent than announced in the fund rules. | |
| Transparency of rehypothecation: Specific transparency requirements will be put in place in order to
increase the contractual and operational transparency. These include
contractual agreement on rehypothecation, prior consent to rehypothecation,
transfer of assets to an account of the party which intends to rehypothecate
them. This would ensure that clients or counterparties are fully aware of the
potential risks involved, in particular in the event of default of the receiving
counterparty. Furthermore, prior to the actual rehypothecation the financial
instruments received as collateral have to be transferred to an account opened
in the name of the receiving counterparty, which would also help prevent a
future crisis scenario, where investors are uncertain about their rights, thus
contributing to financial stability. Such rules are consistent with existing
market practice in major securities markets in the EU. The FSB has developed a
similar policy recommendation on sufficient disclosure to clients in relation
to rehypothecation of assets. | |
| 5.7.
Complementary aspects
5.7.1.
Quantitative assessment of some benefits and
costs | |
| In general, it needs to be stressed that,
given the inherent complexity and special nature of banking and given that many
benefits and costs are dynamic in nature (often related to unobservable
incentives), no quantitative model exists that can reliably, precisely and
comprehensively estimate the social benefits and costs of structural reform
proposals. | |
| Moreover, quantitative analysis in this
specific area is further constrained by the fact that intent-based proprietary
trading cannot be easily distinguished from genuine market making activity (see
also section 5.5.1.1). Accordingly, reliable data on the extent of proprietary
trading and market-making is not available. | |
| In order to support the qualitative
assessment and comparison of reform options carried out above, the Commission
services have attempted to quantify on a best-effort basis and to the extent
possible some of the costs and benefits that could result from structural
separation. | |
| As one element, the Commission services
invited EU banks in the context of the public consultation to model and
estimate the impact of stylised structural reform scenarios on the group's
balance sheet, profit and loss account and selected other bank variables
between now and 2017, taking into account CRR/CRDIV and BRRD. A very limited
number of banking groups responded. Moreover, the simulated impacts (e.g.
funding costs, total costs, return on equity, ratings, etc.) differed
substantially between respondents and gave rise to inconsistencies both within
a given set of results as between different sets of estimated impacts (see
Annex A11). | |
| As another element, the JRC has attempted
to assess some of the costs and benefits of structural separation (see Annex
A10). In relation to benefits, the aim has been twofold. First, to examine the
impact on incentives on the basis of the distribution of gross losses across
stakeholders. Second, to estimate the reduced contingent liability for the
resolution process following the estimated behavioural response of banks to
shrink or recapitalise the trading entity post reform. In relation to costs,
the analysis has focused on estimating the increase in the banks’ private
funding cost post-reform. | |
| It is important to note that the costs and
benefits that the JRC has been able to quantify are not comprehensive and are
dependent on underlying assumptions (how to separate balance sheets,
behavioural responses of banks, required rates of returns for the different
funding sources under different scenarios, etc.). Moreover, important social
benefits (including the reduction in the probability of systemic crisis and in
contagion as well as the impact of the reform on avoiding conflicts of
interest, misallocation of resources and facilitating supervision, etc.) and
costs (such as economies of scope and scale, impacts on liquidity of secondary
markets and legal costs) have not been quantified and modelled. Benefits and
costs are estimated in a scenario where the resolution framework is considered
to apply effectively to the entire considered sample of banks even before any
structural separation of these banks (bail-in is fully effective).[72] | |
| With all these caveats in mind, the
stylised JRC analysis indicates the following for the specific benefits and
costs measured (see Annex A10 for details):[73] | |
| In terms of benefits, the results of the
analysis suggest that trading entities incentives are better aligned, as a
higher part of their losses would be absorbed by their shareholders and
creditors and would be not passed through to the rest of the financial system.
In addition, the contingent liabilities faced by the resolution process for the
banking sector in case of crisis will be reduced following structural
separation. By way of illustration, in a crisis of similar severity to that of
2008, potential gross losses are estimated to decrease by up to €125 billion,
while the share of gross losses absorbed by the trading entity would increase.
The contingent liabilities for the resolution process could be reduced by up to
€58 billion, as there would be lower losses due to better aligned incentives
and reduced risk taking for the trading entity. | |
| In terms of costs, it is important to note
that increased funding costs (under both the subsidiarisation and ownership
separation scenarios) is an intended outcome of structural reform, as it leads
to a more efficient pricing of risk reflecting enhanced market discipline. By
way of illustration, the trading entities subject to separation are estimated
to face an increase in funding costs of up to 9 basis points (in a conservative
scenario where risk premia do not decrease following reduced risk taking and
increased capitalization of the trading entity), which will generate an
increase in the average cost of funding for the affected group as a whole of up
to 3 basis points. As banks subject to separation are estimated to hold about
55% of the assets of the EU banking system, this translates into a sector-wide
funding cost increase of up to 2 basis points – equivalent to approximately up
to €7 billion per annum. | |
| As explained in section 5.2.2, the increase
in the funding cost of the trading entity is an intended outcome of structural
reform and should not strictly be considered a social cost. Nevertheless, the
Commission services have tried to estimate the reduction in GDP growth that
would follow from passing on the estimated funding cost increase following
conservative assumptions (i.e. assuming that the entire funding cost increase
is passed on into higher borrower rates rather than lower profitability or
employee salaries) and making use of the QUEST DSGE model with a banking
sector.[74] The model suggests that an increase in private funding costs of 2-3
basis points translates – under the retained conservative assumptions – into a
reduction of the long term annual level of GDP of between 0.08% and 0.11%. This
clearly represents a worst-case scenario, as the increase in the funding cost
of the trading entity will not be fully reflected in interest rates for credit
to the real economy. In addition, one should note that the negative effect on
the level of GDP in the initial years of the simulations are less than in later
years, i.e. in the long term. Thus, the average annual effect on GDP would be
less than the long-term effect. Moreover, these figures represent a gross cost,
not a net impact, as they do not incorporate any positive impact on GDP growth
stemming from social benefits resulting from facilitated resolution, increased
financial stability, etc. (see above). These results are fully compatible with
the cost estimation methodology presented by the European Commission in the
Impact Assessment of the BRRD.[75] | |
| 5.7.2.
International aspects
5.7.2.1.
Territorial scope of the reform | |
| The objective behind determining the
territorial scope is (1) to ensure that all group entities within the EU are
covered by EU rules and (2) to reduce potential contamination effects stemming
from EU subsidiaries and branches established in third countries. Accordingly,
separation should apply to (i) EU banks, their subsidiaries and branches,
including in third countries; and (ii) subsidiaries in the EU of banks
established in third countries. | |
| EU branches of third
country banks operate under authorisation and conditions imposed by the Member
State where the branch is established with the limitation that they cannot be
treated more favourable than branches of EU banks. They do not enjoy the
freedom to provide services or the freedom of establishment in other EU Member
States. The conditions regarding structural separation vis-à-vis these branches
should thus also be left for the Member State hosting the branch. | |
| 5.7.2.2.
Impact on competitiveness of EU banks | |
| Both the preferred
reform options mirror rules that are either already in place in the US or are in
the process of being implemented: | |
| ·
Option C corresponds to the Volcker Rule of the
Dodd-Frank Act, which prohibits US banks from engaging in proprietary trading,
as well as curtailing their investments in certain funds (See Annex A1 for
further detail); and | |
| ·
Option E would be similar to the rules applying
to US banking groups. While US banking groups (bank holding companies or
financial holding companies) may engage in a wide range of financial
activities, the part of the group that takes insured deposits (“insured
depositary institutions”) still face activity restrictions that limit their focus
to core banking activities (e.g. taking deposits, lending) and other incidental
activities (e.g. custody and asset management). Furthermore, the US also has
rules governing transfers between the different parts of a banking group, which
are aimed at isolating the insured depository institution from excessive risks
arising from the larger financial firm of which it is part (BHC, FHC) and to
prevent the transfer of the subsidy arising from federal assistance to
non-depository financial institutions. These firewalls have been strengthened
as part of the DFA (See Box 2 and Annex A1 for further detail). | |
| Implementing either option is accordingly unlikely
to have material negative effects on the competitiveness of EU banks vis-à-vis
US banking groups.[76] | |
| 5.7.3.
Institutional scope
5.7.3.1.
Thresholds | |
| As argued above, the
Commission services believe that an approach that combines an accounting-based methodology
with an additional systemic risk metric is the best approach to determine the
scope of banks subject to potential structural separation. The systemic risk is
captured by the EU global systemically important institutions. Regarding the
accounting-based approach, the second step has been to review the threshold and
definition of trading activities recommended by the HLEG. | |
| The Commission Services
have in particular decided to analyse the definitions presented in Table 4,
also considering limitations due to the need to rely on publicly available
accounting data. | |
| Table 4: Definitions
of trading activities | |
| 1 || HLEG definition | |
| 2 || Exclusion of Available for Sale (AFS) assets under the assumption that they are mostly held for liquidity purposes | |
| 3 || Gross volumes (assets + liabilities) of securities and derivatives held for trading (to focus on market and counterparty risk) | |
| 4 || Net volumes (assets – liabilities) of securities and derivatives held for trading (to focus on market risk) | |
| The Commission services
do not believe that thresholds necessarily need to be set in legislation.[77] Nonetheless, the Commission services have carried out analysis with
the aim of considering different absolute and relative thresholds. That
analysis notably includes carrying out tests to ensure that any threshold
captures banks sharing similar characteristics (“clustering analysis”). | |
| The HLEG recommended an
absolute threshold of EUR100bn of trading assets and a relative threshold of
trading assets to total assets in the range of 15-25%. Whereas
the thresholds suggested by HLEG (Option 1) would be effective in selecting
systemic banks, it would also include a relatively wide set of banks that do
not appear to be of systemic importance (Annex A8). The disproportionately
large scope of selected banks finds its origin in the consideration of AFS
assets for the purposes of defining trading activities. However, banks tend to
largely hold AFS assets mainly for liquidity purposes. The other options
therefore have excluded AFS assets. | |
| Having excluded AFS
assets from the definition of trading activities and having also modified the
definition of trading activities so as to focus more on market and counterparty
risks, the Commission services have first analysed what would constitute
thresholds for the various definitions equivalent to those suggested by the
HLEG, and then applied clustering techniques to further improve them (Annex
A8). All definitions are based on publicly available balance sheet data and
have been computed as averages over a 6-year 2006-2011 period. The results are
shown in Table 5 below. | |
| Table 5: Proposed
thresholds based on cluster analysis (Annex A8) | |
| Option || THRESHOLDS || SELECTED BANKS || SELECTED BANKS BY SIZE | |
| || Trade Activity EURbn || Share Trade Activity || Number || % of the sample || % of the sample in total assets || Large || Medium || Small (then exempted) | |
| 1 || 80 || 20% || 52 || 21% || 75% || 19 || 16 || 17 | |
| 2 || 70 || 15% || 32 || 13% || 60% || 13 || 10 || 9 | |
| 3 || 70 || 10% || 36 || 15% || 65% || 13 || 16 || 7 | |
| 4 || 30 || 8% || 33 || 14% || 51% || 11 || 7 || 15 | |
| Note:
Large banks are defined as having total assets above EUR500bn. Small banks are
defined as having total assets below EUR30bn. “Trade activity” refers to the
different definitions as set out in Table 4. The sample of banks considered is 245.
In definition 3 (option 3), the actual amount refers to half of the total gross
volumes. | |
| Analysing the banks
selected by these definitions, it can be noticed that the second option, that
exclude AFS from the HLEG definition, does not include all the EU banks that
are currently considered as being of global systemic importance, and hence
would be of limited effectiveness. | |
| Option 4 - which would
focus on the difference between trading assets and liabilities (net volumes) -
would also be of limited effectiveness, as it would exclude an even larger
number of banks with significant trading operations. | |
| The preferred option is
therefore option 3 (with a threshold based on gross volumes of trading assets
and liabilities). This option captures nearly all the EU banks considered to be
of global systemic importance and those with significant trading activities. | |
| In order to avoid that
small banks are selected, an additional floor threshold is applied. The Commission services suggest using the floor for “significant
institutions” used in the SSM-ECB Regulation (EUR30bn of total assets).
Following this adjustment, the preferred option 3 selects 29 medium and large
banks representing about 65% of the assets in the sample. Importantly, this
list includes all but one of the European globally systemic banks (“G-SIBs”)
identified by the FSB. Moreover, the list is not sensitive to small changes in
the thresholds.[78] | |
| Option 3 captures both
market and counterparty risk typically associated respectively with proprietary
trading and market making, and is hence relevant for all the option retained
above. In addition, banks designated as G-SIIs should also
be subject to separation as well. | |
| 5.8.
Impact on stakeholders | |
| This
section discusses the general impact of bank structural reform[79] on the numerous stakeholders. The assessment remains at high level,
as the precise impact will depend on the design of the height and location of
the fence and the institutional scope. | |
| In
general, opponents to structural reform typically raise a series of concerns on
bank structural reform. Allegedly, bank structural reform: | |
| ·
raises the funding costs of banks and hence
lowers economic growth; | |
| ·
harms market liquidity and hence lowers economic
growth (when subsidiarising market making and other trading activities); | |
| ·
increases financial instability as it makes
banking groups less resilient to shocks; | |
| ·
unduly abolishes the European universal banking
model that has proven successful and resilient throughout the crisis; | |
| ·
reduces bank employment; | |
| ·
fragments the internal market by allowing
banking groups to ring-fence their core banking activities according to
national borders; | |
| ·
would not have avoided important bank failures
of the recent financial crisis such as Lehman Brothers, Northern Rock, or Cajas; | |
| ·
is ineffective in shielding the deposit taking
entity from trading risks due to reputational and information contagion; | |
| ·
reduces competition in the EU banking sector, and | |
| ·
is inappropriately timed given the reform
agenda. | |
| This Impact Assessment already has addressed
several of these statements in Chapter 2 and elsewhere. This section presents
additional arguments where appropriate to qualify and/or rebut the above concerns.
The Commission services consider that some concerns are not valid. Others are,
but merely stress the reform costs whilst neglecting the reform benefits that
are likely to outweigh the social costs. The additional communication difficulty
is that private costs are borne by only a few, but vocal and large banking
groups, whereas social benefits are enjoyed by many small taxpayers, only
become obvious in the medium term, and are not easily quantifiable (improved
banking culture, reduced systemic crisis incidence, reduced implicit
subsidies). | |
| 5.8.1.
Impact on bank customers (investors, borrowers,
etc.) and market liquidity
5.8.1.1.
Market liquidity and funding costs | |
| Funding costs are
likely to be unaffected for the deposit taking entities as well as for
medium-sized competitors. The latter gain market share and increase their
profitability whilst at the same time making the market less concentrated and
more competitive. | |
| However, at unchanged
balance sheet size, the impact of the reform would unavoidably lead to some increase
in funding cost increases for the trading entity. In fact, modest increases of
funding costs for the trading entity is an intended consequence of structural
reform and reflects primarily reduced implicit subsidies for the trading
activities (not foregone synergies between relationship banking and trading
activities, as they are exhausted at a small fraction of the balance sheet size
of affected banking groups, see Annex A9). The funding cost would reflect the
underlying riskiness of the trading activities. As a result, incentives to take
excessive risks are reduced, artificial competitive advantages of TBTF banks
are being reduced, thereby restoring the level playing field with deposit
taking banks focused on credit intermediation to corporates and households. | |
| A particular concern is that the increased
funding costs would lead to liquidity problems in the market. Given that bond
markets rely on market makers to act as willing buyers and sellers, subsidiarisation
of market making (in particular ex-ante subsidiarisation under reform option E)
triggers concerns that sovereign and corporate debt markets become less liquid.
“Liquidity” is often left undefined, but typically the fear is that bid-ask
spreads may increase, increasing the costs to trade at any scale. Investor
options will be reduced, as trading entities can no longer trade as much and as
easily as before. Price discovery is made more difficult. And price volatility
may increase, if professional position takers no longer spot price divergences
from rational levels and correct them through speculation and trading. | |
| However, these concerns appear exaggerated
for several reasons. First, the market liquidity concern neglects the fact
that structural separation merely aims to reduce the implicit subsidies that
distort the proper market functioning. Indeed, market prices are distorted when
contaminated with implicit public subsidies and the banking system may in fact
produce excess liquidity (as is evident from its rapid and unsustainable
expansion). | |
| Second, international and past experience
shows that subsidiarisation would not have a substantial effect on liquidity. The
US has 80 years of on-going experience with subsidiarisation of investment
banking activities (including market making, underwriting, etc.), as deposit
taking affiliates within a Bank Holding Company are not allowed to do other
than “core banking activities” (see Annex A1 and Box 2). There is no evidence
that suggests that US bond markets are less liquid than European ones and have
been constrained in their development. To function properly, markets need a
large number of independent traders. Subsidiarisation of market making exposes
this activity to its underlying riskiness. This would ensure fair competition
across stand-alone investment banks and investment banking arms within
universal banking groups. These limitations may increase the number of market
participants, making markets instead more liquid.[80] In the era when Glass-Steagall was in place, which went much beyond
mere subsidiarisation reform options, the US economy has on average been
thriving, compared to the current juncture. | |
| What matters for the real economy is the
level of the interest rate at which corporates and sovereigns can fund
themselves, which is a function of the supply and demand for these securities,
and whether bid-ask spreads are reasonable to allow a normal degree of trading
transactions. The liquidity premium only makes up a negligible fraction of the
interest rate level and reflects the extent to which the security can be
exchanged. | |
| Bid-ask spreads on sovereign bonds of DE,
FR, UK and large corporates were for example already at negligible levels
before broker-dealer arms of universal banks started to sharply increase their
inventories and market making activities in the early years 2000. Bid-ask
spreads on Bund paper have not decreased in the run-up to the crisis, although large
European banks have sharply increased their inventories. Also seen in
perspective, bid-ask spreads are relatively negligible compared to the interest
rate level: 10 year Spanish government bond yields have more than doubled and
increased from less than 3.5% in June 2006 to more than 7.5% in July 2012
(chart 12). Bid-ask spreads in the period June 2006 to August 2013 on average
are 2bp (0.02%) and spiked at 12bp (0.12%) in June 2012 (chart 13). The above
suggests that the willingness and ability of (private sector) market makers to
influence the interest rate level is relatively limited. If anything, their
procyclical behaviour and excessive liquidity provision sows the seeds of
future crises in which they want to deleverage excessively. | |
| Chart 12: Yield to maturity of 10 year Spanish government bonds || Chart 13: Bid-Ask spreads of 10 year Spanish government bonds | |
| || | |
| Source: Commission Services – Bloomberg || Source: Commission Services - Bloomberg | |
| Third, the bulk of the securities
inventories of banks do not correspond to sovereign or corporate debt, but
rather to securities issued by other financial firms. Only a tiny fraction of
the outstanding securities in the Eurozone has been issued by non-financial
non-state issuers (chart 14). A similar observation holds for OTC derivatives,
of which only a tiny fraction have non-financial firms as counterparts. The
bulk of OTC derivatives are intra-financial sector derivatives (see also BIS (2013)). | |
| Chart 14 – Outstanding securities in the
Euro Area according to issuer | |
| | |
| Fourth, Richardson (2013) notes that the
issue of liquidity is more relevant in times of crisis than in normal times
when liquidity is typically not a pressing concern. Private banks have not
performed a significant liquidity role during crisis period and central banks
have stepped in to assume the role of Market Maker of Last Resort (in covered
bond markets, government bond markets, etc.) next to Lender of Last Resort. Finally,
the liquidity concern is often built on the presumption that more liquidity is always
and inherently positive, irrespective of its level, which is not the case.[81] Financial economics does not have a good explanation yet. One
explanation for excessive trading is overconfidence, as in Odean (1999). Recent
work presents models in which trading and trading speed can be excessive (Glode
et al. (2012) and Bolton et al. (2012)). In these models, advances in IT do not
necessarily improve the efficiency of financial markets. French (2008)
estimates that investors spend 0.67% of asset value trying (in vain on average,
by definition) to beat the market. | |
| 5.8.1.2.
Households, SMEs, depositors and taxpayers | |
| Households and SMEs that are clients of a
banking group that needs to subsidiarise certain capital market activities would
typically demand retail-type services which can be provided by the deposit
entity. Hence, the increased funding cost for the trading entity is unlikely to
affect borrowing conditions for households and SMEs. In fact, some capital market
activities entail significant risk. Separating such activities from the deposit
entity will reduce excessive risk taking and artificial balance sheet expansion
and hence may lower the funding cost for the deposit entity. | |
| Medium-sized competitors or new entrants
that are not subject to mandatory separation may gain market share from large
banking groups if artificial competition distortions in favour of too-big-to
fail banking groups are being reduced. Hence, whereas some banking groups may
face increased costs and may no longer serve certain customers, those
activities may be picked up by smaller competitors that do not face structural
separation requirements. Customers are accordingly not likely to be left
unserved. | |
| The impact of the preferred policy options
on households, taxpayers and depositors will be positive. Households will
predominantly be clients of the deposit taking subsidiary and hence will no
longer be vulnerable to the same extent to trading and capital market related
risks and conflicts of interests. At the same time, given that the funding cost
of the deposit taking subsidiary is not estimated to go up, there should be no or
a limited impact on borrowing rates or deposit rates. Importantly and although
not very visible to each of them, they benefit from the reduced likelihood of
taxpayer support for large banks. They will also benefit from being less
vulnerable to conflicts of interest within the bank, as the culture of the
deposit taking subsidiary should be more relationship-oriented and less
affected by a transaction- and deal-oriented culture. | |
| SMEs will primarily be banking with the
deposit taking subsidiary whose funding costs should not be negatively affected
by the separation of trading activities, hence there should be no impact on
borrowing rates or deposit rates of SMEs. SMEs will also benefit from reduced
conflicts of interest within the bank. Given that banks no longer will have
distorted incentives to allocate their capital towards trading activities, SMEs
are also likely to benefit from bank capital being more devoted to serving the
real economy. | |
| The preferred policy options do not imply
the end of the universal banking model, but implements “structured” universal
banking and largely retains any potential economies of scope (e.g. one-stop
shopping) that may be of particular importance to SMEs (even though many SMEs
are likely to have more than one banking relationship in order to foster
competitive terms). The subsidiarisation is expected to reduce diseconomies
of scope, such as excessive risk taking and conflicts of interest. | |
| 5.8.1.3. Large corporates | |
| Large non-financial corporates would no
longer be vulnerable to conflicts of interests, as the bank no longer can make
improper use of client-related information to increase its own profits (e.g. by
means of proprietary trading). Similar to SMEs, while large corporates buys
financial services from a wide range of banks, they would still be able to
procure a full set of financial services from a single bank should they so wish. | |
| In terms of banks attempting to pass on
potential increases in their private costs resulting from separation, large
corporates would be able to exercise pressure to reduce such a potential
impact. They could access capital markets directly or borrow from a competitor
bank. | |
| Following separation, large corporates
would be able to choose their bank of preference on the basis of a
price/quality ratio comparison that is no longer distorted by artificial
funding cost advantages. | |
| The preferred policy options would most
likely lead to increased funding costs for activities performed by the trading
entity. This is indeed a logical consequence of the reform proposal, which aims
at ensuring that the price of an activity internalises the associated risk.
This provides the right incentives for the various banking activities carried
out within a group. Accordingly, whether this could render certain business
lines of EU-based banks less competitive should not be a decisive criterion and
should be weighed against other overriding policy principles are being sought,
i.e. greater financial stability, easier bank resolvability, less likelihood
for public support, and greater benefits for the society as a whole. | |
| 5.8.2.
Impact on bank employment | |
| Structural reform, as it aims at addressing
a misallocation of resources in the economy is likely to have some impact on
bank employment. Some executives and traders would be negatively affected by
the preferred policy options, as it would become more difficult to engage in
proprietary trading given that the funding cost of the trading entity will
reflect the risk of such activities.[82] Competition on the merits would keep economic rents lower. It is
likely that the private cost increases are at least partially shifted to
executives and traders, in terms of reduced remuneration (in particular
bonuses). | |
| Other employees of the deposit bank are
unlikely to face a significant deterioration of their remuneration package. As
relationship-based banking activities tend to be more labour intensive than
trading activities, a refocusing of banks towards these activities should not
imply a negative impact on employment and could even have a positive impact.
The deposit entity will no longer have to act as buffer to absorb shocks and
losses from the trading entity. | |
| More generally, the flow of the most
talented individuals into financial services may not be desirable, because
social returns in other occupations may be higher, even though private returns
are not. Philippon and Reshef (2012) find that workers in finance earn the same
education- and other characteristics adjusted wages as other workers until
1990, but by 2006 the premium is 50% on average (i.e. the compensation of finance
employees is 50% higher than expected). Top executive compensation in finance
follows the same pattern and timing, where the wage is on average 250% higher
than expected. An almost identical rise in the wage levels of finance workers
relative to other business sectors was also seen in the 1920s. It was only in
the late 1930s that banking pay fell to levels comparable with other industries
where they stayed for almost 5 decades. Philippon (2013) claims that financial
deregulation is responsible for the excessive wages in the finance sector,
rather than the technology of modern finance.[83] | |
| Several authors (Baumol (1990), Murphy,
Shleifer and Vishny (1991), Philippon (2013)) argue that the flow of talented
individuals into financial services from other sectors of the economy (such as
manufacturing, IT) may not be entirely desirable, because social returns may be
higher in other occupations, even though private returns are not.[84] Many bank employees have strong science or engineering backgrounds.
They could also increase the talent base for regulators. | |
| In principle, structural reform is aimed at
better directing bank capital and resources to those activities that finance
the real economy. Proponents argue that without any structural separation,
banks may be incentivised to allocate capital and human resources to trading
and intra-financial activity and away from lending activity. Opportunities to
engage in socially less useful activities in finance (speculation) can crowd
out the provision of useful financial services (lending and banking services)
or make them more expensive (Arping (2013)). | |
| 5.8.3.
Impact on bank shareholders and unsecured creditors | |
| Structural reform should create incentives
for shareholders to be more mindful of excessive risk. In particular for the
deposit taking entity, risk would be lowered and required returns should be
lowered accordingly. So, whereas return on equity will be lowered, the
risk-return trade-off does not need to be worse. There is a potential to
rebuild a relationship of trust with bank stakeholders. | |
| The financial crisis has underlined the
importance of effective scrutiny and the exercise of discipline by creditors.
Such discipline has been lacking, in large part as a result of the perceived
taxpayer guarantee. The measures to reduce the implicit public subsidies would
be the most effective way of correcting this, as bondholders would have a
greater incentive to assess credit risk. Market discipline from creditors
should encourage banks and their managements better to balance downside and
upside risks. | |
| Creditors of the trading entity would
require and receive higher returns as a compensation for the higher risk
exposure, given that they will no longer be shielded by an implicit subsidy, as
before. | |
| 5.8.4.
Impact on regulators and supervisors | |
| Regulators and supervisors will benefit
from increased transparency as separate entities will be subject to separate
reporting and governance, and constrained in terms of activities they can
conduct. The structural separation should allow simplifying bank regulation and
tailoring it to the specific entities. | |
| Philippon and Reshef (2012) argue that
regulators do not have the human capital to keep up with the finance industry.
Given the wage premium that they document for finance employees, it is
impossible for regulators to attract and retain highly skilled financial
workers because they cannot compete with private sector wages. They also report
that the ratio of executive compensation in finance (the top regulated) to the
highest salaries paid to regulators (the top regulators) grew from 10 in 1980
to over 60 in 2005 (or 40, excluding bonuses). This provides a potential
explanation for regulatory failures and for circumvention of regulatory
requirements. | |
| Following structural reform, regulation and
supervision could be better tailored to the nature of the banking activity in
the deposit taking entity and trading entity, respectively. Arguably, banking
groups engaged in a variety of activities also require much more complex
regulation and supervision. More simplicity in terms of corporate structure of
banks would normally allow simplifying regulation and supervision of banks, and
potentially render supervision and regulation more effective. Likewise, the
prudential regulation of banks is difficult for investors to understand.
Accordingly, investors do not or are not able to fully exercise the “watch-dog”
function under Basel's “pillar 3“ (market discipline). Unsecured bank creditors
and investors perceive modern banks as opaque and as black boxes and it is
possibly for this reason, inter alia, that they have started to call for
structural separation. Institutional investors voiced their concern that banks
are too opaque and complex to invest in.[85] If this claim were confirmed there is a prospect that certain forms
of structural reform could, in fact, improve banks’ funding strains. | |
| 5.8.5.
Impact on EU banking industry | |
| Given the TBTF focus, structural reform
would target a limited set of banking groups that are large, complex and engage
in significant trading activity. Hence, structural reform would not affect the
large majority of 8000+ banking groups in the EU, and would in particular
exclude small cooperative and savings banks that focus on serving the financing
needs of local communities and small businesses. It would therefore preserve
the diversity of the EU banking sector, e.g. in terms of different business
models. Given the reduced reliance on implicit public subsidies, competition on
the merits would become more important, which should lead to inefficient
competitors exiting the market and allowing more efficient competitors,
including new entrants, to gain market share and revenues. Each part of the
group would be subject to its own profitability and resource constraints. To
the extent that structural reform facilitates and enhances the effectiveness of
bank resolution, exit barriers are being removed, which gives more
opportunities for banks that have a sound and prudent business model (European
Commission (2011)). | |
| The success and resilience of the universal
banking model should not be taken for granted. The current EU financial system
is dominated by relatively few large, interconnected and diversified universal
banking groups. Whereas several of those large EU universal banking groups have
weathered the crisis well, the EU financial system as a whole would have likely
imploded due to a system-wide cascade of banking failures without the
extraordinary and on-going taxpayer, government and central bank support
(European Commission (2011, 2012)). The (contingent) taxpayer support to date
amounts to 40% of EU GDP (€5.1 trillion parliamentary committed aid measures)
and has undermined the solidity of several Member States' public finances. In
the case of some Member States it has contributed to turn a banking crisis into
a sovereign crisis (European Commission (2011, 2012)). This has had the effect
of further increasing the fragility of the banking system since banks hold
large volumes of sovereign bonds on their balance sheet - and hence confidence
on these banks depends on the robustness of the public safety nets). Implicit
subsidy estimates suggest that the EU universal bank profitability may be
artificially high given the indirect and implicit sponsoring by their
sovereigns: the largest EU banks are likely to benefit more from implicit
subsidies (which represent a sizeable part of their profitability, see Annex
A4). | |
| Bank balance sheets would no longer grow as
aggressively as before. Large European banks have expanded and leveraged up
rapidly in the run-up to the crisis. They have also expanded internationally,
by relying on USD short term wholesale markets and investing in USD claims,
effectively intermediating between US savers and US borrowers (Shin (2012)). | |
| Note that the retained structural reform options
are not calling for a break up of banking groups (with the exception of
proprietary trading activities which constitute a small share of banks’ balance
sheets), but simply wants to disentangle the activities that are considered
long-term and relationship-oriented from those that are short-term,
transaction-oriented, and the most prone to rapid change, while at the same
time it wants to maintain banks’ ability to efficiently provide a comprehensive
range of financial services to their customers. The proposal is simply to
introduce more structure in EU banks, not to break them up. Structural reform
through subsidiarisation merely intends to clarify the structure of universal
banks. The nature of the activities drives the distinction in underlying
cultures. Commercial banking typically involves long-term lending
relationships, whereas trading typically involves a short-term perspective. The
separation of the two distinct cultures would avoid that a short-term oriented,
deal- and fee-based trading culture negatively influences the long-term
relationship-based culture of the deposit and lending entity. There is
significant public support for structural reform, as highlighted in section
1.1, and as voiced by top economists and financial experts.[86] | |
| Amongst others, banks operate the payment
system, make loans to households, businesses and governments, help households
and businesses to manage their risks and accommodate their financial needs over
time. The purpose of the financial sector and banks should be to serve the
“real economy”. A safe and sound banking sector is a pre-condition to fulfil
these essential functions, serve the real economy, and allow for sustainable
growth. Sustainable economic growth is what counts, not temporarily boosted
artificial growth that results in booms and subsequent busts. As such, there is
no conflict between stability and growth. As shown in the on-going banking
crisis, taxpayer bailouts often prevent the market exit of failing banks,
rather than just ensuring the minimum possible (i.e. the continuation of
critically important activities and services that cannot easily be provided
through other players). | |
| In addition, the increased funding costs
are likely to reflect the underlying riskiness of the activities. Genuine
economies of scale are found to be exhausted at relatively low levels of assets
and banking groups that would be subject to structural reform operate at scales
that typically exceed that level (see Annex A9). | |
| Also it is not obvious that any benefits
are passed on to consumers. Philippon (2013) find that the unit cost of
intermediation has not decreased over the past 30 years, despite advances in
information technology, changes in the organisation of the finance industry,
and despite the growth of new markets, notably for financial derivatives. | |
| Given the importance of implicit subsidies
in terms of banks’ profits, bank profitability is likely to be reduced
following the funding cost increase of the trading entity. However,
risk-adjusted bank profitability will not necessarily be lower, as structurally
reformed banks will be less risky.[87] | |
| Philippon and Reshef (2012) find that much
of the increase in financial activity has taken place in the more speculative
fields, at the expense of traditional finance. From 1950 to 2006, credit
intermediation (lending, including traditional banking) declined relative to
“other finance” (including securities, commodities, venture capital, private
equity, hedge funds, trusts, and other investment activities like investment
banking). Wages in “other finance” sharply increased relative to those in
credit intermediation. Bolton et al. (2012) argue that a significant amount of
speculation and deal-making is pure rent-seeking. In other words, it is
wasteful activity that achieves nothing more than enabling the collection of
rents on items that might otherwise be free. | |
| Cecchetti and Kharroubi (2012) empirically
find that the enlargement of the financial system, beyond a certain the size,
is associated with reductions in real productivity growth. This, in part, may
be due to the financial sector competing with the rest of the economy for
scarce resources. Arcand et al. (2012) also find that there can be “too much”
finance. When private credit reaches 80% to 100% of GDP, which is largely
exceeded for several crisis-affected EU Member States such as DK, NL, IE, CY,
UK, ES, PT, further private credit is found to be negatively associated with
GDP growth. The hypothesis is that excessively large financial systems may
reduce economic growth because of the increased probability of a misallocation
of resources, the increased probability of large economic crashes[88], or the endogenous feeding of speculative bubbles. Philippon (2008)
observes that outstanding economic growth was achieved in the 1960s with a much
smaller financial sector. | |
| Furthermore, structural reform could have
an important beneficial impact on the stability of the financial system.
Structural reform could affect the probability of banking crises such as Lehman
Brothers, Northern Rock or Cajas. Following structural reform, Lehman Brothers
would have been less connected to deposit taking banks, and therefore the
impact of its failure would have been less disruptive. Under lower levels of
interconnectedness with deposit entities, resolvability of Lehman Brothers
would pose fewer concerns and would thus be more likely. Anticipating this, the
scope for aggressive pre-crisis growth and contagion upon failure would have
been reduced through increased market discipline. Investment banks would not
have been obliged to compete as aggressively as they did, faced with
competitors that enjoyed artificial funding cost advantages thanks to their
safety net coverage. The repeal of Glass-Steagall may have significantly
increased the competitive pressure felt by pure investment banks like Lehman
Brothers and Bear Stearns given that they faced commercial banks that were
allowed to enter the investment banking area after 1999 and which could do so
at artificially low funding costs. | |
| In the case of Nothern Rock and Caja
collapses, structural reform could contribute to avoiding the aggressive growth
and lending practices of these institutions. Such practices were only made possible
by relying on financial innovation, including wholesale funding, securitisation
of mortgages, and derivatives to structure these products for distribution to
investors, which in turn reflected the expansion of the largest European banks.
The rationale of structural reform is to refocus the deposit entities of large
banks towards a sustainable relationship-oriented model of banking and move
away from a transaction-oriented fee-based and short term oriented business
model. Although the rules and restrictions would not apply to Northern Rock and
Cajas, they would not feel similar pressure and they would not dispose of
similar possibilities to leverage up as quickly as they did. Moreover, the
current real estate crises, unlike most in history, imperilled sovereigns because
sovereigns were obliged to bail out not only deposit entities but also banking
activities that they should not have had to bail out. | |
| Some argue that reputational or
informational contagion would still create spill-overs between the two entities
in a crisis and that deposit taking entities would not be able to avoid
confidence crises if problems arise in the trading entity of the group.
However, authorities will have more options to act in dealing with a distressed
banking group, if the basic parts are more distinct from each other. Better
structured groups allow to isolate the problem better than when the group
structure is opaque.[89] Finally, structural reform aims to make the safety net more limited
in scope and hence more credible and effective in stopping a run when it does
occur. | |
| 6.
Monitoring and Evaluation | |
| Monitoring will take
place during the phase-in period. | |
| Ex-post
evaluation of all new legislative measures is a priority for the Commission. Evaluations are planned about 4 years after the implementation
deadline. The forthcoming Regulation will also be subject to a complete
evaluation in order to assess, among other things, how effective and efficient
it has been in terms of achieving the objectives presented in this report and
to decide whether new measures or amendments are needed. | |
| In terms of sources of
information that could be used during the evaluation, the data provided from
the national central banks, the national regulators, European bodies such as
the ECB, EBA and ESRB and from international organizations such as BIS, OECD,
IMF and FSB. Relevant data could also be collected by relevant market
participants or intermediaries. | |
| Relevant indicators to
evaluate the effectiveness of the reform proposal could include: | |
| ·
Number and aggregate assets of banks subjected
to structural separation requirements; | |
| ·
Allocation of activities to deposit-taking or
trading entity; | |
| ·
Transaction volumes, spreads or liquidity in
relevant markets; | |
| ·
Trends in market shares of banks subject to
structural separation; | |
| ·
Market concentration in activities subject to
structural separation; | |
| ·
New entrants in activities subject to structural
separation; and | |
| ·
Trends in profitability of banks subject to
structural separation, benchmarked against international peers and
risk-adjusted. | |
| ·
Measures of TBTF banks’ funding cost advantage; | |
| ·
Measures of trading and loan activity by TBTF
banks; and notably | |
| ·
Measures of the size of implicit public
subsidies. | |
| References | |
| Acharya, V., T. Cooley, M. Richardson, and I. Walter
(2009), "Manufacturing tail risk: a perspective on the financial crisis of
2007-2009", Foundations and Trends in Finance, 4, 4, pp. 247-325. | |
| Admati, A. and M. Hellwig (2013), The Bankers' New Clothes:
What's Wrong with Banking and What to Do about It, Princeton University Press. | |
| Adrian, T. and H. Shin (2010a), “Liquidity and
leverage”, Journal of Financial Intermediation, 19, 3, pp. 418-437. | |
| Adrian, T. and H. Shin (2010b), “The Changing Nature
of Financial Intermediation and the Financial Crisis of 2007–2009”, Annual
Review of Economics, 2, 603–18. | |
| Alessandri, P. and A. Haldane (2009), "Banking on
the State", paper underlying a presentation delivered at the FRB Chicago
International Banking Conference on 25/09/2009. | |
| Arcand, J-L., E. Berkes and U. Panizza (2012), “Too
much finance?”, IMF Working Paper 12/161. | |
| Arping, S. (2013), “Proprietary trading and the real
economy”, Duisenberg School of Finance – Tinbergen Institute Discussion Paper,
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| [1] For reform efforts to date
and the complementarity of structural reform, see Section 2.3 and Annex
A3. | |
| [2] Too-big-to-fail is meant to cover
too-interconnected-to-fail (TITF), too-complex-to-fail (TCTF), and
too-systemically-important-to-fail (TSITF). See also European Commission
(2013b). | |
| [3] For a mandate and list of members, see http://ec.europa.eu/internal_market/bank/docs/high-level_expert_group/mandate_en.pdf | |
| [4] The other recommendations of HLEG included (2) that a
separation of additional activities may be necessary conditional on the
recovery and resolution plan; (3) the use of bail-in as a resolution tool; (4)
a review of capital requirements on trading assets and real estate related
loans; and (5) measures aimed at strengthening the governance and control of
banks so as to strengthen bank scrutiny and market discipline. This Impact
Assessment focuses on the mandatory separation recommendation. | |
| [5] See http://ec.europa.eu/transparency/regdoc/rep/10061/2013/EN/10061-2013-2037-EN-F-0.Pdf. | |
| [6] European Parliament (McCarthy 2013), Reforming the
structure of the EU banking sector, 2013/2021 (INI) | |
| [7] Consultation by the High-level Expert Group on
reforming the structure of the EU banking sector, May/June 2012. http://ec.europa.eu/internal_market/consultations/2012/banking_sector_en.htm | |
| [8] Consultation on the recommendations of the High-level
Expert Group on Reforming the structure of the EU banking sector, http://ec.europa.eu/internal_market/consultations/2012/hleg-banking_en.htm | |
| [9] Consultation by the Commission on the Structural
Reform of the Banking Sector, http://ec.europa.eu/internal_market/consultations/2013/banking-structural-reform/index_en.htm | |
| [10] Next to the higher importance
of bank intermediation compared to market intermediation in the EU compared to
the US, there are two other important factors that explain the discrepancy of
total banking sector size between the EU and US. First, large EU banks apply
IFRS to report their financial statements, whereas US banks apply US GAAP. The
latter allows to net financial derivatives, implying that an identical bank can
report a significantly smaller balance sheet size under US GAAP rules than under
IFRS reporting rules. Second, whereas mortgages are recorded on balance for
large European groups, a significant amount of US mortgages is recorded on the
balance sheets of the US Government Sponsored Entities (GSEs) which are not
included in Table 1. | |
| [11] Commercial banking activities include notably deposit
taking and lending to individuals and businesses, traditional investment
banking activities include securities underwriting and advisory services. | |
| [12] The main bank failures (and avoided failures) have been
attributed to overreliance on short-term wholesale funding, excessive leverage,
excessive trading/derivative/market activity, poor lending decisions due to
aggressive credit growth, and weak corporate governance (see Liikanen (2012)). Size relative to GDP matters, but also the speed at which
bank balance sheet growth outpaces GDP growth. If total assets outpace GDP
growth, it implies that the banking sector increasingly relies on funding that
is not coming from households and corporates, but rather from other financial
intermediaries and capital market investors, which implies less funding
stability. | |
| [13] In the case of some Member States it has contributed to
turn a banking crisis into a sovereign crisis (European Commission (2011,
2012)). This has had the effect of further increasing the fragility of the
banking system since banks hold large volumes of sovereign bonds on their
balance sheet and since some of their funding sources are explicitly or
implicitly insured by their sovereign. | |
| [14] The findings of the JRC research as well as an
extensive review of the relevant literature are provided in Annex A4.1 and
A4.2. | |
| [15] Other activities, notably insurance, are typically carried
out in wholly owned but separately capitalised subsidiaries. | |
| [16] The most common regulatory and legal model for large
banking groups in the EU is the “universal banking model”, whereas it is the
“holding company model” in the USA. Financial holding company structures have a
single holding company that typically holds all shares of the separate
capitalised subsidiaries (amongst which may be a bank holding company). There
is typically complete legal separation between the parent and the subsidiaries,
and in case the holding company is non-operating, there is also operational
independence and the latter acts solely as an investment company. Under a
holding company structure, a group is headed by one entity which does not
itself conduct any business but simply owns a series of other businesses and
co-ordinates their strategies. Parent-subsidiary structures may consist of a
parent bank that operates directly, with separately capitalised subsidiaries
carrying out separate activities. | |
| [17] Deposit insurance refers to the explicit government
guarantee related to certain categories of deposits to a certain extent (in the
EU up to 100 000 EUR per retail depositor is 100% insured). Lender of last
resort liquidity facilities are provided by central banks. Central banks should
lend in principle at penalty rates and against adequate collateral to illiquid
but solvent banks (Bagehot principles). | |
| [18] Freixas et al. (2007) show that financial conglomerates
utilise excessive risk-taking due to their access to the public safety net, and
that this effect wipes out any diversification benefits. | |
| [19] See Liikanen (2012) and Buiter and Rahbari (2012) for
an overview of the changing business models in this respect. | |
| [20] At the end of 2011, each of the ten largest EU banking
groups had total on-balance-sheet assets exceeding 1000 billion euro. Unlike
their US peers, several large EU banking group balance sheets exceed domestic
GDP. The geographic scope of large European banking groups’ is also significant
in relative terms, as EU banking groups hold a far larger percentage of their
assets abroad, compared to North American or Asian banking groups (65% compared
to 32% and 26%, respectively, according to Claessens et al. (2011)). | |
| [21] Popov and Smets (2011) analyse the role of direct
intermediation through financial markets with the indirect intermediation
through levered banks. They argue that less deep financial markets in the EU
relative to those of the US are, to a large extent, responsible for the smaller
increase in productivity and slower pace of industrial innovation. They also
compare the liquidity spirals, asset fire sales, and interbank market freezes
of the recent financial crisis with the much more orderly burst of the dot-com
bubble. They argue that the credit boom of the 2000s was driven by debt
finance, while the dot-com bubble was mostly driven by an expansion in equity ownership,
and equity is not held in levered portfolios. | |
| [22] Haldane (2010a) discusses the earnings of the financial
sector in detail and concludes that “risk illusion, rather than a productivity
miracle, appears to have driven high returns to finance”. Philippon and Reshef
(2008) study wages earned in the financial sector and conclude that a large
part of the observed wage differential between the financial sector and the
rest of the economy cannot be explained by observables like skill differences.
Philippon (2012) provides a quantitative interpretation of financial
intermediation in the USA over the past 130 years and concludes that “…the unit
cost of intermediation has increased since the mid-1970s and is now
significantly higher than it was at the turn of the twentieth century. In other
words, the finance industry that sustained the expansion of railroads, steel
and chemical industries, and later the electricity and automobile revolutions
seems to have been more efficient than the current finance industry.
Surprisingly, the tremendous improvements in information technologies of the
past 30 years have not led to a decrease in the average cost of intermediation.
One possible explanation for this puzzle is that improvements in information
technology have been cancelled out by zero-sum activities, perhaps related to
the large increase in secondary market trading”. | |
| [23] Credit Rating Agencies often
provide two different types of credit ratings in their assessment of the
probability of default of a bank’s issued debt: a stand-alone rating and a
higher support rating which not only takes the intrinsic strength of the bank
into account, but in addition the agencies' estimate of the external support
that the bank under consideration would receive from public authorities (and
parent companies). | |
| [24] Investors that have replied to the Commission’s
consultation on the HLEG report chaired by Liikanen stated that “All banks
fail to provide sufficient transparency of their circumstances, meaning that
investors tend to mistrust almost all of them with equal fervour” (Hermes
2012, page 5). | |
| [25] This is reflected in the price-to-book ratios of large
and complex EU banking groups, which hover around 0.5 (i.e. the market values
their assets at half the price at which they are accounted for), whereas they
were as high as 2.0 in the run-up to the crisis. Part of that value destruction
reflects the legacy of the past (and possibly on-going forbearance), and
another part may reflect weak perceived profitability going forward. However,
it is clear that a significant part may reflect the difficulty of valuing the
individual components of large and complex banking groups with any degree of
certainty. | |
| [26] See for example Hoenig and Morris (2011) and Haldane
(2012). | |
| [27] Besides minimum capital requirements (pillar 1) and
supervisory review process (pillar 2). | |
| [28] Several international regulators have been
investigating suspected cartel arrangements between traders involving a number
of international banks. The purpose is to find out if traders of interest-rate
derivatives colluded to manipulate the interest rate benchmarks (such as
Euribor and Libor) in order to obtain a benefit in their own trading positions.
In December 2013, the Commission settled on fines of more than EUR 1.7bn with
several international banks and brokers (Deutsche Bank, Société General, RBS,
JPMorgan, Citigroup and RP Martin). See http://europa.eu/rapid/press-release_IP-13-1208_en.htm. Two international banks, UBS and Barclays benefited from immunity
from the leniency program. Other international
regulators have set fines that amount to USD 454m for Barclays, USD 87m for
ICAB, USD 1.1bn for Rabobank, USD 1.5bn for UBS, and USD 612m for RBS for Libor
rigging (by October 2013). | |
| [29] G20 Leaders, September 2013: “We recognize that
structural banking reforms can facilitate resolvability and call on the FSB, in
collaboration with the IMF and the OECD, to assess cross-border consistencies
and global financial stability implications.” | |
| G20
Ministers, October 2013: “We will pursue our work to build a safe and
reliable financial system by implementing the financial reforms endorsed in
our Leaders’ Declaration, which are aimed at building upon the significant
progress already achieved, including in creating more resilient financial
institutions, ending too‐big‐to‐fail, increasing transparency and market integrity, filling
regulatory gaps, addressing the potential systemic risks from shadow banking
and closing information gaps.” | |
| [30] “The ratio of risk-weighted assets to total assets
differs significantly between banks. It is remarkable that the banks with the
highest amount of trading assets, notional derivatives, etc. (i.e. banks that
are least "traditional") tend to have the lowest ratio.” Report
of the HLEG, p. 43. | |
| [31] “[…] for a sample of 16 large EU banks, the capital
requirements for market risks vary between close to 0% to just over 2% of the
total value of trading assets, the average being close to 1%.” Report of
the HLEG, p. 48. This explains why some measures have been taken, e.g. the use
of stressed VaR as part of Basel 2.5’s revisions to the market risk framework. | |
| [32] European Banking Authority (2013), “Interim results
of the EBA review of the consistency of risk-weighted assets. Top-down
assessment of the banking book”, February 2013; Basel Committee on Banking
Supervision (2013), “Regulatory consistency assessment programme (RCAP) –
Analysis of risk-weighted assets for market risk”, January 2013. | |
| [33] See e.g. response of Algebris Investment’s to the
Commission’s 2012 consultation on the recommendations of the HLEG: http://ec.europa.eu/internal_market/consultations/2012/hleg-banking/other-organisations/algebris-investments_en.pdf | |
| [34] Banks cannot enter normal
bankruptcy and suddenly stop performing their special and critical role in the
payment system, nor can they freeze their deposits, because of the financial
panic that would result and because their business model and raison d’être is
to provide liquidity to its depositors. | |
| [35] See EBA (2012), “Opinion of the European Banking
Authority on the recommendations of the High-level Expert Group on reforming the
structure of the EU banking sector”, December 2012. | |
| [36] See e.g. Moody’s (2013) assessment of the BRRD: “Taken
at face value, the draft is credit-negative for senior unsecured creditors of
the roughly two-thirds of EU banks whose ratings incorporate some level of
systemic support uplift. It is unlikely we would remove all systemic support
from every EU bank’s rating in the foreseeable future, but a change to our
assumptions would imply lower ratings for some or all banks. However, there are
a number of important areas in which we need greater clarity before we can take
a definitive view on the implications for EU bank ratings. For example, to be
able to assess the Directive’s impact we would ideally want to understand […]
the plans for broader structural changes in the EU banking industry” | |
| [37] For example, the forthcoming UK retail ring-fencing
rules would apply to UK-incorporated subsidiaries of EU banks (e.g. Santander
UK) but not to branches (e.g. Deutsche Bank’s UK branch). | |
| [38] The former risk has been acknowledged in some of the
national reform debates. For example, the UK ICB acknowledged the risk but
dismissed it due to disproportional net cost for banks as well as reputational
concerns. The National Bank of Belgium (2012, 2013) highlighted the difficulty for
a small country like Belgium to impose unilateral structural reforms due to
banks’ ability to switch into branches and the unlevel playing field this would
give rise to. | |
| [39] Of the banks that would exceed the thresholds
considered in Chapter 5 on the basis of historical data, a majority would be
subject to distinct national structural reforms. | |
| [40] In order to better understand and make markets in
commodity derivatives, some banks have in recent years engaged increasingly in
the trading of physical commodities. The involvement of banks has given rise to
a number of concerns, ranging from possible market manipulation to potential
risks to the solvency of banks due to their exposure to volatile commodities
prices. Both the French law on banking structural reform and draft secondary
legislation published by the UK government restrict trading in physical
commodities such as metals, oil or agricultural commodities (only the latter in
the case of the French law). In the US, the Federal Reserve currently interprets
US legislation such as to allow certain Bank Holding Companies (BHCs) to engage
in trading of physical commodities, subject to specific conditions and
restrictions. However, on 19 July 2013 the Federal Reserve announced that it
was reviewing its 2003 decision that first allowed banks to engage in trading
of physical commodities. | |
| [41] Securities underwriting is a typical investment banking
activity in which banks raise investment capital from investors on behalf of
corporations and governments that are issuing securities (both equity and debt
securities) in return for a fee. It is a way of selling newly issued
securities, such as stocks or bonds, to investors. | |
| [42] Securitisation involves the creation and issuance of
tradable securities, such as bonds, that are backed by the income generated by e.g.
an asset, a loan or another revenue source. | |
| [43] The Act originally contained four short sections of the
Banking Act of 1933: Section 16 prohibiting banks from underwriting or dealing
in securities; Section 21 prohibiting securities firms from taking deposits;
and two remaining sections (20, 32) prohibiting banks from being affiliated
with firms that are principally or primarily engaged in underwriting or dealing
in securities (see also Box 2). | |
| [44] Global Shadow Banking Monitoring Report 2013, 14
November 2013, FSB | |
| [45] In order to support the qualitative assessment and
comparison of reform options, the Commission services have on a best-effort
basis attempted to quantify to the extent possible some of the costs and
benefits referred to here. See section 5.7.1 and Annexes A10, A11 and A12 for
further detail. | |
| [46] Note that the direct GDP impact of the funding cost
increase will initially be zero, as the increased funding cost implies an
offsetting benefit for bank creditors (note that risk is not captured in GDP
metrics). However, despite this initial offsetting GDP benefit originating in
the higher proceeds for bank creditors, a negative impact on GDP on balance
will still materialise over time when the private funding cost increase is
passed on to other bank stakeholders. When it is passed on to bank customers
through higher borrower rates for households and higher cost of capital for
SMEs and firms, household consumption and business investment and hence GDP
will be negatively affected (the consumption or investment of creditors will
not increase correspondingly, as the higher remuneration reflects higher risk
exposure). Alternatively, banks may pass on the cost to their shareholders
(lower RoE) or their employees (lower wages), which would again lead to reduced
consumption by shareholders and employees and a loss of GDP. However, the
evidence so far suggests that this GDP cost may be limited even for a broad
trading entity and when introducing conservative estimates about the pass-through
rates. In the UK, the long-term GDP level is expected to be reduced with 7.5
basis points when opting for a relatively narrow deposit entity and a
relatively strong separation (Impact Assessment of HM Treasury (2013)). This
GDP reduction social cost estimate is shown to be almost an order of magnitude
smaller than the social benefit of the proposed structural reform, following
the estimated reduction in the probability or impact of financial crises (and
its impact on economic growth). See also Annex A12 for Commission Services
estimates of the impact of funding cost advantages on economic growth. | |
| [47] Several of the benefits of
structural reform listed in Section 3.2 can be interpreted as eliminating
potential diseconomies of scope in large and complex banking groups
(such as excessive risk taking, lack of resolvability, and conflicts of
interest). Whereas the benefits stress the beneficial impact of eliminating
distortions on incentives and behaviour, we (should) quantitatively correct for
the distortions when assessing the economies of scale and scope. Annex A9 provides a review of the relevant
literature. | |
| [48] See e.g. Davies and Tracey (2012) that found no
economies of scale in a sample of large international banks with assets above
USD100bn. See Annex A9 for a review of the relevant literature. | |
| [49] Annex A7 sets out the alternative options and policy
levers to design the stronger legal, economic and operational separation. | |
| [50] For the purposes of this Impact Assessment, “complex” (and
“simple“) securitisation will be defined by reference to the ECB ABS
eligibility requirements for repo purposes and as currently elaborated and
refined by European supervisory authorities (for example EIOPA in its
non-public “technical report on standard formula design and calibration for
certain long-term investments”). | |
| [51] In the context of this Impact Assessment, complex
derivative transactions” refer to the structuring, arranging or execution of
derivative transactions other than standardised interest
rate and foreign exchange derivatives transactions for the prudent management
of liquidity, funding and overall balance sheet risk (i.e. to perform its asset
and liability management). In principle, the compensation package of the
dedicated staff that is to perform the prudent management should reflect the
hedging objective and cannot consist of bonuses that per definition are linked
to the profitability of the unit or overall banking group. | |
| [52] In the context of this Impact Assessment, “underwriting”
is interpreted in the broad sense, as also incorporating the market making activity
that underwriters typically perform in the days following primary market
transactions. See Annex A6. | |
| [53] Many of the
leading UK banks have told the UK Parliamentary Commission on Banking Standards
that they do not engage in proprietary trading at all. The same message was
given by Dutch banks to the Members of the Commission on the structure of Dutch
banks. A non-public Febelfin survey provides evidence that proprietary trading
amounts to 2% of trading revenues for Belgian banks in the first semester of
2012, down from 13%, 11% and 8% in 2009, 2010, and 2011 respectively. In turn,
trading revenues are estimated to amount to 9% of overall bank revenues in the
first semester of 2012. The French and the German structural reform proposals
propose to subsidiarise proprietary trading. Their cost-benefit analysis
findings have not been made public, but BNP Paribas corporate banking and
investment banking revenues are estimated by the banks to be impacted by the
government plans by less than 2%. Annex 2 of National Bank of Belgium (2013)
documents how trading activity more generally has evolved between 2008:Q1 and
end 2012 for the four largest Belgian banks. | |
| [54] See US GAO (2011) and PCBS (2013). | |
| [55] Market makers often have signed on to a voluntary code
of conduct, which already considers manipulative practices by banks with each
other or with customers to be “unacceptable trading behaviour”. However, the
multiple financial scandals in the years since signing these voluntary
agreements cast doubt on their effectiveness. | |
| [56] Kroszner and Rajan (1994), Kroszner (1998), Hebb and
Fraser (2003) and Stiglitz (2010). | |
| [57] See Hodgkinson (2001) and Bessler and Stanzel (2009). | |
| [58] Kroszner and Rajan (1994), Puri (1994), Benston (1990),
Hebb and Fraser (2002), Hebb and Fraser (2003). | |
| [59] Underwriting is a case in point. Underwriting and
advisory services require relationship-building with clients. These traditional
(investment) banking activities are closely connected to corporate banking.
From the corporate client’s perspective, issuing a bond is an alternative way
of financing to taking a bank loan. Given that underwriting is not as easily
scalable as pure market making, the scope for moral hazard reduction is
significant, but smaller than for market making. Underwriting as such does not
give rise to significant interconnectedness across financial institutions. The
evidence does not suggest that conflicts of interests are obvious between
underwriting and loan making. In fact, it suggests that bonds underwritten by
commercial banks default less often than bonds underwritten by investment
banks. There may be economies of scope to be enjoyed from spreading fixed costs
of acquiring information over multiple outputs; more specifically, concurrent
lending and underwriting could be beneficial. | |
| [60] See footnote 72. | |
| [61] See US GAO (2011) and PCBS (2013). | |
| [62] It might, however, need to be enforced through
line-of-business restraints. | |
| [63] Underwriting is a case in point. Underwriting and
advisory services require relationship-building with clients. These traditional
(investment) banking activities are closely connected to corporate banking.
From the corporate client’s perspective, issuing a bond is an alternative way
of financing to taking a bank loan. Given that underwriting is not as easily
scalable as pure market making, the scope for moral hazard reduction is
significant, but smaller than for market making. Underwriting as such does not
give rise to significant interconnectedness across financial institutions. The
evidence does not suggest that conflicts of interests are obvious between
underwriting and loan making. In fact, it suggests that bonds underwritten by
commercial banks default less often than bonds underwritten by investment
banks. There may be economies of scope to be enjoyed from spreading fixed costs
of acquiring information over multiple outputs; more specifically, concurrent
lending and underwriting could be beneficial. | |
| [64] Duffie (2012) argues that "market making is
inherently a form of proprietary trading". A market maker acquires a
position from a client at one price and then lays off the position over time at
an uncertain average price. The goal is to "buy low, sell high." In
order to accomplish this goal on average over many trades, with an acceptable
level of risk for the expected profit, a market maker relies on its expectation
of the investors’ needs and the future path of market price and therefore
necessarily this activity involves holding an inventory. | |
| [65] A supervisor can only do so either through prescriptive
rule-making or through a purpose based restriction. In either case it would
involve supervisory capital and enforcement can only be done ex post and would
be costly and possibly ineffective. | |
| [66] The
treasury function of a bank needs to engage in trades to manage excess
liquidity or hedge the risk from for example selling fixed-rate mortgages while
being funded with floating rate borrowing. Over time the treasury functions in
some banks have become more aggressive traders with strategies that could be
seen as resembling proprietary trading. In some cases, Treasury operations no
longer merely manage the natural dynamics of the balance sheet arising from
customer activity, but increasingly perform a set of trading activities in themselves
and become pure profit centres. | |
| [67] For example, an attempt to identify particular hedges
for particular transactions and prohibit all others would be counterproductive
because it would encroach on a trader's ability to be creative and innovative
as products and product lines become more intricate and new sources of risk
emerge (Chatterjee, 2012). | |
| [68] A type I error is when an activity is identified as
proprietary trading when in fact it is not, and type II errors mean that an
activity is not identified as proprietary trading when it in fact should have
been. | |
| [69] US experience with the intra-group firewalls provided
by Section 23A and B of the Federal Reserve Act are instructive in this regard.
According to those rules, the Federal Reserve Board have authority to exempt individual
transactions from the requirements of section 23A. During the financial crisis,
which at its height posed a threat to systemic financial stability, the FRB
exercised this authority on numerous occasions, thereby allowing depository
institutions to provide financing to their affiliated securities firms,
derivatives dealers and money market funds in order to prevent their failure
and the effects this might have had on the financial system and the broader
economy. “Crisis containment and systemic risk considerations consistently
prevailed over the statutory purpose of preventing the leakage of the federal
subsidy outside the depository system” (Omarova (2011)). The UK’s
implementation of the ICB recommendation has tried to avoid such concerns by
clearly framing exemptions in primary law (e.g. related to simple derivatives). | |
| [70] As stated in chapter 4.1, there are certain retail
activities that under any scenario could not be separated, i.e. deposit-taking
and retail payment services. | |
| [71] Of the banks exceeding the
threshold, roughly two thirds are located in a Banking Union participating
Member State. | |
| [72] Although the present proposal is also aimed at facilitating
resolution, this conservative assumption is used to avoid double counting some
of the benefits calculated in the context of the Impact Assessment of the BRRD. | |
| [73] The point estimates below are based on JRC analysis and are
conditional on the methodology employed and underlying assumptions. Confidence
intervals around the reported point estimates could not be calculated. | |
| [74] For more information on the QUEST model, see http://ec.europa.eu/economy_finance/research/macroeconomic_models_en.htm.
Simulations using several hypothetical scenarios of funding cost increases are
shown in Annex A12. | |
| [75] See SWD(2012)166/3, table 23, p. 158 in Annex 13, explained in
more detail in appendix 5 thereof. | |
| [76] US regulators are also considering imposing leverage
limits on the largest US banks that would be stricter than the ones foreseen by
Basel III. | |
| [77] For example, while the international standards for
global systemically important banks contain numerical thresholds, the
provisions in the CRR incorporating those standards do not, but leave it to the
EBA to set such thresholds on the basis of principles and guidance set in the
CRR. | |
| [78] Supervisors would always have the possibility to
subject additional banks to structural separation. | |
| [79] This section outlines the likely and stylised impact of
the reforms retained above on different stakeholders. The main baseline is the
mid-range scenario of the three retained options, i.e. reform option E-.
Material differences of options C+ and option C/E- are highlighted where
appropriate. | |
| [80] Zingales (2012): “The third reason why I came to
support Glass-Steagall was because I realised it was not simply a coincidence
that we witnessed a prospering of securities markets and the blossoming of new
ones (options and futures markets) while Glass-Steagall was in place, but since
its repeal have seen a demise of public equity markets and an explosion of
opaque over-the-counter ones. | |
| [81] For example, benefits of market liquidity should become
smaller with the degree of market liquidity. The additional benefits of the
extra liquidity derived from high-frequency trading must be of negligible (or
negative) value compared to the benefits from having a market which is
reasonably liquid on a day-by-day basis. Moreover, ever greater market
liquidity may give rise to destabilising momentum effects, such as cycles of
undervaluation and overvaluation. | |
| [82] Note that this concern needs to be put into
perspective. Financial industry employment in London has decreased with 30%
between 2007 and 2012, as a result of the financial crisis. | |
| [83] Philippon (2013) documents that the income share of the
finance industry in the US economy starts just below 2% of GDP in 1880. It
reaches a first peak of almost 6% of GDP in 1932. Note that this peak occurs
during the Great Depression, not in 1929. Between 1929 and 1932 nominal GDP
shrinks, but the need to deal with rising default rates and to restructure
corporate and household balance sheets keeps financiers busy. Similarly, the
post-war peak occurs not in 2007 but in 2010, just below 9% of GDP. | |
| [84] In a survey of
elite US universities, Rampell found that in 2006, just before the
financial crisis, 25% of graduating seniors at Harvard University, 24% at Yale,
and 46% at Princeton were starting their careers in financial services. Those
percentages have fallen somewhat since, but this might be only a temporary
effect of the crisis. | |
| [85] Investors
that have replied to the Commission’s consultation on the HLEG report chaired
by Liikanen stated that “All banks fail to provide sufficient transparency
of their circumstances, meaning that investors tend to mistrust almost all of
them with equal fervour” (Hermes 2012, page 5). | |
| [86] Paul Krugman, Alan Greenspan, Paul Volcker, Thomas
Hoenig, Sheila Bair, Andrew Haldane, Simon Johnson, Mervyn King, John Kay,
Luigi Zingales, Willem Buiter (Citigroup), David Komansky (Merrill Lynch),,
Phil Purcell (Morgan Stanley), etc. | |
| [87] Alessandri and Haldane (2009) document that large UK
banks recorded an average annual return on equity of 7% from 1920 to 1970 (with
a standard deviation of 2%), whereas the average annual return on equity
amounted to 20% on average in the period 1970 to 2007 (with a standard
deviation of 7%). | |
| [88] Popov
and Smets (2011) analyse the role of direct intermediation through financial
markets with the indirect intermediation through levered banks. They argue that
less deep financial markets in the EU relative to those of the US are, to a
large extent, responsible for the smaller increase in productivity and slower
pace of industrial innovation. They also compare the liquidity spirals, asset
fire sales, and interbank market freezes of the recent financial crisis with
the much more orderly burst of the dot-com bubble. They argue that the credit
boom of the 2000s was driven by debt finance, while the dot-com bubble was
mostly driven by an expansion in equity ownership, and equity is not held in
levered portfolios. | |
| [89] In that sense, the EU state aid control policy and
corresponding rescue and restructuring plans would be made easier and more
uniform. | |
| LIST OF ANNEXES | |
| ANNEX A1. Overview of structural reforms
and reform proposals - PAGE 2 | |
| ANNEX A2. Summary of replies to the
stakeholder consultation - PAGE 27 | |
| ANNEX A3. Assessing the complementarity
of structural separation with the current reform agenda - PAGE 43 | |
| ANNEX A4.1. Implicit subsidies: Drivers,
Distortions, and Empirical Evidence - PAGE 55 | |
| ANNEX A4.2. Size and determinants of
implicit state guarantees to EU banks - PAGE 79 | |
| Annex A1: Overview of existing
structural reform proposals | |
| The financial crisis has led to an overhaul
of the regulatory and supervisory structures governing the financial system in
Europe and beyond. These reforms have been coordinated at international level
via the G20. However, reforming the structure of banks – i.e. regulatory
interventions to directly amend the organisational structure or specific
business models of banks – have not been part of this internationally agreed
set of reforms. Instead, bank structural reform was initially pursued by those
two countries at the epicentre of the early stages of the financial crisis,
i.e. the United States and the United Kingdom. Since then, some other countries
have followed suit and have adopted or considered to adopt bank structural
reform measures (France, Germany, Belgium, The Netherlands, Switzerland).
Furthermore, a High-level Expert Group appointed by the European Commission and
chaired by Erkki Liikanen has recommended specific reforms of the structure of
European banks. | |
| This chapter assesses and compares some of
the most mature reform proposals along three dimensions: (i) the activities
that are to be separated, (ii) the type of separation and the impact on
economic linkages within the banking group, and (iii) the scope of banks it is
likely to apply to. Before assessing on-going reforms, an introductory section
places these reforms in a historical context by briefly outlining how the
different national banking systems have evolved over time. | |
| 1.
A long history of evolving bank structures | |
| The debate about reforming the structure of
the banks is influenced by the different shapes of national banking systems.
That structure largely reflects economic history and the different roles banks
have played in financing economic development. | |
| Broadly speaking, banking systems have
developed differently in Anglo-Saxon countries compared to continental Europe.
In the UK and US the larger financing needs related to industrialisation was
predominantly served by capital markets with access to those markets provided
by specialised intermediaries (clearing banks in the UK, broker/dealers in the
US). Banks were typically small and focused on retail clients. In continental
Europe, industrialisation occurred later and substantial amounts of capital
were needed to catch up with the industrial forerunners and given that capital
markets were less developed, banks became the main source of financing to the
large corporates who required a universal set of services. The universal
banking model therefore has long historical roots in some countries, whereas in
other countries banks were more specialised. | |
| In terms of regulation, approaches have
also evolved. In several countries with universal banks, concerns with close
links between banks and commerce coupled with the Great Depression saw the
introduction of activity restrictions in several countries (e.g. US, IT, BE).
However, against the backdrop of the general financial liberalisation and
deregulation that occurred from the 1970s onwards, restrictions were relaxed
over time due to competitive pressures, perceptions of economies of scope
resulting from combining a universal set of activities in one roof and
increased faith being put on the ability to manage risks that might arise as a
result of these business combinations. Prior to the start of the financial
crisis, the universal bank model had accordingly gained prominence
internationally. | |
| Box 1:
Historical development of national banking structures[1] | |
| United
States: in the US, prior
to industrialisation, banks tended to be small and fragile. As a result, they
avoided concentrated lending and preferred arm’s lengths relations. The large
scale financing needs related to the growing economy was primarily done via
capital markets, with specialised non-bank institutions acting as gatekeepers.
This also reflected long-standing restrictions on banks engaging in securities
business. At the turn of the century, banks started to consolidate and a
national banking system emerged capable of better serving the growing economy.
During that process, some banks gained national prominence and became the main
providers of funding to the large US corporate trusts. The increasing power of
the largest banks and their close integration with the largest corporates
provoked an increasing backlash, with e.g. the establishment of the Federal
Reserve system in 1913 ending the ‘central bank’ role provided by the JP Morgan
and other large New York banks, and the Sherman Antitrust Act breaking up the
trusts and limiting the influence of banks. These changes culminated with the
1933 Glass-Steagall Act, which fully prohibited banks from engaging in
securities business. That segmented banking system came under attack in the
1960s, as US commercial banks felt disadvantaged vis-à-vis its competitors both
nationally and internationally due to restrictions on their ability to expand
their activities. This prompted US regulators to gradually become more
permissive as to the extent to which US banks could engage in prohibited
activities. In 1999, the Gramm-Leach-Bliley Act finally eliminated the sections
of the GSA that prohibited banks from entering into non-banking activities. As
a result, US banking groups can organise themselves as financial holding
companies, and are then able to provide a universal set of services in
different functional subsidiaries. | |
| United
Kingdom: the UK until the
mid-1980s by and large had a two-tier banking system, with a limited number of
nation-wide clearing banks focusing on commercial banking and a number of
specialised merchant banks focusing on providing access to securities markets
(there were also a number of specialised institutions, such as building
societies). The origins of that division of labour can be traced back to the 17th
century, when the Bank of England had a monopoly on joint stock banking, small
country banks provided local financial services, and London-based merchant
banks provided trade finance and placement of government bonds. With the advent
of limited liability banking, the small country banks eventually consolidated
into nation-wide clearing banks that focused on commercial banking. This focus
was not legally imposed but was rather explained by merchant banks occupying
the securities market space and commercial banking producing sufficient profit
opportunities given the increase in wealth resulting from industrialisation.
This system remained stable for most of the 20th century. Following
deregulation in the 1960s and 1970s clearing banks began to provide a wider set
of services, but their access to investment banking remain hampered by rules of
the London Stock Exchange, which required members to specialise either as
brokers or market-makers and prevented outsiders from owning a significant
financial interest in member firms. Those rules were eliminated in the context
of the big bang of October 1986 and as a result, the clearing banks finally
also went into investment banking. Since then, the UK banks have provided a
universal set of services. | |
| Germany: The German banking system consists of
three pillars (private banks, savings banks and cooperative banks) all of which
offer a universal set of services. As regards the private banks, they played a
central role in the industrialisation process during industrialisation. Given
the limited capital markets, banks were the only ones able to pool the amounts
of capital necessary and direct it towards the growing sectors of the economy.
Commercial banking was eventually dominated by a few large Berlin-based banks
that provided a universal set of services to a set of large corporates to which
they were closely associated (by banks taking on shareholdings and
directorships in the companies they served). Meanwhile, the retail segment was
served by local savings and cooperative banks. However, due to their unstable
funding structure (e.g. lacking stable retail deposits), the commercial banks
suffered heavily during the Great Depression and had to be nationalised (e.g.
state acquired 90% of Dresdner Bank, 70% of Commerzbank, and 35% of Deutsche
Bank). To address the perception that excessive competition had undermined the
solidity of banks, they faced more intrusive regulation (e.g. price caps and
branching limits) and essentially became closely associated with the stage in
the form of a government controlled cartel. Banks were reprivatized in 1936,
but continued to be closely linked to the state. After the war, the commercial
banks were broken up along geographic lines (one bank per Land) but no activity
restrictions were as such imposed. Following the start of the Cold War, the
1950s saw a gradual reconsolidation of the commercial banks, who by the end of
that decade were again allowed to reconstitute themselves as national universal
banks. In the 1970s, these universal banks were again questioned due to the
financial power and lack of competition resulting from these banks' close links
with large corporates. However, policy did not change as a result.[2] However, link between
banks and companies have evolved for a variety of reasons (e.g. tax reform
making the sale of company stakes more attractive). | |
| France: from the end of World War II until the
1980s, the French banking sector was compartmentalised, with deposit banks on
the one hand and banques d’affaires et banques de credit on the other hand.
This reflected legal activity restrictions on deposit banks. Large parts of the
banking sector were also under public ownership, which was further expanded in
the early 1980s. However, the 1984 Banking Act created a single legal and
supervisory framework and eliminated activity restrictions, thus paving the way
for universal banks. Following this, the French banking sector consolidated
rapidly, also exploiting the opportunities for cross-border expansion offered
by the European single market. The French banking sector is today dominated by
a limited number of large universal banks, some of which have their origins in
the savings bank and cooperative banking sectors (BPCE, Crédit Agricole and
Crédit Mutuel). | |
| Italy: Italy’s financial system was largely
bank-based, given that capital markets were thin and illiquid. Similar to
Germany, Italian banks developed close ties with large corporates, whom they
funded through lending and, increasingly, capital ownership as they developed.
The banking system went through a number of crises during the late 19th and
early 20th century. In the late 1920s and early 30s most of Italy’s universal
banks had to be rescued and during those rescue operations, they were forced to
divest their industrial stakes and revert to exclusive short-term commercial
banking only. These changes were translated into law in 1936, which accordingly
effectively separated commercial and investment banking. Similar to Germany,
the new law also limited competition by means of e.g. branching limits. The
1936 law contributed to nearly half a century of financial stability and remained
in place until the early 1990s. However, this stability came with a price, due
to the inefficiencies originated by the limited competition in the Italian
banking market. This was compounded by the relevant dimension and market share
of publicly-owned banks. Regulatory changes enacted in the 1990s (1990
"Amato-Carli" law, 1993 Banking Law, 1998 "Ciampi" law)
privatised and liberalised the banking sector and completed the removal of all
the limitations introduced by the 1936 Banking Law, allowing the emergence of
universal banks. These changes unleashed a consolidation wave, predominantly
domestic in nature. | |
| Belgium: similar to the United States, Germany and
Italy, Belgium also saw a policy debate in the wake of the Great Depression
regarding the close links between banking and commerce.[3] Banks having large
holdings of shares in industrial and commercial companies exposed them to
concentration risk, which could weaken their retail bank activities. A 1934
decree accordingly required mixed banks to separate their deposit taking
activities from their investment banking activities by incorporating the latter
into a holding company. However, the retail banks also became subsidiaries of
the holding. To further guarantee the independence of deposit taking banks vis-à-vis
the holding, a 1935 decree notably prohibited banks from holding shares of
industrial and commercial companies with the aim of preventing holding
companies from using their bank as a vehicle to indirectly finance their
investments. These restrictions were relaxed in the 1960s and 1970s and were
eventually abolished in 1993 in the context of the single market paving the way
for universal banks. | |
| 2.
United States | |
| Whereas nearly all attention as regards
structural reform has focused on the Volcker rule, that rule builds on a long
US history of bank structural regulation. This section accordingly places a
discussion of the Volcker rule in that broader context. | |
| 2.1.
Existing structural regulation | |
| US structural regulation is built on three
pillars that first, separate banking from commerce, second, restricts and
isolate the core banking activities within broader financial groups, and third,
limits the institutional concentration of the banking and financial sector. | |
| 2.1.1.
Separation of banking and commerce | |
| In the US a company that controls a bank
holding company (BHC) cannot engage in activities of a commercial nature, be it
directly or indirectly through a subsidiary. This reflects long-standing policy
concerns that such combinations could give rise to conflicts of interest, a
misuse of banking resources, or the creation of firms that are difficult to
supervise. There are a few limited exceptions to this rule, including a de
minimis exemption (less than 5% investments in commercial firms) and exemptions
made for some grand-fathered firms. | |
| 2.1.2.
Restriction and isolation of core banking
activities | |
| During most of the 20th century,
the 1933 Glass-Steagall Act 1) separated commercial banking from investment
banking, by prohibiting any affiliation between BHCs and firms principally
engaged in securities underwriting and dealing. The Act also 2) limited BHCs
to a set of core commercial banking activities and other closely related
activities (e.g. investment advisory, securities brokerage and leasing). It
finally 3) prohibited BHCs from engaging in insurance underwriting and
agency activities. These restrictions were substantially liberalised by the
1999 Gramm-Leach-Bliley Act. Under that act, BHCs that meet certain
regulatory capital and management criteria may choose to become Financial
Holding Companies (FHCs). FHCs are allowed to engage in a broad set of
financial activities, including securities underwriting and dealing, insurance
underwriting and agency, and merchant banking. However, they are still not
allowed to engage in commercial activities. | |
| Nevertheless, structural remnants have
remained that restrict and isolate core banking activities. While the banking
group (BHC and FHC) may engage in a wide range of financial activities, the
insured depositary institutions still face activity restrictions that
limit their focus to core banking activities (e.g. taking deposits, lending)
and other incidental activities (e.g. custody and asset management). | |
| The US also has rules governing transfers
between the different parts of a banking group, which are aimed at isolating
the insured depository institution from excessive risks arising from the larger
financial firm of which it is part (BHC, FHC) and to prevent the transfer of
the subsidy arising from federal assistance to non-depository financial
institutions: | |
| ·
Section 23A of the Federal Reserve Act (i)
imposes quantitative limitations on certain extensions of credit and other
transactions between a bank and its affiliates that expose a bank to an
affiliate’s credit or investment risk, (ii) prohibits banks from purchasing
low-quality assets from their nonbank affiliates, and (iii) imposes strict
collateral requirements with respect to extensions of credit to affiliates;
Section 23A has a number of exemptions, the most important one being for
transactions that are between banks where 80% of each bank’s shares are owned
by the same company. | |
| ·
Section 23B of the same act furthermore
stipulates that these and other transactions[4] between
a bank and its affiliates should take place on market terms, i.e. the same
terms and conditions as those for non-affiliated companies;[5] Section
23B excludes banks from the term “affiliate” however. Banks that are part of a
chain banking organization are thus exempt from section 23B. | |
| ·
Regulation W of the Federal Reserve explains and
simplifies the interpretation and application of these two acts. The Regulation
notably limits a bank’s ’covered transactions’ with any single affiliate
to no more than 10% of the bank’s capital and surplus and stipulates that
overall covered transactions with all affiliates cannot exceed 20% of
capital and surplus. The regulation also states that loans to affiliates should
be fully or over-collateralised.[6] | |
| These requirements have been subject to
significant debate. In that context, two issues have been identified: | |
| ·
Not all transactions were subject to the rule.
Section 23A has not applied to derivative transactions. Instead, the
Federal Reserve Board required banks to maintain internal policies and
procedures for managing derivatives exposures to affiliates. Derivatives were
nevertheless included in Section 23B. | |
| ·
The provisions were not consistently implemented
and enforced. The Act grants the regulator (Federal Reserve Board)
considerable leeway in interpreting the meaning and scope of application. The
Board also has the power to exempt transactions and relationships from the
requirements of these provisions, if such exemptions are in the public interest.
It has been demonstrated that during the financial crisis, the Board granted
numerous financial institutions exemptions from these quantitative and
qualitative requirements in order to enable banks to use their deposit-taking
subsidiaries as a source of emergency financing for other entities within their
corporate structure, thereby preventing the failure of their nonbank businesses
and to avert broader market dislocations.[7] | |
| 2.1.3.
Limits on market concentration | |
| US market concentration has historically
been limited by e.g. geographic restrictions that limited the ability of banks
to establish or buy branches in other states. The 1994 Riegle-Neal Act
liberalised these interstate branching limits. To reduce the risk of excessive
concentration it imposed a national concentration limit for the deposit market
(national deposit cap), prohibiting interstate expansions that would
result in one BHC controlling more than 10% of the total deposits of all US
insured depository institutions. The Dodd-Frank Act introduced a financial
sector concentration limit, which prohibits any firm affiliated with an
insured depository institution from expanding if the total consolidated
liabilities would exceed 10% of the aggregate consolidated liabilities of all such
financial firms. | |
| 2.2.
Volcker Rule | |
| Building on the existing structural
regulation, Section 619 of the Dodd Frank Act and its final implementing rule, known
as the Volcker Rule, as voted the relevant US agencies on 10 December 2013,
further restricts financial groups that contain such institutions from engaging
in certain types of market oriented activity (proprietary trading) and also puts
significant limits on their investments in hedge funds and private equity
funds. | |
| The rule first prohibits any banking entity
(i.e. an insured depository institution, any company that controls such an
institution, a bank holding company…) from engaging in proprietary trading.
Proprietary trading activity includes any purchase or sale as principal of any
security, derivative, commodity future, or option on any such instrument for
the purpose of benefitting from short-term price movements or realizing
short-term profits. This activity is judged as as
incompatible with the appropriate risk profile and customer-driven mission of
banking entities. | |
| The prohibition on proprietary trading is
subject to exceptions for certain ‘permitted activities’ including market
making, underwriting, hedging, organizing and offering a hedge fund or private
equity fund and trading in certain government obligations, in particular US
government, agency, State and municipal debt obligations and foreign debt
instruments under certain conditions. Under these exceptions, banks will be
able to engage in market-making activities as long as they prove these
activities are aimed at meeting the “reasonably expected near term demands of
clients, customers or counterparties”. The final rules exempt, provided certain
requirements are met, trading on behalf of a customer in a fiduciary capacity
or in riskless principal trades and activities of an insurance company for its
general or separate account. Provided certain requirements are met activities
are other activities are not considered proprietary trading, including trading
solely as an agent, broker, or custodian; through a deferred compensation or
similar plan; to satisfy a debt previously contracted; under certain repurchase
and securities lending agreements; for liquidity management in accordance with
a documented liquidity plan; in connection with certain clearing activities; or
to satisfy certain existing legal obligations. | |
| The rule limits these exemptions if they
involve a material conflict of interest; a material exposure to high-risk
assets or trading strategies; or a threat to the safety and soundness of the
banking entity or to U.S. financial stability. | |
| Permitted proprietary trading activities may
not result in a material conflict of interest between the bank and its customers,
clients, or counterparties; lead to material exposure to high-risk assets or
high-risk trading strategies; pose a threat to the safety of the bank; or pose
a threat to the financial stability of the US. | |
| Second, the Volcker Rule also provides
strict restrictions on banks' investments in hedge funds and private equity
funds. It prohibits any banking entity from: | |
| ·
Owning more than 3% of any individual hedge fund
or private equity fund; | |
| ·
Investing more than 3% of its tier 1 capital in
hedge funds and private equity funds in the aggregate; | |
| ·
Engaging in any asset sale or lending
transaction with a hedge fund or private equity fund it sponsors; or | |
| ·
Bailing out a sponsored hedge fund or private
equity in any way. | |
| Similar to the proprietary trading
prohibition no permitted investments may involve high-risk trading strategies
or assets or a material conflict of interest with customers, clients, or
counterparties. | |
| The Volcker rule entails full ownership
separation, thus the cease and divestment of the prohibited activities. Compared
to existing US regulation, the Volcker Rule applies
broadly at the consolidated level and restricts very specific types of
activities that, although clearly financial in nature and in some cases very
difficult to differentiate from permitted activities, were deemed by the US
Congress to be incompatible as a policy matter with the appropriate risk
profile and customer-driven mission of banking entities. It is therefore
different from the regime in place under the Glass-Steagall Act between 1933
and 1999, which more bluntly separated commercial banking from investment
banking and did not attempt to make fine distinctions between “high-risk” and
“low-risk” activities, or “proprietary” and “customer-driven” activities, in
regulating bank structure. | |
| Concerning corporate governance, to hold
bank chief executives accountable, they must attest in writing that their banks
are setting up processes to maintain, enforce and review compliance programmes.
The rule does not impose on bank executives however that they certify that the
bank is not engaged in proprietary trading. The rules also grant a broader
exemption for banks’ market-making desks, on the condition that traders aren’t
paid in a way that rewards proprietary trading. Trading-desk compensation must
not reward either proprietary trading or “excessive or imprudent risk-trading”. | |
| These rules are likely to affect a
relatively limited part of US banks’ balance sheet. An in-depth examination by
the US Government Accountability Office (GAO) of the proprietary trading
activities of six largest US banks that carry out the bulk of trading overall
highlighted that proprietary trading revenues were generally small compared to
overall trading revenues and overall activities of these bank holding
companies.[8]
The combined revenues between 2006 and 2010 from stand-alone proprietary
trading[9]
represented between 1.4% - 12.4 of combined quarterly revenues for all trading,
and between 0.2 – 3.1% of combined quarterly revenues for all activities at the
bank holding companies. As regards revenues from hedge fund and private equity
fund investments these were also small compared to overall revenues of the
concerned bank holding companies, representing between 0.08% - 3.5% of the bank
holding companies’ combined revenues between 2006 and 2010.[10] | |
| Given the attempt to make these
distinctions but the difficulty of providing clear ex-ante definitions by means
of legislation, the Volcker Rule relies on a reporting and compliance regime
that will collect new data to be monitored over time and to a certain extent on
supervisory judgment. The
compliance requirements under the final rules vary based on the size of the
banking entity and the scope of activities conducted. Banking entities with
significant trading operations will be required to establish a detailed
compliance program. Small banks, particularly US community banks, will have no
compliance obligations under the final rule if they do not engage in any
covered activities other than trading in certain government, agency, State or
municipal obligations. | |
| The proposed rulemaking was published for
consultation in November 2011. The consultation closed in February 2012 and
generated a substantial number of responses.[11] Key
concerns raised by commenters during the consultation process included: (1) the
appropriate scope of the exemption for market making-related activities,
including concerns about (i) the impact on market liquidity if such exemption
is not construed broadly and (ii) the potential for arbitrage and evasion if
the exemption is not construed narrowly; (2) the scope and potential burden of
compliance program and data reporting requirements included in the proposed
rule; (3) the over breadth of the statutory definition of “hedge fund and
private equity fund”; and (4) the extraterritorial implication of the Volcker
Rule’s statutory application to (i) the non-U.S. activities of foreign banks
and (ii) proprietary trading in non-U.S. sovereign debt by both U.S. and foreign
banks. | |
| US relevant regulatory agencies (Fed, FDIC,
OCC, CFTC and SEC) have voted and adopted the final rules on 10 December 2013. The
rules go into effect on April 1 2014, although the compliance date will be
delayed for a year to July 21 2015. Starting in June 2014, large banks are
required to begin reporting certain information. | |
| In sum, in terms of the three dimensions
highlighted at the outset, the Volcker rule’s provisions amounts to full
ownership separation of proprietary trading and investments in certain funds and
applies to all US financial groups containing insured depository institutions as
well as to any foreign bank with a US branch or agency subject to certain
exemptions. | |
| 2.3.
Swaps Push-out | |
| Section 716 of the Dodd-Frank Act, known as
the Swaps Push-out provision, states that if banks want to continue to benefit
from federal assistance (deposit insurance and Federal Reserve discount window)
they either have to stop engaging in certain swaps (certain credit derivatives,
all equity and most commodity derivatives) or do such swaps in a separate legal
entity, registered as a swap dealer and subject to capital requirements and
margin requirements under the derivatives sections of the Act. The provision
would not affect those derivatives judged to be important for banks’ management
of risks (i.e. interest rate, foreign exchange, gold/silver, credit derivatives
where underlying is an investment-grade security), which could thus continue to
be provided within the bank. The concerned derivatives are likely to be a
fraction of the overall derivatives business of major US banks.[12] | |
| The large US banks that dominate US
derivatives activity already have separately capitalised affiliates that could
house the pushed-out derivatives. Moreover, the additional capital required is
likely to be incremental. The main cost of the provision appear to be for
clients that could lose the benefits related to cross-derivative product
netting and who would have to deal with one more counterparty (the separately
capitalised affiliate). | |
| This provision is scheduled to enter into
effect in July 2013. However, insured depository institutions can apply for a
two-year extension, with a further one-year extension available afterwards.
Furthermore, the US Congress is debating potential changes to Section 716,
which would significantly broaden the range of permissible derivatives.[13] | |
| 2.4.
On-going discussions on further structural
measures | |
| US policymakers continue to discuss
potential additional structural measures to address banks that are too-big-to-fail.
These discussions are primarily driven by some members of Congress and some
supervisors. While these bills are at an early stage of debate and do not
necessarily muster sufficient political support, they are indicative of an
ongoing US debate on structural measures as regards TBTF banks. Different
alternatives arise in these discussions. One draft legislative bill has
proposed to significantly increase capital standards of the largest banks at
both consolidated level and the level of individual subsidiaries; introduce
stricter firewalls between these subsidiaries; and, would prohibit
non-depository institutions having access to the safety net.[14] Another draft has instead
proposed to introduce absolute size limits[15],
whereas a third draft bill[16]
would effectively reinstate the prohibition on ownership affiliations between
commercial banks and securities broker/dealers of the Glass-Steagall Act. | |
| 3.
United Kingdom | |
| In June 2010, the UK government set up and
Independent Commission on Banking (ICB) with the task of assessing bank
structural reform. In September 2011, the ICB recommended that large UK banks
should ring-fence their retail bank operations into separate legal subsidiaries
subject to their own prudential safeguards. It also recommended that such groups
should increase their loss absorbing capacity both at group level and at the
level of the ring-fenced retail entity. The UK government has put forward draft
primary legislation aimed at implementing the ICB’s recommendations, aimed at
enabling pre-legislative scrutiny by a Parliamentary Commission on Banking
Standards (PCBS), set up in October 2012 as part of a broader exercise aimed at
assessing the UK banking sector.[17]
The PCBS made a number of suggestions for amending the legislative proposal,
some of which were taken up by the UK Government in the bill finally submitted
to the Parliament in February 2013.[18]
Secondary legislation is forthcoming and the government has indicated that all
legislation will be in place by May 2015. The framework is scheduled to enter
into force by the start of 2019. | |
| 3.1.
Activities to be separated | |
| The ICB divided activities into ‘mandated’,
‘prohibited’ and ‘ancillary’ services. The UK draft bill distinguishes between
core activities (and related services) and excluded activities. More
specifically: | |
| ·
Mandated services / core activities: mandated services are services where even temporary interruption
has significant economic costs and where customers are not well equipped to
plan for such interruption. The ICB defined such services as taking of deposits
from and providing overdrafts to individuals and SMEs. These services would
have to be separated and could only be provided by the ring-fenced retail bank.
The bill takes this on board, specifying accepting deposits as a ‘core activity’
and outlining three ‘core services’ that only ring-fenced banks can provide
(including withdrawal/payments and overdraft). The bill also grants the
Treasury the ability to include additional activities as well as exempt certain
activities and services subject to certain conditions. The government has
indicated that it will use the exemption possibility in secondary legislation
to exempt high-net worth individuals and large corporate entities from the
ring-fence obligation. | |
| ·
Prohibited services / excluded activities: some services cannot be provided by the ring-fenced entity. The
ICB stated that those are services that (i) make it harder/more costly to
resolve ring-fenced bank, (ii) increase exposure to global financial markets,
(iii) involve risk taking and are not integral to provision of payments
services to customers or direct intermediation of funds between savers and
borrowers within non-financial sector, and (iv) services that threaten the
objectives of the ring-fence. The ICB did not exhaustively define those
services, but highlighted that it would include (i) services provided to
customers outside EEA, (ii) services that result in exposure to non-ring-fenced
bank or non-bank financial organisation (except payment services), (iii)
services that result in trading book asset, (iv) services that result in having
to hold regulatory capital against market risk, (v) purchase/origination of
derivatives /other contracts resulting in having to hold regulatory capital
against counterparty credit risk, and (vi) secondary markets activity including
purchase of loans/securities. The government bill states that dealing in
investments as principal is an excluded activity. Similar to core activities,
it grants Treasury the power to rule other activities as excluded, as well as a
power to provide for exceptions to the ban on dealing in investments as
principal. | |
| This has an impact on
derivatives. The ICB recommended that ring-fenced banks would only be
able to act as agents for derivative products sold by others, not as principal.
In its response to the ICB, the government argued that ring-fenced banks should
be able to sell simple derivatives subject to certain conditions (e.g.
only certain types, to certain customers, centrally managed risks, and subject
to certain limits). The government has indicated that those conditions will be
set in secondary legislation. Meanwhile, the PCBS has concurred with the
government in that that there might be a case for permitting ring-fenced banks
to sell simple derivatives but has proposed additional conditions: (i)
safeguards to prevent mis-selling, (ii) a limited and durable definition in
legislation of ‘simple derivatives’, and (iii) that there would be an
additional cap on the gross volume of derivative sales for ring-fenced banks,
and on the total value of derivatives used for hedging. It also called on the
regulator to report annually on ring-fenced banks’ sale of derivatives. The
government has committed to incorporate the PCBS’ suggestions into secondary
legislation. | |
| ·
Ancillary services: activities that are necessary for the efficient provision of
mandated services may be provided by the ring-fenced bank. This concept has not
been reflected in legislation so far. | |
| Possible
conditions governing ring-fenced banks’ dealing in derivatives as principal | |
| In
allowing ring-fenced banks to sell derivatives, a number of safeguards have
been considered to ensure that this activity does not expose the ring-fenced
banks to additional risks and/or make it more difficult to resolve. The
safeguards are aimed at restricting the sale of derivatives to more simple ones
and to limit the economic importance of this potential business. | |
| The government[19] has
previously outlined that simple derivatives would only mean certain types
of derivative contracts (standardised interest rate and foreign exchange
derivatives) and could only be sold to certain customers (only to holders of
mandated deposits, i.e. households and SMEs, and non-financial institutions).
It has also considered conditioning the sale of derivatives on their risk
management characteristics. Along that line, the ring-fenced bank should show
that it can manage counterparty and market risk and that the portfolio can be
unwound or transferred if the bank fails. Accordingly, ring-fenced banks could
be able to hedge its net market risk if it used standardised derivatives on arm's
length/third party basis. Hedging derivatives could also be permitted if they
were centrally cleared on a CCP or bilaterally cleared with daily margin calls
and exchange of collateral. However, residual market exposures should be capped
at a low percentage of the ring-fenced bank's Tier 1 capital, and netting
arrangements should respect ring-fenced banks’ independence. | |
| The PCBS[20] has
proposed three additional safeguards: (i) prevent mis-selling, (ii) a limited
and durable definition in legislation of ‘simple derivatives’, and (iii) an
additional cap on the gross volume of derivative sales for ring-fenced banks,
and on the total value of derivatives used for hedging. | |
| According to UK government and ICB
estimates, this separation would lead to a relatively narrow deposit bank and a
broad trading entity. It would retain 18%-36% of the UK total banking assets in
the deposit-taking ring-fenced retail bank and would shift the remaining 64%-82%
to the other legal entity that does trading and is not allowed to take insured
deposits.[21] | |
| 3.2.
Strength of separation | |
| As regards the strength of the separation,
the ICB put forward recommendations related to (i) the legal and operational
links, and (ii) economic links of ring-fenced banks that are part of a wider
group. | |
| As regards legal and operational links,
the ICB recommended that ring-fenced part should be possible to isolate from
group in some days and able to continue provide services without solvency support.
For that to be the case, the following conditions should be met. First, the
ring-fenced bank should be a separate legal entity. Second, if the ring-fenced
bank owns other organisations, these should only do activities permitted within
retail ring-fence. Third, the wider corporate group should ensure that
ring-fenced bank has access to all services it needs to continue its operations
irrespective of the state of wider group. Finally, the ring-fenced bank should
be direct member of payment systems, or use another ring-fenced bank as agent. | |
| As regards economic links, the ICB
stated that ring-fenced bank's relations with other parts of group should take
place on a third party basis. Ring-fenced bank should not be dependent on
group's continued financial health for its solvency or liquidity. Accordingly,
relationships with other group entities should for regulatory purposes be
treated similar to relations with third parties. Second, transactions with
other group entities should be conducted on commercial and arm's length basis.
Third, assets sold to other group entities should be at market value. Fourth, ring-fenced
bank should meet regulatory requirements, including for capital, large
exposures, liquidity and funding on a solo basis. Fifth, ring-fenced bank should
only distribute dividends/transfer capital if its board believes it has
resources to do so. If this leads it to breach capital requirements, they would
need explicit regulatory approval. Sixth, the board of ring-fenced bank should
be independent. Furthermore, ring-fenced bank make regulatory disclosures on a
solo basis and, finally, the board of ring-fenced bank and board of parent
company have duty to maintain integrity of ring-fence. | |
| The government has accepted these
recommendations. The proposed primary legislation has structured the rules that
ring-fenced banks have to respect to ensure their legal, operational and
economic independence vis-à-vis the wider group along five dimensions
highlighted during PCBS hearings by Andy Haldane of the Bank of England and Sir
John Vickers: | |
| ·
Separate governance; | |
| ·
Separate risk management; | |
| ·
Separate balance sheet (treasury) management; | |
| ·
Separate remuneration structure and human
resourcing; and | |
| ·
Independence of capital and liquidity. | |
| In addition, debate continues on additional
measures to strengthen the separation. First, the PCBS debate has highlighted a
concern with the durability of the ring-fence in light of regulatory arbitrage
eroding it over time. To counter that risk, the PCBS has proposed granting
additional reserve powers to ‘electrify’ the ring-fence if banks do not
comply, i.e. to force full ownership separation. This, it is argued, would
discourage banks from testing the limits of the ring-fence. A first reserve
power would empower regulators to, subject to conditions force a specific
banking group to divest itself fully of either its ring-fenced bank or its
non-ring-fenced bank. In addition, the PCBS argues that the ring-fence
framework should be subject to regular independent review, which should assess
whether ring-fencing is achieving its objectives and, as a second reserve
power, assess whether there is a case for a move to full ownership separation
across the banking sector as a whole.[22] Whereas the government has agreed to amend the bill to reflect the
first reserve power it has not accepted the independent review or the second
reserve power. The PCBS has accordingly suggested amendments to the bill.[23] | |
| Second, as regards group corporate
structures, apart from stating that ring-fenced banks could not own
entities that provide prohibited services, the ICB was not prescriptive about
groups with ring-fenced banks should be structured. It notably did not suggest
prohibiting non-ring-fenced banks from owning ring-fenced banks. The case has
since been made that the bill should include a power to prohibit such
‘parent-child’ ownership structures on the grounds that it would undermine the
strength of the ring-fence and notably the provision that relations should be
on an arm’s length basis. A parent-subsidiary structure based on control would
contradict this principle. A ‘sibling’ ownership structure, where the
ring-fenced and non-ring-fenced banks are subsidiaries of a holding company,
would facilitate the objectives of the ring-fence. The PCBS have accordingly called
for the bill to be amended so as to require concerned banking groups to
organise themselves as sibling structures with holding companies on top.[24]
The government has rejected this call, arguing that the first reserve power
combined with additional powers being considered as part of the EU Bank
Resolution and Recovery Directive would grant sufficient powers to regulators
to intervene in group structures to this end. The PCBS has accordingly put
forward an amendment requiring that shares in a ring-fenced body are held only
by another member of the group that is not carrying on an excluded activity.[25] | |
| 3.3.
Institutions to be covered by separation
requirement | |
| The ICB recommended that the ring-fence
obligations would apply to all UK domiciled banking groups. The bill excludes
building societies from ring-fencing.[26] The bill also grants the Treasury power to exclude other
institutions from the ring-fencing obligation. The government has indicated
that it would use this power to exempt smaller institutions from the ring-fencing
requirement by means of a de minimis exemption whereby which banks with less
than £25bn in mandated deposits would not have to implement the ring-fence. | |
| 3.4.
Loss absorbency | |
| As regards loss absorbency, the
Government endorses the ICB's recommendations on loss absorbency. Ring-fenced
banks should accordingly hold a minimum level of 17% of primary loss
absorbing capacity (PLAC) consisting of an equity buffer of 3% and a choice for
banks whether to hold the remaining 7 percentage points in either equity or
highest quality loss absorbing debt. For non-ring-fenced banks, the
Government proposes that the most systemic UK G-SIBs (those subject to 2.5%
G-SIB surcharge) should hold at least 17% PLAC against all domestic and
non-exempted overseas operations.[27] The ICB proposed to scale these requirements in line with an
institution's size; the Government proposes to await conclusion of
international negotiations on D-SIBs before making a decision on how to scale. | |
| The government furthermore takes up the
ICB’s suggestion to change the creditor hierarchy so that insured deposits
(those covered by the UK deposit guarantee system – FSCS) are preferred in
insolvency, i.e. depositors rank ahead of other creditors (depositor
preference). The aim is to sharpen the incentives for other senior
unsecured creditors to exert discipline on banks' behaviour. | |
| Contrary to the ICB, the government does
not propose to require larger ring-fenced banks to respect stricter leverage
limits than those considered internationally. Accordingly, it endorses the
3% limit currently contained in Basel III. This is being contested by the PCBS
that instead endorses stricter and more immediately applicable leverage limits.[28] | |
| The government supports bail-in and
expects to implement it when transposing the European Commission's proposal for
a Recovery and Resolution Directive (RRD) that contains bail-in powers, and not
earlier as requested by the PCBS. PLAC should accordingly consist of capital
(equity, Additional Tier 1 and Tier 2) and long-term unsecured debt that is
subject to the bail-in power. | |
| 4.
France | |
| The French government in December 2012 put
forward a proposal for a law separating and regulating banking activities.[29]
The proposal has since been approved with modifications by the Assemblée
nationale and the Sénat.[30] Both assemblies will now be working towards a common version. The
law would amend the legislative section of the Monetary and Financial Code.
Subsequent changes to the regulatory section are likely to follow to further
spell out the exact provisions. | |
| 4.1.
Activities to be separated | |
| The French draft reform proposes that
French banking groups with trading activities above a certain limit (to be
defined by administrative provisions) would only be allowed to engage in (i)
certain own-account dealings – hereinafter 'proprietary trading' –d and (ii) in
certain dealings with leveraged funds by means of ring-fenced subsidiaries that
are not funded by insured deposits. | |
| As regards the provision separating
proprietary trading, it is stated that French banking groups would still be
allowed to engage in certain own-account activities that are deemed useful for
the real economy, subject to certain conditions: | |
| ·
Provision of investment services (notably
risk hedging) to clients. In order to determine that these activities are
client oriented, the services in question should be remunerated by the client
and the risks should be prudently managed; | |
| ·
Risk hedging for the credit institution or
group, i.e. with the aim of reducing risk exposures
related to credit and market risks, where the hedges must present an economic
link with the identified risk (to be defined by administrative provisions); | |
| ·
The clearing of
financial instruments; | |
| ·
Market-making,
i.e. either the simultaneous publication of firm and competitive two-way quotes
for comparable volumes with the result of providing liquidity to the market, or
involving as part of its usual activity the execution of buy and sell orders on
behalf of clients. The draft law proposes a set of indicators that would need
to be monitored so as to determine that the market-making activity is not
concealed proprietary trading. The draft law would also grant the power to the
Minister of the Economy to set a threshold above which banks would no longer
benefit from the exemption[31]; | |
| ·
Prudent group treasury management, subject to forthcoming conditions (the forthcoming conditions
related to prudent management have been added to avoid JP Morgan CIO style
events); and | |
| ·
Group investment operations, i.e. long-term investments. | |
| In addition, any ownership interests or unsecured
exposures towards certain leveraged funds (e.g. hedge funds) would also
have to be transferred to the investment entity. | |
| The French government impact analysis did
not publish any figures for the proportion of assets that would be affected by
the separation requirement.[32]
This was due to the limited number of banks[33]
concerned and the associated confidentiality problems. The analysis did neither
disclose an average number, as the extent of proprietary trading vary
substantially between the banks in question. However, external analyses suggest
that proprietary trading constitute a very limited proportion of bank assets.[34] This has prompted
analysts to conclude that this reform would have a moderate impact on the
French universal banking model.[35] | |
| 4.2.
Strength of separation | |
| The segregated entities would be authorised
as investment firms or, by derogation, as credit institutions. These would have
to respect the following conditions: | |
| ·
They would be barred from taking guaranteed
deposits and from providing payment services to clients with guaranteed
deposits; | |
| ·
They would have to respect prudential
requirements on an individual or sub-consolidated basis. The banking group
controlling these entities would furthermore have to deduct the exposures to
these entities when calculating their own fund requirements; | |
| ·
As regards large exposures, the segregated
entity is regarded as being part of the group; and | |
| ·
The segregated entity should have a separate
commercial identity (e.g. name) so as to avoid confusion; | |
| ·
The segregated entity should have separate
corporate governance, in the sense that the persons that determine its business
focus cannot be the same ones as the wider group; | |
| ·
Finally, the segregated entities would be
prohibited from carrying out (a) at high frequency trading and (b) trading in
agricultural commodity derivatives. | |
| The law also foresees a strengthening of
the supervision of market activity, as well as granting the supervisor (ACPR)
extended powers to ban banks from engaging in specific activities or providing
certain products. | |
| 4.3.
Institutions to be covered by separation
requirement | |
| The scope of the proposed reform is limited
to banking groups (credit institutions, financial holding companies, and mixed
financial holding companies) with significant trading activities, measured as a
share of their total assets. The threshold for such a de minimis
exemption will be defined by decree.[36] | |
| 5.
Germany | |
| In February 2013, the German government put
forward a draft bank-separation law and new criminal-law provisions for the
financial sector.[37]
The draft law was modified in the parliamentary procedure.[38] The law, which was
promulgated in the Federal Law Gazette (Bundesgesetzblatt) on 12 August
2013[39],
amends in particular the German Banking Act. The provisions dealing with
separation of activities (Article 2 of the law) are similar to the French
approach, with some differences as regards the activities to be separated and
strength of separation. The law also contains a fleshed-out de minimis
exemption. Article 2 of the law will enter into force on 31 January 2014. | |
| 5.1.
Activities to be separated | |
| In terms of activities, it prohibits
banks and enterprises belonging to the same group as a bank from engaging in
(i) proprietary business, (ii) lending and guarantee business with hedge funds
and European or foreign alternative investment funds (AIFs), and (iii)
proprietary trading with the exception of market-making unless that activity is
conducted in a separate financial trading institution (FTI). An FTI would not
be allowed to provide payment services or e-money services. | |
| However, business that is (i) aimed at
hedging transactions with clients (except from AIFs) or that serve the
institution's or its alliance's[40]
interest rate, currency, liquidity or credit risk management, (ii) that involves
the purchase or sale of long-term holdings or business which does not serve the
purpose of drawing profit from the short-term use of existing or expected
differences between the purchase and sale prices or volatilities of prices or
interest rates, would not be prohibited. | |
| Irrespective of the de minimis
exemption, the supervisor BaFin will be able to prohibit a bank or an
enterprise belonging to the same group as a bank to carry on certain activities
(market-making activities, activities that when exceeding the thresholds are
prohibited by law or activities that are comparable in terms of risk to the
these activities) and ask it either to cease these activities or to transfer
them to an FTI if there is a concern that this business threatens to jeopardise
the solvency of the bank or the enterprise belonging to the same group as a
bank due to the volume, profit or risk structure of the activity. | |
| The explanatory notes accompanying the
German proposal did not publish any figures for the proportion of assets that
would be affected by the separation requirement. This may be due to similar
confidentiality problems. Similar to French banks, proprietary trading is
likely to constitute a very limited proportion of German banks’ assets. | |
| 5.2.
Strength of separation | |
| The business to be separated would be
operated at a commercially, organisationally and legally separate enterprise
(i.e. FTI). | |
| The FTI would have to secure its own
refinancing independently. Dealings between the banking group and its other
entities with the financial trading institution should be dealt on a third
party basis. | |
| In terms of governance, BaFin will be able
to issue orders to ensure appropriate business organisation in terms of
separation. | |
| Specific reporting obligations for the bank
and the superordinated enterprise of a group encompassing a bank towards the BaFin
may be imposed by secondary legislation. The supervisory boards of the FTI, the
bank and the superordinated enterprise are obliged to inform themselves
regularly and as required on the activities of the FTI, the risks involved and
compliance with requirements. | |
| 5.3.
Institutions to be covered by separation
requirement | |
| The law sets a de minimis exemption regarding
the statutory prohibition of activities for banks and groups comprising a bank which
either have (i) assets held for trading and available for sale under €100bn, or
(ii) have total assets of less than €90bn, subject to the above-mentioned trading
assets not constituting more than 20% of total assets. This exemption does,
however, not apply for the power of the BaFin to prohibit activities and
ask for their cessation or transfer. | |
| The statutory prohibition of activities
will apply as of 1 July 2015. However, the relevant business is only prohibited
and has to be ceased or transferred to an FTI twelve months after exceeding one
of the thresholds. The BaFin's power to prohibit activities and ask for
their cessation or transfer will apply as of 1 July 2016. | |
| 6.
High-level Expert Group on reforming the
structure of the EU banking sector (Liikanen) | |
| The High-level Expert Group on reforming
the structure of the EU banking sector, chaired by Erkki Liikanen, delivered
its report in October 2012. It notably recommended the mandatory separation of
certain high-risk trading activities into a separate legal entity. | |
| 6.1.
Activities to be separated | |
| The Group concluded that it is necessary to
require the legal separation of certain particularly risky financial activities
from deposit-taking banks within the banking group. The Group therefore
recommended that the following activities would need to be assigned to a
separate legal entity (“trading entity”): | |
| ·
Proprietary trading; | |
| ·
All assets or derivative positions incurred in
the process of market-making, other than the activities exempted below; and | |
| ·
Any loans, loan commitments or unsecured credit
exposures to hedge funds (including prime brokerage for hedge funds), SIVs and
other such entities of comparable nature, as well as private equity
investments. | |
| The group argued that these activities
naturally belong to each other and accordingly should be conducted within the
same entity. | |
| The following activities would be exempted
from the separation requirement: | |
| ·
Hedging services to non-banking clients (e.g.
using forex and interest rate options and swaps) which fall within narrow
position risk limits in relation to own funds, to be defined in regulation; | |
| ·
Securities underwriting; | |
| ·
Use of derivatives for own asset and liability
management purposes; and | |
| ·
Sales and purchases of assets to manage the
assets in the liquidity portfolio. | |
| Only the deposit bank would be allowed to
supply retail payment services. All other banking business would be permitted
to remain in the entity which uses insured deposits as a source of funding
(“deposit bank”), unless firm-specific recovery and resolution plans require
otherwise.[41] | |
| The Group furthermore recommended that
authorities should be able to require a bank to separate a wider set of trading
activities, if the recovery and resolution planning highlighted that this
activity involved (i) particularly complex trading instruments, (ii)
particularly complex governance and legal structures, and (iii) led to risk
positions that were large in relation to overall market size for the particular
instrument. | |
| 6.2.
Strength of separation | |
| In terms of strength of separation, the
Group put forward the following recommendations: | |
| ·
Separate capitalisation: Both the deposit bank and the trading entity would each
individually be subject to all the regulatory requirements (e.g. CRR/CRDIV and
consolidated supervision) which pertain to EU financial institutions. They
would accordingly need to be separately capitalized according to the respective
capital adequacy rules, including the maintenance of the required capital
buffers and possible additional Pillar 2 capital requirements. In addition, the
trading entity and deposit bank only pay dividends if respect capital
requirements; | |
| ·
Limits on intra-group transfers: intra-group transfers would need to be on market-based terms and
should be restricted according to normal large exposure rules. Direct or
indirect transfers would furthermore not be allowed to the extent that capital
adequacy, including additional capital buffer requirements on top of the
minimum capital requirements, would be endangered; and | |
| ·
Corporate structure: The requirements would apply on the consolidated level and the
level of subsidiaries. The Group furthermore stated that the legally-separate
deposit bank and trading entity could operate within a bank holding company
structure. At any rate, the deposit bank would need to be sufficiently
insulated from the risks of the trading entity. | |
| 6.3.
Institutions to be covered by separation
requirement | |
| Structural separation would only be
mandatory if the activities to be separated amount to a significant share of a
bank’s business, or if the volume of these activities can be considered
significant from the viewpoint of financial stability. Accordingly, the
smallest banks would be considered to be fully excluded from the separation
requirement. The Group suggested that the decision to require mandatory
separation should proceed in two stages: | |
| ·
Examination thresholds: In the first stage, if a bank’s assets held for trading and
available for sale exceed (1) a relative examination threshold of 15-25% of the
bank’s total assets or (2) an absolute examination threshold of EUR100bn, the
banks would advance to the second stage examination. | |
| ·
Separation threshold: In the second stage, supervisors would determine the need for
separation based on the share of assets to which the separation requirement would
apply (i.e. proprietary trading, market-making, and loans and unsecured
exposures to certain funds). This threshold, as share of a bank’s total assets,
would need to be calibrated by the Commission. Mandatory separation would apply
to all banks for which the activities to be separated are significant, as
compared to the total balance sheet. | |
| Once a bank exceeds the final threshold,
all the activity concerned should be transferred to the legally-separate
trading entity. | |
| 6.4.
Other | |
| The Group furthermore made a number of
recommendations in other areas. | |
| It recommended possible amendments to the
use of bail-in instruments as a resolution tool, notably that the
bail-in requirement would be used explicitly only to a certain category of
clearly defined debt instruments and that the bail-in instruments would not be
held within the banking sector. | |
| It called for a review of capital
requirements on trading assets and real estate related loans, once on-going
international reviews finalised, and at a general level called for strong and
coordinated actions to improve the consistency of internal models across banks.
Furthermore, to strengthen the macro-prudential framework, it called on Member
States to include caps on loan-to-income and loan-to-deposits in their
macro-prudential toolboxes; and | |
| It recommended measures aimed at strengthening
the governance and control of banks, including e.g. fit and proper tests to
ensure management ability to run large and complex banks; measures related to
remuneration, and more detailed risk disclosure at legal entity level so as to
strengthen scrutiny and market discipline. | |
| 7.
Conclusion | |
| From the above, whereas the different
proposals share the ambition of better protecting retail deposits, they differ
as regards (i) the activities they formally suggest separating, (ii) the
strength of separation considered, and (iii) the scope of institutions they are
intended to apply to. The proposals are summarised in the table below. | |
| Table 1 –
Overview of structural reform measures in place or being proposed | |
| || Measure || Type of separation || Activities || Strength || Institutions || Other | |
| US || Bank Holding Company Act (BHC) || Functional separation || · BHC cannot engage in activities of commercial nature; · Insured depository institution can only engage in core banking activities (e.g. taking deposits, lending) and incidental activities (e.g. custody and asset management) || · Quantitative limits on certain transactions between a BHC and its affiliates (FRA Section 23A); · Transactions between BHC and affiliates to be on market-based terms (FRA Section 23B). || BHC || | |
| Prohibition on proprietary trading and investments in certain funds || Ownership separation || · Proprietary trading, except permitted activities: - Underwriting and market-making; - Risk-mitigating hedging activities; - Trading in US government securities - … · PE/hedge fund investments, unless (de minimis): - Less than 3% of individual fund; - Less than 3% of bank’s Tier1 capital in aggregate. Permitted /de minimis activities may not lead to: · Material exposure to high-risk trading strategies or assets; · Material conflict of interest with customers & counterparts; · Threat to safety of bank; or · Threat to US financial stability. || Prohibition Prohibition with de minimis exemption || Any US depository institution; Any firm affiliated with a US depository institution; and Any foreign bank with a US branch or agency || Reporting and compliance regime adapted to magnitude of banks’ trading activity. | |
| Ring-fencing of certain derivatives (“Swaps Push-out”) || Functional separation || Banks benefiting from federal assistance cannot engage in certain swaps (certain credit derivatives, all equity and most commodity derivatives). If they do, such swaps must be transferred to a separate legal entity, registered as a swap dealer and subject to capital requirements and margin requirements under the derivatives sections of the Dodd-Frank Act. Swap entities do not have access to federal assistance. || || Any US depository institution; Any firm affiliated with a US depository institution; and Any foreign bank with a US branch or agency || | |
| UK || Ring-fencing of retail banking activities || Functional separation || · Core activities (deposit taking) · Core services (incl. withdrawal, payments and overdraft) || Legal separation - Separate legal entity ring-fenced from group; - If RFB owns other organisations, those only do activities permitted to RFB; Separate governance - RFB independent board; - RFB separate disclosure; - Boards RFB and NRFB have duty to uphold ring-fence. Operational links - Operational independence irrespective of state wider group; - RFB member of payment systems; - Separate remuneration structure and human resourcing; Economic links - Relations between RFB and non-RFB on third party basis; - Transactions RFB-NRFB on commercial, arm’s length basis; - Assets sold at market value - Independence of capital and liquidity. - Separate risk management - Separate balance sheet (treasury) management; - Dividends/transfer of capital only if board believes sound; || All UK incorporated banks subject to exemptions: - Not building societies; - Not banks below certain size (Secondary legislation, indication GPB25bn) || Additional loss absorbency (equity, debt): - Ring-fenced bank: primary loss absorbing capacity (PLAC) of 17% RWA (equity buffer 3%, remainder either equity or loss absorbing debt); - Non-ring-fenced bank: at least 17% PLAC against all domestic and non-exempt overseas operations. Annual review of ring-fence effectiveness by PRA Reserve powers (electrification of fence) to regulators to require ownership separation from specific banks if attempt to circumvent. | |
| FR || Ring-fencing of certain trading activities || Functional separation || 1. Proprietary trading 2. Unsecured lending for own account to leveraged entities || Legal separation - Separate legal entity ring-fenced from group Economic links - Independence of capital and liquidity - TE not take guaranteed deposits - TE not provide retail payment services - Tighter intra-group large exposure limits Separate governance - Different commercial identity; - Different leadership || De minimis exemption for banks with trading activity below a certain threshold (secondary legislation) || | |
| Prohibition of certain trading strategies and trading in certain instruments || Ownership separation || Segregated entity cannot engage in following activities: - High frequency trading - Trading in agricultural commodity derivatives || || || | |
| DE || || Functional separation (ring-fencing of certain trading activities) || 1. Proprietary business; 2. Lending and guarantee business with hedge funds and AIFs; 3. Proprietary trading with the exception of market-making || - Commercial separation; - Legal separation; - Organisational separation; - Own refinancing of financial trading institution (FTI) to be secured independently; - Group transactions on third party basis; - Reporting obligations towards the BaFin (secondary legislation) || Banks and enterprises belonging to the same group as a bank. De minimis exemption for entities with trading assets (HFT+AFS) that are: - below €100bn; or - below 20% of total assets if total assets are below 90bn. || | |
| HLEG || || Functional separation (ring-fencing of certain trading activities) || 1. Proprietary trading; 2. Market-making; and 3. Loans/unsecured exposures related to hedge funds etc. || - Separate legal entity – trading entity (TE) - Can operate within holding company structure; DB must be sufficiently protected from TE risk. - RRP to ensure operational continuity of IT/payment system infrastructures in crisis. - Independence of capital and liquidity - Intra-group transfers on market-based terms - Intra-group transfers according to normal large exposure rules - Dividends and direct/indirect intra-group transfers only possible if still respect capital requirements (incl. buffers) - TE not take guaranteed deposits - TE not provide retail payment services || De minimis exemption, as only apply to banks with significant trading activity: - Examination thresholds: Relative threshold of 15-25% of the bank’s total assets; absolute threshold of EUR100bn; - Separation threshold: supervisors determine need for separation based on share of assets to which the separation requirement would apply. Threshold, to be calibrated by the Commission. || | |
| Annex A2 – Summary of replies to the
stakeholder consultation on structural reform of the banking sector | |
| In the context of the impact assessment
accompanying a potential legislative proposal on reforming the structure of
large EU banks, the Commission services have conducted a public stakeholder
consultation. The consultation was open for eleven weeks (16th May
2013– 11th July 2013). It contained both qualitative and
quantitative sections, with the former focusing on questions related to the
need for EU action and the different options for legislative reform, and the
latter containing a data template for banks to provide data on short and medium
term implications of different reform scenarios on their balance sheets. This
document summarises the responses to the qualitative part. This note follows
the structure of the consultation document and provides a high-level summary of
the nature of responses of different stakeholders. The following graphs
accompanying each section of the consultation document indicate the proportions
of each category of respondents that gave a certain answer[42]. | |
| The Commission services received 540
replies. These responses came from the expected type of respondents: banks and
other financial institutions, corporate clients, investors, public authorities,
and consumer associations and individuals (analysis shown in Graph 1). However,
while the composition is fairly traditional, the number of responses from
individuals (439) and consumer associations (11) stand out. The majority of
these 439 replies took either the exact, or abbreviated, form of a
recently-publicised Finance Watch response to the consultation. | |
| Graph 1: Overall breakdown of consultation
respondent by stakeholder type. | |
| The following graph shows the breakdown of
all other responses by nationality. It may be worth noting that the relatively
high number of responses from Belgium is composed mainly of international
organisations headquartered in Belgium, but representing several European
countries and member associations. | |
| Breakdown by nationality of the 439
responses from consumer individuals is excluded, as respondents did not
indicate within their response from which Member State they wrote. The majority
of consumer individuals responded in English (270), followed by French (131),
German (22), Italian (15), and 1 response was written in Danish. | |
| Graph 2: Overall summary of responses
by nationality | |
| 1.
Problem drivers | |
| The consultation document outlined the
problems that continue to affect the EU banking sector and outlined the
potential contribution structural reform could make in addressing those
problems. Stakeholders were then asked whether structural reform of the largest
and most complex banking groups could address and alleviate these problems. The
answers are summarised in Graph 3. | |
| Graph 3: Are banking structure reforms
relevant? | |
| The above graph, showing the type of
response as a percentage of overall responses from each group of stakeholder,
excludes the responses of individual consumers. This large group's inclusion
skews the graphic representation. Individuals responded in large numbers in
favour of the reform proposal (433 out of 439 in favour, but with 4 disagreeing
with the proposal). Along with the above graph, it is clear that there is a
distinct fault line between the responses of banks, on the one hand, and
consumers and non-bank financials on the other hand. The former are to an
overwhelming extent against structural separation (with the exception of some
cooperative banks). The latter are largely in favour. The views of other
categories are more balanced. Corporate customers, while acknowledging the need
to address TBTF, express opposition, based on the potential impact of such
reforms on the cost of financing. | |
| As shown in the graph, some cooperative
banks, consumer associations, non-bank financial companies, and public
authorities added the comment that they agreed with the proposal, but that it
should target smaller banks and should consider the detriment of a shadow
banking sector in the proposal process. | |
| 2.
Subsidiarity | |
| The consultation document then highlighted
the on-going reforms within Member States and outlined the potential benefits
of action at the EU level, that is, to preserve the integrity of the internal
market. It then asked for stakeholders’ views on whether they considered an EU
proposal in the field of structural reform necessary. | |
| Graph 4: Is EU action needed? | |
| Views on the need for EU action mirror the
views on the merits of such reforms in the first place. There is accordingly a
large opposition from most banks (excluding cooperatives) and non-financial
corporates. Consumer associations and individuals are again unanimously in
favour. It may also be interesting to note the relatively high number of
consumer responses that supported allowing Member State legislation to "go
further," than supranational reform, if possible. | |
| 3.
Policy options | |
| The remainder of the consultation document
asked for views of stakeholders on the three different elements of bank
structural reform: the scope of banks to be subject to potential separation,
the activities to be separated, and the strength of separation. It also asked
for stakeholders’ views on the best combination of activities and strength. | |
| 3.1.
Scope of banks | |
| As regards the scope of banks, the
consultation document asked questions related to, first, the threshold for
banks to becomes subject to separation, and second, the extent of supervisory
judgement in applying the threshold. | |
| As regards the threshold for separation,
the document outlined four options: | |
| (1)
Using the HLEG definition (Assets held for
trading and available for sale); | |
| (2)
A more narrow definition for separation, which
excludes available-for-sale assets, as they are mostly composed of securities
held for liquidity purposes; | |
| (3)
A definition focused on the gross volume of
trading activity, which is likely to focus on proprietary traders and
market-makers; | |
| (4)
A definition focused on net volumes, which is
likely to only capture those institutions that have a higher share of
unbalanced risk trading (proprietary traders). | |
| It then asked stakeholders which of the
four definitions would be the best indicator to identify systemically risky
trading activities. If none of the above, it asked stakeholders to propose an
alternative indicator. The views of stakeholders are summarised in Graph 5a.
Many stakeholders, particularly consumers, did not respond to this rather
technical question. Of those who did, many rejected the HLEG recommendation
(option 1). Most banks, as well as public authorities, argue in favour of a
risk-based approach. For those banks that expressed an opinion on the four
options given (standard and cooperatives and savings), the majority favours
option 4 (net volumes). Among other stakeholders, the debate lays between gross
and net volumes, with the latter having the most widespread constituency. | |
| Graph 5a: Threshold options by total
consultation response. | |
| Graph
5b: Threshold options by respondent | |
| As regards the degree of supervisory
judgement, the consultation document outlined three options: | |
| (1)
Ex post
separation subject to constrained discretion by the supervisor; | |
| (2)
Ex ante
separation subject to evaluation by the supervisor; or | |
| (3)
Ex ante
separation. | |
| It then asked for stakeholders’ views on
which would be the most appropriate approach, including suggestions for
alternatives. The pattern of responses is similar to views of the fundamental
merits of structural separation. Bank respondents however are more divided,
already showing some acceptance of separation with limited supervisory
discretion, mostly to ensure a level playing field in the market and ensure
legal certainty. The graph below does not reflect the responses of individual
consumers, as the volume of these respondents again will skew the graphic
illustration. The consumers who did answer this question (216) expressed
complete support for no supervisory discretion. | |
| Graph 6: The degree of supervisory
judgement (excluding individual consumers) | |
| Of those non-individuals who responded to
this question, 3 of the 18 total standard banks responded favourably to leaving
no supervisory discretion, with ex ante separation. The graph below depicts
the composition of respondents (excluding the 216 individual consumers) who
responded in the same way. | |
| Contrastingly, a third of all standard
banks who responded to the consultation replied in favour of either entire or
important discretion: | |
| 3.2.
Activities | |
| The consultation document highlighted the
broad range of activities banks may engage in and provided three scenarios for
separation, ranging from only some activities (e.g. proprietary trading, PT)
being separated and the trading entity thus remaining ‘narrow’ and the
deposit-taking entity ‘broad’; to a scenario where many activities (e.g. all
wholesale and investment bank activities, WIB, would be separated and the
trading entity accordingly becoming ‘broad’ and the deposit entity
correspondingly ‘narrow’. More specifically: | |
| (1)
“Narrow” trading entity and “broad” deposit
bank; | |
| (2)
“Medium” trading entity and “medium” deposit
bank; or | |
| (3)
“Broad” trading entity and “narrow” deposit
bank. | |
| It then asked a question specifically
related to the separation of market-making (MM) and underwriting activities.
This question has served as a foundation for classifying responses into the
three options highlighted above. | |
| Responses here again reflect the general
pattern of replies. Bank responses are divided between those who argue against
separation, and those who argue that if there is to be separation, then it
should only focus on proprietary trading. This sentiment is echoed by
corporates, who argue in favour of an as narrow separation as possible in order
not to affect their access to (low cost) financial services. Individuals and
consumer associations on the other hand favour option 3, i.e. separation of all
investment bank activities. | |
| Graph 7: Which activities should be
separated? | |
| Consumer individuals are excluded from the
above graph, as 243 extra favourable respondents skewed the scale of the chart.
The individuals who were in favour of the reform and who responded to the
question, however, were all in favour of separating all wholesale and
investment activities. As shown in the graphs, standard banks who accept a
certain degree of separation favour separating proprietary trading only from
the deposit-taking entity, much like non-financial companies and some public
authorities. | |
| Graph
8: Activities to be separated, by respondent | |
| The consultation document also highlighted
the particular case of risk management products, where the banking group and
its constituent entities not only need to be able to engage in prudent risk
management practices for treasury purposes, but where the deposit entity may
provide risk management products to its clients. The consultation document
therefore asked if deposit-taking entities should be allowed to directly
provide risk management services to clients, and if so, whether any additional
safeguards should be considered. | |
| Many stakeholders did not respond to this
rather technical question. Of those who did, many (most banks) responded in
favour of the deposit-taking entity being able to provide such services. Some
argued in favour of safeguards (e.g. simple derivatives, caps). Consumers, some
non-bank financials (investors) and public authorities were against such
provisions. | |
| Graph 9: Should the deposit entity be
able to provide risk management products? | |
| 3.3.
Strength of separation | |
| The consultation document subsequently
highlighted different forms of separation and indicated that the Commission
services were considering three degrees of strength: | |
| (1)
Functional separation with economic and
governance links restricted according to current rules; | |
| (2)
Functional separation with tighter restrictions
on economic and governance links; or | |
| (3)
Ownership separation (full prohibition). | |
| It then asked stakeholders for their views
on the pros and cons of stricter legal and economic separation, as well as
views on full ownership separation. | |
| · As regards legal and economic separation, the classical pattern can
be observed, with some cooperatives being concerned about the potential
implication of structural reform on their reverse-ownership structure; | |
| · As regards ownership separation, this has polarised opinion, with
most banks highlighting the costs, and consumer associations and individuals
and some non-bank financials highlighting it as the simplest and most effective
option in the longer term. | |
| Graph 10: Is there a case for stricter
legal separation? | |
| Graph 11: Is there a case for stricter
economic separation? | |
| Graph 12: Is there a case for full
ownership separation? | |
| Non-financial companies have been excluded
from the above graphs, as they consistently did not reply to the questions on
the strength of eventual activity separation. | |
| As shown by comparing the three graphs,
there is a high level of consistency across respondents. That is, a large proportion
of respondents in favour of increased economic separation are also in favour of
increased legal separation, for example. | |
| 3.4 Options | |
| The consultation document then highlighted
a number of preliminary and illustrative combinations of different degrees of
activity restrictions and separation degrees that would be subject to further
assessment in terms of costs and benefits (Table 1). | |
| Table 1: Overview of policy options | |
| Activities strength || Functional separation 1 (SUB) Current requirements || Functional separation 2 (SUB+) Stricter requirements || Ownership separation Ownership separation | |
| Narrow trading entity/ broad deposit entity E.g. Proprietary trading + exposures to HF (PT ) || Option A || Option B [≈ FR, DE baseline] || Option C [≈ US Volcker] | |
| Medium trading entity/ medium deposit entity E.g. PT + market-making (MM) || Option D || Option E [≈ HLEG; ≈ FR, DE if wider separation activated] || Option F | |
| Broad trading entity/ narrow deposit entity E.g. all investment banking activities || Option G || Option H [≈ US BHC; ≈ UK] || Option I [≈ Glass-Steagall] | |
| It then asked stakeholders whether (i) the
above matrix captured a sufficiently broad range of structural reform options
and (ii) which option would, in stakeholders’ views, best address the problems
identified. Fundamental views show up again, with a large portion of banks
expressing a blanket opposition to structural reforms or endorsing option A (PT
Only). Consumer associations and individuals, however, argue that option E
(HLEG) is the minimum effective option and express a preference for either
option H (UK ICB) or I (Glass-Steagall). | |
| Graph 13: Preferred reform approach | |
| As with several of the other responses, it
is worthy to note that the respondents do not necessarily add up to the total
number of responses received by the Commission. For this question in
particular this is especially evident, as many stakeholders expressed their
preference for Option E as a minimum option, but said that combinations such as
H and I or F and I would also work. | |
| Only one public authority cited capping
total assets as the preferred reform method. Others were divided fairly evenly
over the range of options. | |
| With regards to consumer associations, four
respondents preferred option H (~UK), while 14 respondents preferred the
Glass-Steagall type option on structure, or option I for separation. Only
Option G received no support from any respondent. | |
| 4.
Conclusion | |
| While consumers are overwhelmingly in
favour of the proposal for structural reform and banks are predominantly
against, where respondents addressed the numerous detailed choices within the
proposal, they displayed a wide range of views. Of course especially for the
final policy option and the divide between banks and consumers regarding supervisory
discretion, some dominant choices appear. Accompanied by several detailed,
analytical responses to the consultation document, as well as the quantitative
feedback from banks, the Commission has gleaned much information from the
varied group of respondents. | |
| Annex A3 – Assessing the complementarity
of structural separation | |
| Since the start of the financial crisis,
the European Commission (the "Commission") has – in parallel to the
management of the crisis by national authorities, state aid control by the
Commission, and non-standard interventions by central banks – engaged in an
ambitious overhaul of financial system regulation and supervision.[43] The objectives of
those reforms have been to create a safer, sounder, more transparent and
responsible financial system that works for the economy and society as a whole.
In particular this has been done by: (i) strengthening capital requirements
related to trading, securitisation and derivatives activities (the CRDII and
CRDIII)[44]
and to improve both the quantity and quality of bank capital more broadly (the
CRR/CRDIV)[45];
(ii) introducing rules that enable authorities to better manage failing banks
(the BRRD)[46];
(iii) creating a stronger micro- and macro-prudential system of supervision at
EU level by the creation of the European Supervisory Authorities and the
European Systemic Risk Board (the "ESRB") and the proposal on the
Single Supervisory Mechanism (the "SSM") as a fundamental pillar of
the Banking Union; (iv) strengthening the regulatory framework for the trading
of different classes securities, the provision of investment services and
activities and the treatment of OTC derivatives (the MiFID review and EMIR). | |
| The case for structural reform depends on
demonstrating in what ways such reforms could complement those reforms. The
purpose of this annex is not to provide an in-depth, comprehensive description
of the details of all these large and complex reforms. Instead, this annex: (i)
briefly outlines the objectives and principles of the major reforms either agreed
or currently under negotiation; and, (ii) assesses the extent to which bank
structural reform could complement already existing tools that provide powers
to take measures aimed at: (a) strengthening bank capital, governance,
supervision, recovery and resolution, derivatives clearing and trading, and,
taxation of financial transactions, and (b) restricting
or limiting the legal and economic organization and operation of banks. The annex also takes stock of how bank structural separation would
affect the general tension of increased regulation leading to a shift of
activities towards the less regulated shadow banking sector. | |
| 1.
Capital | |
| Banks play a critical role for the
functioning of the financial system and the economy as a whole. The business of
credit intermediation is nevertheless inherently unstable. Prudential
requirements to back up a bank's balance sheet by a certain level of own funds
in order to absorb losses have therefore since a long time been a key
instrument to control and limit these inherent risks. The financial crisis
highlighted shortcomings both as regards the level and loss-absorbing nature of
banks’ own funds. | |
| Efforts have therefore been undertaken at
both international (Basel Committee on Banking Supervision (the
"BCBS")) and European level (changes to the Capital Requirements
Directive (the "CRD")) to improve the quantity and quality of bank
capital. At the early stages of the crisis, capital requirements related to
trading, securitisation and derivatives activities were strengthened in order
to address the materially undercapitalised trading book exposures (the CRDII
and CRDIII). The crisis also initiated a more fundamental review of the capital
requirements framework at international level (Basel III), requiring banks to
have more and better quality capital overall. The BCBS has also developed
additional capital buffers for banks that are of global systemic importance.
These changes have been incorporated into European law by the recent CRDIV.[47] | |
| The reforms to bank capital requirements
will reduce incentives to take excessive risks. It will also enable banks to
absorb more losses before defaulting. These two effects will reduce the
probability of default. The increased capital requirements on banks’ trading
books may also reduce banks’ rapid balance sheet growth. | |
| Even so, risk weighted assets as compared
to total assets for large cross-border banks, which typically have an important
trading book, are significantly lower than for other banks.[48] Moreover, the
risk-based capital requirements based on value-at risk ("VaR") model
calculations can still be small compared to the size of trading assets.[49] This explains why some
measures have been taken[50]
and that standard setters at both international (BCBS) and European level (by
the European Banking Authority (the "EBA")) are assessing the
consistency and accuracy of the risk-weighted asset approach.[51] | |
| The subsequent revisions to the Basel
agreement and the CRD build on the same regulatory approach as the previous
Basel framework (risk-based capital requirements), even though it also
introduces a leverage ratio designed to serve as a backstop to risk-based
capital requirements. Trading, securitisation, short term wholesale funding and
other activities were all supposed to be assessed by supervisors as part of the
Pillar 2 supervisory review process introduced by Basel 2, as well as partially
by the Pillar 3 process of market disclosure. It therefore remains to be seen
whether these revisions will address all the difficulties of supervision and market
monitoring. | |
| In addition, CRDIV enhances the Pillar 2
supervisory review process by providing supervisors with powers to impose
certain structural measures on a bank when it is at risk or pose a risk to the
entire financial system. | |
| The capital requirements framework sets
capital and liquidity requirements that depend on the riskiness of the
individual entities and/or of the consolidated group. Structural reform could
therefore complement the capital requirements framework by imposing ex ante stricter
capital constraints on specific activities which are likely to generate the
most risk. If as a result, complex activities no longer benefit from being
covered by the public safety net, this would remove one source for excessive
growth of such activities. | |
| More fundamentally, capital requirements do
not address conflicts of interest and cultural problems, and as such do not
address the problem drivers associated with structural reform. Structural
reform (i.e., separation) combined with strengthened governance rules could
therefore prevent the investment bank side to affect the business of the
commercial banking part of an integrated group.[52] | |
| Moreover, irrespective of the changes to
capital requirements that increase the amount of capital that needs to be held,
banks may still have significant incentives for engaging in risky activities
that yield substantial profits, as they do not have to fully cover the
potential losses arising from such activities.[53]
Given limited liability as regards losses, the activities in question would
accordingly yield excess private returns. This could induce a broad-based shift
towards these activities, with an increase in systemic risk being the
consequence. | |
| Finally, structural reform could also
complement the CRDIV powers to impose structural measures by setting a uniform
standard for how relevant authorities should review the need for and
subsequently apply structural measures. | |
| Structural bank reforms could complement the reforms related to
capital requirements by: | |
| –
Imposing ex ante constraints on
specific activities, as opposed to ex post
capital requirements that depend on the riskiness of the individual entity
and/or of the consolidated group; | |
| –
Ex ante addressing
remaining incentives to engage in excessive trading activities over credit activities. Structural reform would be a more direct
way of addressing excess returns resulting from insured deposit the benefits of
which currently flow freely throughout integrated groups. It could lead to a
better pricing of risk, which over time could help reducing excessive trading
activity and thereby limit the build-up of systemic risk. This could also
complement the systemic risk charges for SIBs by adding another disincentive
towards banks excessively expanding their risky trading activities, thus
putting a break to the main source of bank growth in recent years; | |
| –
Allowing a more effective and transparent tailoring
of capital requirements to the different legal entities. A structural
separation would entail different entities holding separate capital and
liquidity buffers aligning the prudential requirements more closely with the
risk. This promotes market discipline; | |
| –
Setting a uniform standard for how
relevant authorities should review the need for and subsequently apply
structural measures; and | |
| –
Facilitate Pillar 3 market monitoring by providing more transparent group structures that match main
business lines, and by providing more disclosure of the data of the segregated
business entities. | |
| 2.
Governance | |
| One of the key contributors to the financial
crisis has been the implicit or explicit guarantees of bank deposits and other
liabilities, which induced excessive risk-taking (including, for example, high
leverage and own-position taking) and bad lending and acquisition decisions.
The problem was exacerbated by ineffective governance arrangements within
banks, which did not offer sufficient checks and balances within their internal
processes, resulting in a lack of effective oversight of management
decision-making and excessively short-term and risky management strategies.
This was compounded by ineffective ownership and control due to fragmented
shareholder structures. Is that not the same thing? | |
| Another contributing factor has been
passive debt holders. This passivity is partly due to the complexity of banks.
Banks are engaged in many activities and active across many markets and their
balance sheets are accordingly complex and opaque. This limits the ability of
investors to fully understand banks and exercise effective scrutiny. The
complexity is mirrored in e.g., the prudential regulation of banks (e.g., the
Basel capital adequacy framework), which is also complex and difficult for
investors to understand. Accordingly, investors have not fully exercised the
"watch-dog" function granted to them under Basel's pillar 3 (market
discipline) framework. | |
| The high leverage and guarantees have
encouraged boards to give undue focus to return on equity (and make decisions
that do not meet a bank's true overall cost of capital). | |
| Current reforms address many of these
problems, notably by imposing leverage limits (the CRR/the CRDIV), by
strengthening banks’ and investment firms’ internal governance structures, enhancing
risk oversight by boards, improving the status of the risk management function
and ensuring effective monitoring of risk governance by supervisors (the CRDIII
and CRDIV and the MiFID review) and by more clearly exposing debt holders to
risks of failure (the BRRD provisions on bail-in). However, current reforms do
not address the intra-group subsidies arising from the public guarantees on
deposits or the issues arising from the complexity of group structures.
Furthermore, internal management structures (e.g., boards) are an imperfect
substitute for market discipline. | |
| Structural reform could therefore strengthen bank governance
by e.g., providing for separate and independent governance structures for
deposit taking banks and the trading entity of a group. Such decentralised
governance structures could lead to better managerial focus on managing the
risks specific to those business lines. | |
| 3.
Supervision | |
| Bank supervision is essential to monitor a
bank's risk profile and intervene if the bank's own management does not take
appropriate action to reduce excessive risks. Since the start of the crisis,
the CRD has been strengthened to enhance and harmonise national supervisors'
powers. Also the review of the MiFID has reinforced the powers of securities
regulators, at national and European level (the European Securities and Markets
Authority). Moreover, most if not all supervisors in the EU have reviewed their
supervisory approaches and increased their resources. | |
| Supervision of cross-border banks
represents particular challenges. The financial crisis laid bare a gap between
transnational banking markets and cross-border groups and essentially national
supervisors. The CRDII package recognised the important role of Colleges of
Supervisors for these purposes. Since 1 January 2011, the newly created EBA
coordinates national banking supervisors. The EBA has binding mediation powers,
notably as regards approving banks’ internal risk models, and the Pillar 2
supervisory review. In order to strengthen macro-prudential supervision, the EU
has set up the European Systemic Risk Board (the "ESRB") that is
responsible for issuing early warnings and recommendations in relation to the
build-up of systemic risk. In order to address the negative feedback loops
between bank stability and Member States' finances, the European Council in
June 2012 asked for a road map to achieve a genuine Economic and Monetary
Union. Following a specific call from the Euro Area Summit, on 12 September
2012 the Commission presented legislative proposals for the establishment of a
single supervisory mechanism within the EU, as a first step towards Banking Union.
Political agreement was reached in December 2012 and the SSM should become
fully operational in summer 2014. | |
| While the above measures have and will
significantly strengthen the supervision of cross-border banks in Europe,
supervision of the largest and most complex banks in the EU will remain
challenging, given their complexity, size, and interconnectedness and with
business lines where risk profiles can change significantly in a very short
time and thereby risk outpacing supervisory control. | |
| Structural reforms could complement these reforms by adding
further transparency by e.g., separating the activities that are most
complex into a separate legal entity. This could facilitate supervision and could
allow market discipline to more effectively assist supervisors. | |
| 4.
Recovery and resolution | |
| Neither strict prudential rules nor close
supervision can exclude bank failures. In order to ensure that such failures
can be managed without impact on the stability of other financial institutions
or financial markets, and without recourse to public resources, the Commission
proposed in June 2012 a Bank Recovery and Resolution Directive (the BRRD)
requiring all Member States to have in place resolution regimes, consisting of
a number of elements: (i) an obligation on banks and certain investment firms
to draw up recovery plans and on authorities to prepare resolution plans; (ii)
a power to authorities to require changes to banks legal or operational
structure if they present an obstacle to resolvability; (iii) early intervention
powers; (iv) a harmonised set of resolution powers (including e.g., bail-in,
whereby the bank would be recapitalised with shareholders being wiped out or
diluted and creditors having their claims reduced or converted to shares); and,
(v) the creation of dedicated resolution funds in order to ensure that
resolution authorities can resolve banks without recourse to taxpayers’ money.
Negotiations in the European Parliament and the Council on the proposal have
reached an advanced stage and are about to close. | |
| The implementation of this proposal would
make it easier to stem bank problems at an early stage as well as making it
easier to resolve banks once they are beyond the point of repair. It would thus
help to address one of the major problems highlighted by the crisis, i.e., the
inability of banks to default in an orderly manner without leading to systemic
disruptions. | |
| This framework, (combined with the
proposals to maintain resolution and supervision of larger euro area banks at
the supranational level through the Single Resolution Mechanism and the SMM)
addresses impediments to resolving banks in an orderly way. Nevertheless,
structural separation could facilitate the effective and timely resolution of
banks. First, structural separation along the lines considered in the main
report would facilitate resolution because risky activities would either no
longer feature on a bank's balance sheet or be lodged in a separate subsidiary
ring-fenced from the rest of the group. In either case, the risks would have
less potential to contaminate the remaining part of a bank's activities. | |
| Second, while the implementation of an
effective bank recovery and resolution framework is a critical part of the
on-going financial reform programme, the preparation of recovery and resolution
plans (RRPs) will be particularly challenging for especially the largest EU
banking groups, given their organisational complexity, interconnectedness,
international scope, and ability to rapidly expand their balance sheet.[54] Structural banking reform
can therefore facilitate resolvability.[55]
More specifically, by complementing the RRP efforts, structural reform will be
able to benefit from and build on the resolvability assessment conducted under
the BRRD framework, and spur a mutually reinforcing progress toward removing
impediments to recovery and resolution for the institutions concerned.[56] | |
| Furthermore, resolution may be rendered
more complex by the co-mingling of activities within legal entities and
financial dependencies within financial groups.[57] Large EU banking
groups have a complex legal and corporate structure, in some cases involving a
myriad of different legal entities. During early intervention or resolution
this can make it difficult to identify and isolate the root of the problem. Structural
reform could enhance the simplification of groups by providing for competent
supervisor with the ex ante ability to separate certain activities. This
simpler structure could facilitate the exercise of the discretionary powers
provided for by the BRRD to reset the group structure and to remove further
impediments to resolvability stemming from the group operational or legal
structures and therefore improve the overall resolvability of banks. Resolving
complex banking groups may also be difficult because of the interconnectedness
of their subsidiaries and their centralised support functions. Central to the
resolution and restructuring of a failing firm (and potentially restoring the
viability of the bank, or parts of it) is the ability to identify and assess
the losses and the capital required to meet these losses. The writing down of
creditor claims and the conversion of debt claims to equity are important steps
early in a resolution process. Timing is critical in this process. While it is
important to value these losses accurately, it is also important that creditors
are treated fairly and quickly, and that any restructuring is done efficiently.
Perceptions of a disorderly process can encourage fears of contagion. | |
| Impediments to resolution may appear
gradually, for example as a bank's business model or activities change or as
deficiencies in the governance structure and performance emerge; but the risk
that those impediments carry can materialize suddenly. It could be that a
process to remove impediments (operational or governance-related) that rely on
multi-agency consultation and cooperation (and in the case of cross-border
groups, different authorities and supervisory colleges) would sometimes face
challenges in responding quickly enough to ensure that these risks do not
materialize. Ex-ante separation could mitigate for this by separating
the banks that would be the most difficult to resolve, before risks materialize
and threaten its viability. | |
| The early intervention and resolution tools
are new and authorities need to gain practical experience. For these tools to
be effective, authorities need to invest significant resources to scrutinise
banks as to their effective recovery and resolvability. This applies in
particular to the potential changes to banks' legal and operational structure
resulting from the RRP process. The burden of proof to demonstrate the need for
such measures will be on authorities, and may be tested in court. | |
| Structural reforms could complement these reforms in a number of
ways: | |
| –
The top-down – i.e. horizontal legislation
setting ex ante rules applying to similar entities – structural change implied
by structural reform could complement the preventative powers of the BRRD
that may result in a bottom-up reorganisation (i.e. individual ad hoc actions
addressing specific impediments to resolution at individual banks) of banking
groups. The combination of these two processes could over time lead to a
greater consistency between business lines and legal structures. Structural
reform could also facilitate the preventative powers by providing a base upon
which they would be exercised, thus limiting the degree of divergent outcomes. | |
| –
It is an ex ante tool to address a broader
set of objectives beyond facilitating the orderly recovery and resolution
of a banking group. Structural reform also aims at reducing the complexity,
interconnectedness, cultural problems and conflicts of interest between the
different banking entities within a given group, and aims at reducing the
excessive growth of bank balance sheets by constraining the coverage of the
public safety nets to specific activities only. | |
| –
By simplifying balance sheets and by introducing
functionally segregated and autonomous balance sheets rather than one large
complex one, separation could expand the options for resolving banking
groups. Also, separation could limit the scale of the task on an entity
basis and thereby make it more feasible to apply the different resolution
tools. This could also allow a swifter resolution process, as it would
be easier to identify problems and apply targeted solutions; | |
| –
It would give authorities the option of treating
different entities of the group in a separate way. Different resolution
strategies can be applied to different parts of the group; | |
| –
Separation could make it easier to identify
and assess losses as they would either no longer be accounted for, or be
accounted for in separate entities. This could e.g., make it possible to apply
differentiated bail-in requirements, if appropriate, to the different parts of
the group; | |
| –
Separation could also improve market
discipline by ensuring that the losses arising from certain risky
activities have to be borne solely by the creditors and investors of that
entity, and not be diluted across the creditors and investors of the whole
group. Those creditors and investors would accordingly have a greater interest
in the risk that the entity is running, and creditors and investors in other
less risky activities would be better protected. | |
| 5.
Trading and clearing of financial instruments,
including derivatives | |
| Market developments and experiences amid
the crisis showed that the existing EU regulatory framework centred on trading
activities on shares and on the operation of regulated markets needed updating.
Regulation needed to address challenges posed by a more complex market reality
and an increasing diversity in financial instruments and methods of trading.
This was the basis for important regulatory interventions in this area, also in
line with G20 commitments, such as the reviews of the Markets in Financial
Instruments Directive (the "MiFID") and the Market Abuse Directive
and the legislation on short selling and certain aspects of credit default
swaps. Focusing on derivatives, these instruments have been growing significantly
over the last decade. Derivatives markets today constitute a major part of some
banks' investment banking activities. The failure of U.S. Lehman Brothers
highlighted the size and interconnectedness of derivatives exposures and the
difficulties to manage and orderly resolve counterparty risk. It also
underlined the lack of transparency in derivatives market, which is mostly
carried out in private over-the-counter (“OTC”) venues rather than on public
trading venues. | |
| In order to limit contagion between banks
from OTC derivatives positions, the European Market Infrastructure Regulation
(the "EMIR") requires that, as of 2013, OTC derivatives must be
collateralised and that standardised transactions be cleared by Central
Counterparties ("CCPs") that interpose themselves between the parties
and assume their counterparty risk. Moreover, the EMIR establishes trade
repositories that will collect information on non-standardised derivatives,
with the aim to increase transparency for regulators. | |
| The MiFID review includes a proposal to
require that all standardised derivatives be traded on trading venues, it
introduces transparency requirements for non-equities, including derivatives
and strengthens powers of supervisors, including in the area of commodity
derivatives. | |
| The increased use of CCPs and higher
collateralisation of derivatives rights and obligations will limit the risk of
contagion. The cost of OTC derivatives will increase as a result of
counterparty requirements to better internalise the associated risk. This may
contribute to reducing the growth of the balance sheet of those EU banks that
are significant users and/or providers (i.e., dealers) of derivatives. | |
| Structural reforms could still complement these by reducing the
extent to which depositors are exposed to counterparty risks. Moreover,
multilateral clearing on CCPs will only apply to those derivatives that are
sufficiently standardised.[58]
The remaining ones will be subject to an enhanced bilateral clearing process
(e.g., higher collateral requirements). | |
| Furthermore, the MiFID review includes a
measure that would provide for an organisational separation between a bank
dealing-on-own-account business and the operation of a trading venue. While
this will address one instance of conflicts of interest (the MiFID II is
focussed on protecting market integrity and investors and is not intended to
deal with issues concerning the setting-up of different legal entities for the
provision of different services or activities) it will not require separate
subsidiaries with stand-alone capital. Neither does it deal with the separation
of traditional banking activities (e.g., deposit taking and lending) from the
provision of investment services and activities. It is accordingly unlikely to
affect intra-group subsidies. | |
| Structural separation could complement this provision by requiring
that certain forms of trading activity would have to be located in a separately
capitalised and funded entity. | |
| 6.
Taxation of financial transactions | |
| The Commission initially proposed a
Financial Transaction Tax (the "FTT") to be implemented by all 27
Member States by September 2011. However, following discussions in the Council,
it became clear that unanimous support for such a tax would not be reached. In
October 2012, following a request from 11 Member States[59], the Commission
proposed a decision to allow enhanced cooperation on the FTT. After an
agreement had been reached between the European Parliament and the Council, the
Commission put forward a detailed proposal for a FTT in February 2013. | |
| The objective of the FTT is to: (i) tackle
fragmentation of the Single Market that an uncoordinated patchwork of national
financial transaction taxes would create; (ii) ensure that the financial sector
makes a fair and substantial contribution to public finances; and, (iii) create
disincentives for financial transactions that do not contribute to the
efficiency of financial markets or to the real economy. | |
| The base for the FTT is broad, covering all
transactions carried out by financial institutions on all financial instruments
and markets that have an economic link to the FTT-zone. While the FTT base is
broad, the tax rates are low.[60]
Even so; the FTT would have to be paid by each financial institution involved
in the transaction. | |
| If adopted in current form, the FTT could
have a significant impact on the cost base of some of the risky activities that
are being considered for separation. These activities could accordingly be
expected to decrease in importance. For example, the impact assessment
accompanying the FTT foresees a significant reduction in derivatives activity,
albeit with a strong degree of uncertainty. The FTT would in that case achieve
one of the objectives of this exercise, namely to reduce incentives to engage
in excess trading activity at the expense of real economy activities. | |
| However, the FTT is at an early stage of
negotiations and the contours let alone detailed specifics of the proposal are
far from settled. Second, even if adopted, the FTT would only apply to banks
incorporated in the FTT zone. This excludes banks incorporated in some of the
major EU financial centres, which would make it susceptible to circumvention by
means of relocation.[61] | |
| Nevertheless, given the significant impact
of the FTT on transaction costs, banks would have strong incentives to find a
way around the safeguards. | |
| Accordingly, bank structural reform applicable to EU28 could provide
an additional safeguard to the FTT and limit regulatory arbitrage. | |
| 7.
Shadow banking | |
| Structural reform of banks may trigger a
migration of activities away from the regulated banking sector to the
unregulated or less regulated "shadow banking sector", i.e.,
institutions of different kinds that provide services similar to the core
banking functions (e.g., liquidity transformation and lending) thereby falling
outside the scope of application of the EU banking prudential rules which can
increase systemic risk and lead to financial stability issues. Although, when
risks move to a less regulated sphere and out of the scope of the supervisors’
screen it is also the case that the activity would no longer benefit from the
implicit public safety net.[62] | |
| In pursuing structural reform, policymakers
therefore need to be vigilant to avoid that much of the regulated activities
migrate elsewhere. Banks may actually invest in products provided by shadow
banking entities or even acquire some of these alternative institutions
providing credit intermediation functions.[63] | |
| Accordingly structural reform would create
a need for parallel regulatory actions in order to address a potential risk of
regulatory arbitrage. | |
| This would particularly be the case if some
trading activities were to be isolated in a separate entity within a banking
group. In this case, they should remain covered by high prudential standards
and appropriate supervisory arrangements. The status of such “trading entities”
should normally be the one of "investment firm" subject to the MiFID
and to the relevant prudential requirements of the CRDIV/CRR. Unless these
entities are controlled, the overall net reduction of risk could be limited.
[Also a strict ban on proprietary trading may require stricter prudential
requirements such as, for example, stricter exposure limits between deposit
taking institutions and "shadow banks".] | |
| Structural reforms only offer an incomplete
response to the above, and needs to be completed by rules addressing risks
posed by the potential increase of shadow banking. | |
| The Commission's strategy so far has been
to try and tackle all financial risks in a global and comprehensive way and by ensuring
that the positive effects expected from the strengthening of supervision of
financial players and markets are not neutralised by a transfer of financial
risks towards less regulated sectors. This strategy has been articulated in the
Commission's Green Paper on shadow banking published in March 2012[64]. The overall concern regarding
shadow banking is also shared by G20 leaders which have mandated the Financial
Stability Board[65]
to prepare policy recommendations on the topic. | |
| Following the public consultation on the
Commission’s Green Paper, the Commission now intends to set out its roadmap in
a communication. This Communication will comprehensively set out the issues at
stake in relation to the shadow banking system and outline the priorities for a
Commission initiative such as: (i) increasing the transparency of the shadow
banking sector; (ii) adopting a harmonised framework for money market funds; (iii)
developing securities law to further address risks associated with securities
financing transactions (i.e., securities lending and repurchase transactions); (iv)
strengthening provisions for interactions between shadow banking and banks
including consolidation of activities which could be moved outside the banking
sector; (v) identifying bank-like activities which may be provided outside the
regulated sector; and (vi) providing for supervision arrangements to ensure
that specific risks are adequately addressed. | |
| As the shadow banking sector changes over
time certain areas will require further and continuous analysis, particularly
on the basis of the analyses of the Commission services and the G20 final
recommendations. | |
| 8.
Conclusion | |
| The on-going banking regulatory reform
agenda is of vital importance. It will significantly increase the resilience of
both individual banks and the banking sector as a whole. Steps have been taken
to address systemic risks and an EU resolution framework will soon be in place. | |
| Current and on-going reform measures are
intended to improve financial stability and provide a more robust base for
economic growth and a well-functioning Single Market for financial services.
Measures such as increased bank capital requirements, improved bank regulation
and supervision will all help to avoid excessive risk-taking of banks. | |
| However, the current reforms do not
directly address the problems and distorted incentives that originate in the
implicit public safety net, banks’ complexity and interconnectedness.
Structural reform would therefore be an important complement to on-going regulatory
reforms, as it would offer one way of more directly addressing intra-group
complexity, intra-group subsidies, and excessive risk-taking incentives. It
also targets a broader set of objectives, such as ensuring that the deposit
taking bank is not unduly influenced by a short term oriented trading culture
and prone to conflicts of interest at the detriment of its customers. | |
| Annex A4.1: Implicit subsidies: Drivers,
Distortions, and Empirical Evidence | |
| 1.
Introduction | |
| In a perfectly competitive market, inefficient
companies or firms may fail and exit the market. However, in the banking
sector, profits are often claimed to be privatised while losses are socialised
as governments have often intervened to avoid bank failures. In order to
prevent widespread failure, governments have been designing bail-out programmes
for banks across the globe. The recent financial crisis has shown that
policymakers are prone to do so particularly in order to bail-out large or
otherwise important banks. These institutions deemed to be systemically
important are typically referred to as too-big-to-fail ("TBTF").
Anticipating public support for these institutions, bondholders and depositors
are willing to lower their requested return on these banks' liabilities.
Therefore, these banks benefit from a lower funding cost. These benefits may
stem from explicit government measures, such as deposit guarantee schemes (to
the extent they are inadequately priced) as well as from the expectation that
certain holders of banks' debt would not face the (full) risk of loss an
explicit safety net ("implicit subsidy"). While the government safety
nets can contribute to the prevention of systemic crises, they also have
several adverse effects. In addition to the direct impact of imposing strains
on public finances, they also lead to several market distortions. By making
banking losses social, implicit subsidies lead to moral hazard as the market
has a significantly reduced incentive to monitor banks' activities resulting in
excessive risk-taking. Also, they distort the level playing field across large
and small banks (as large banks are more likely to benefit from the funding
cost advantage) and between banks headquartered in sovereigns with different
ability to provide such support (depending on the state of their public
finances). The implicit subsidy also leads to allocative inefficiency as it
makes the financial sector more lucrative thereby luring resources from other
sectors. The first part of the Annex explores these issues and explains the
motivation for public intervention in banking as well as the side effects of
the implicit subsidies. | |
| In the second part of this Annex, we review
the empirical evidence on the quantification of implicit subsidies. There has
been significant interest by academics and policymakers on "putting a
figure" on the size of the implicit government guarantee to the banking
sector. By definition, the implicit subsidy is not transparent, and therefore
not observable and not easy to estimate with great precision. There have been
several strands of literature on the valuation of the implicit subsidy,
including the funding advantage models, the contingent claims model, event
study methodology, and by measuring market distortions. Empirical analyses
typically confirm that implicit subsidies exist and in most cases are very
significant, with subsidies reaching levels of several billion euros annually
that represent a significant share of banks' profitability. However, the
precise estimate of the level of the implicit subsidies is highly dependent on
the exact methodology used, as well as on the sample period and countries under
consideration. A summary table of the methodology and results of empirical
papers is provided in Appendix A of this Annex. The Joint Research Centre (JRC)
has also performed an in-depth empirical analysis based on the funding
advantage model (rating methodology) in order to determine the size of the
implicit subsidies and to find its main determinants, which is provided in Annex
A4.2 (and is briefly discussed below). | |
| 2.
Implicit subsidies: Drivers and Distortions
2.1.
Why do governments intervene? | |
| Deposit-taking banks are vulnerable to bank
runs given their asset maturity transformation role. Their mix of illiquid
assets and liquid liabilities (deposits that may be withdrawn at any time) may
give rise to self-fulfilling confidence crises and force banks to liquidate
illiquid long term assets at a loss even when they are, in reality, solvent (as
explained in the seminal paper by Diamond and Dybvig (1983)). The stakes from
bank runs are even larger as very often a bank run may have a contagion effect,
given that banks are interconnected. If a large bank fails then other banks
that rely upon this bank and its creditors to fulfil their obligations may
collapse as well, and so on.[66]
By creating a domino effect (through a direct contagion effect but also
indirectly due to reputational or informational contagion), the failure of a
TBTF bank threatens to adversely affect the real economy. A TBTF bank would
receive support if the regulatory authorities consider that its failure could
impose severe negative externalities upon society at large. Anticipating
government interventions, depositors are less likely to run on banks.
Therefore, ensuring depositor confidence may help prevent wide-scale collapse
of the banking sector and facilitates banks' ability to engage in effective
maturity transformation. Also, when banks fail the information capital they
have developed may disappear resulting in many borrowers not having access to
funds to pursue productive investment opportunities. As a result of the above,
widespread banking crises significantly affect the economy's ability to channel
funds to productive investment opportunities, possibly leading to a full-scale
economic crisis and a large decline in investment and output.[67] In order to
address these social costs of financial crises there are public safety nets
measures to restore depositor confidence. These measures include deposit
insurance, lender of last resort facilities (discount window central banks
role) and government bailout of these institutions. | |
| These explicit and implicit public safety
nets allow banks to enjoy significant benefits, as their funding costs are
artificially lowered given that creditors take into account the lower credit
risk. Explicit deposit insurance measures have been introduced since the 1929
Great Depression and now they exist in more than 90 countries worldwide. In
July 2010, following concerns about some Member States' banking sectors, the
level of deposit protection in the EU increased from a minimum of EUR 20 000 to
a uniform level of EUR 100 000, with a maximum pay-out delay of 7 days. In
addition to these explicit guarantees, policymakers will be inclined to
bail-out institutions that are considered to be systemically important and
therefore whose potential failure could threaten the stability of the entire
financial system. There is an expectation from the market participants that the
government might step in and bail-out at least some stakeholders. For example,
in several cases during the recent financial crisis, bondholders did not face
the (full) risk of loss, even if equity holdings were diluted. Consequently,
these banks may in turn enjoy favourable treatment from market participants
exploiting these safety nets. While for explicit subsidies it is possible for
governments to recoup the cost of intervention by levying a charge for it (or
at least for a great part of it), for implicit guarantees this is typically not
possible. Therefore, to the extent they are not recouped, implicit subsidies
are a transfer of resources from the government to the financial sector. Bank
creditors, customers, staff, and shareholders may benefit at the expense of
taxpayers. | |
| 2.2.
What determines governments' decision to
intervene and bail-out banks? | |
| Concerning implicit subsidies, the
authorities do not have any explicit ex ante commitment to intervene.
Therefore, by definition, implicit subsidies are not ex ante transparent and
market participants cannot know with certainty which institutions and which
creditors the public authorities would bail-out. Instead, when referring to
implicit subsidies, it is useful to think about the bail-out as a probabilistic
event (that is, assigning a probability that some institutions' creditors will
be subject to a bail-out). | |
| Stern and Feldman (2004) consider that
there are three motivations for policymakers to engage in TBTF policies.
Firstly, public authorities worry about the system-wide consequences of bank
failures and therefore act in the public interest. Secondly, regulators and
supervisors may have incentives that differ from the public. For example, they
might bail-out banks to avoid looking bad in case of bank runs, or to preserve
prospective career opportunities in banks for supervisors. Thirdly, public
authorities may want to direct credit: protecting large banks that are often
government-controlled helps encourage the public to put their savings in the
institutions, giving them resources to lend according to the government's
wishes. They also acknowledge that during a financial crisis it is inevitable
that some decisions are made as new information emerges, and it is easier for
policymakers to err on the side of caution. That is, if policymakers bail-out a
bank at risk, they would risk wasting taxpayer money and provoking public
outrage. If, though, policymakers wrongly do not intervene, then the whole
financial system may collapse (with consequences for the real economy). | |
| López-Espinosa et al (2013) analyse a large
sample of banks operating in 24 countries and investigate whether firm-specific
characteristics affect the likelihood of recapitalisation and the volume of
these capitalisations. They find that banks' sources of funding, management
quality, and the degree of international diversification help predict future
fiscal liabilities. Leveraged banks relying on non-stable funding and fewer
deposits, as well as banks with low management quality, and those more exposed
to fair value securities, are more likely to require public capital. Similarly,
a bank with domestic operations is more likely to be rescued, as national
authorities are not likely to weigh to the same extent the global externalities
from the disorderly failure of an internationally-active bank. | |
| Credit rating agencies (CRAs) also assess
the likelihood of government intervention. For example, Moody's (2011) explains
that the availability of support will reflect the sovereign's willingness to
provide public finds and its ability to intervene. Governments will be more
willing to intervene if banks have a greater systemic importance, and will
depend on the extent and type of resources required to prevent failure, and the
availability of alternative policy instruments (such as resolution
mechanisms). A government's ability to intervene will depend on the
government's debt rating. Also, the more widespread the problems in the banking
sector are, the less likely that governments would be in a position to
intervene. | |
| 2.3.
Side effects of implicit (and explicit)
guarantees | |
| To the extent that they are under-priced
there are budgetary implications from the implicit (and explicit) subsidies, as
well as market distortions due to this implicit guarantee, which tend to create
efficiency costs in the economy. Morrison (2011) argues that the most important
costs of the TBTF problem are incurred ex ante, in the form of distorted
incentives that arise as a consequence of distortions to the capital markets,
and to the choice of banks' scale and scope. | |
| 1. Negative impact on taxpayers and public finance of ex post bail-out | |
| As explained above, implicit subsidies are
probabilistic events (that is one cannot anticipate with certainty which
institutions and under which conditions governments will intervene). Sometimes
bail-outs (of at least some categories of creditors) arise as governments
intervene to avoid a devastating impact on real economic activity. Governments
are very reluctant to let large and interconnected banks fail given the high
potential costs, or if they do they would like to bail-out some categories of
creditors. For example in the 1984 Continental Illinois case in the US the
government also guaranteed all accounts (even if the deposit insurance was
limited to a fixed amount) and prevented losses for the banks' bondholders. As
shown by the recent financial crisis, governments have stepped in in several
cases with significant exposure for taxpayers. For the UK alone, Morrison
(2011) estimates taxpayer exposure to banking sector losses at GBP 955 billion,
and taxpayers' paper loss on RBS and Lloyds shares at around GBP 12.5 billion.
This UK example illustrates that implicit subsidies, at some point, become
explicit, and divert resources from the public budget which might have greater
added value to the society. | |
| Furthermore, the massive scale of the
adopted public recapitalisation measures, while succeeding in some cases in
preventing the collapse of the financial sector, has magnified spillover
effects from banking institutions to sovereigns. Negative feedback loops in
banking and sovereign balance sheets have been observed as massive public
interventions lead to higher sovereign risk, which in turn negatively affects
banks (for example, through their exposure to their sovereign bond risk).
Acharya et al (2010) find that sovereigns that announced bank bail-out
programmes during the financial crisis had a substantial increase in market
perception of their default risk, measured by the price of the credit default
swaps (CDS). Also, the close link between banks and sovereigns is confirmed by
the high correlation in the subsequent movements in CDS prices for sovereigns
and large banks. | |
| Therefore, public bail-out can impose
significant financial burden on taxpayers in the form of direct funding costs,
greater costs of sovereign borrowing, and inefficient allocations of public
finances. | |
| 2. Moral hazard and excessive risk | |
| From a theoretical perspective, the impact
of bail-out expectations on bank risk-taking is ambiguous. On the one hand,
excessive risk-taking on behalf of bank managers and personnel would arise as a
result of the market discipline hypothesis. According to this hypothesis, due
to the expectation that unsecured depositors, bondholders, and even
shareholders might be bailed-out, they would have a reduced incentive to
monitor the bank's activities closely and ask for a higher premium if the bank
is taking too much risk. Risk-shifting may occur if deposit insurance is not
fairly priced (Merton, 1977), or if governments provide guarantees to holders
of bank debt (Flannery and Sorescu, 1996). This increased moral hazard arises
with any safety net or insurance that is under-priced (see Freixas et al
(2004)). Furthermore, an adverse feedback loop exists, as implicit subsidies
lead to higher risk-taking, which in turn increases the likelihood of implicit subsidies
and further increases the level of implicit subsidies. For example, Kane (2009)
relates the market's appetite for structured securitisation to the implicit
safety net and supervisory cover provided to the sponsors of these products.
Similarly, Blundell-Wignall et al (2009) suggest that the TBTF problem is also
the result of the excessive growth through derivatives and structured products
trading, which present significant risks.[68]
On the other hand, under the charter value hypothesis, government support
decreases banks’ funding costs with depositors and creditors demanding lower
rates. The decline in funding costs increases the interest margin and raises
banks’ charter values, which leads to banks taking fewer risks to protect
future rents (Keeley, 1990). Therefore, according to this latter hypothesis,
implicit subsidies and the threat of losing future rents act as a deterrent of
risk-taking. | |
| Empirical evidence, however, provides
support to the market discipline hypothesis. Marques, Correa and Sapriza (2013)
find that the intensity of government support is positively related to bank
risk-taking, using an international sample of bank data and government support
for 2003-2004 and 2009-2010. They also show that this relationship is stronger
in 2009-2010 compared to 2003-2004. Acharya, Anginer and Warburton (2013)’s
findings from a large US sample also provide support for the market discipline
hypothesis. They show that for institutions that achieve systemically important
status, bond spreads are less sensitive to risk as the bond spread-risk
relationship diminishes with TBTF status. They also find that larger financial
institutions follow risker strategies than smaller ones. Gropp et al (2010a)
find evidence that public guarantees may be associated with substantial moral
hazard effects. They use the removal of government guarantees by court decision
in 2001 for savings banks in Germany as a natural experiment on the effect of
public guarantees. They show that when these guarantees were removed, those
banks’ credit risk reduced, as they cut the riskiest borrowers from credit
(with the Z-score of average borrowers increasing by 7.5%). Banks also
increased interest rates on remaining borrowers (by around 46 basis points),
and banks' bond yield spreads increased by 5 basis points. They conclude that
"a credible removal of guarantees will be essential in reducing the risk
of potential future financial instability."[69] Dam
and Koetter (2012) also explore German data of actual bail-outs and official
records of distress during 1995-2006 and show that significant increases in
expectations of bail-outs for banks (measured through political factors and
historical bailout probabilities) lead to significant increases in risk-taking. | |
| Furthermore, Gropp et al (2010b) argue that
there is a third effect (in addition to the market discipline and charter
value), as government guarantees may also affect the risk-taking of, not only,
the protected banks but also, through competition, of the protected banks'
competitors. This indirect effect arises as government subsidies reduce the
profit margins of competitor banks, due to fiercer competition from banks that
are able to refinance at subsidised levels. This leads to greater risk-taking
of the competitor banks. Gropp et al (2010b) find evidence from a sample of
banks from OECD countries that the main channel of increased risk-taking is
through increasingly risky competitive conduct of other banks. They conclude
that bail-out policies increase market expectations of bail-outs in the future,
which may distort competition and increase risk-taking of all banks, and lead
to greater financial instability in the future. | |
| There is some empirical evidence that
structural reform can address excessive risk-taking. For example, Marques,
Correa and Sapriza (2013) find that capital supervision and regulation were not
enough to fully prevent additional risk-taking by banks with more government
support, but banks that faced more restrictions in terms of activities they
were allowed to perform were less likely to take on more risk (see also
Blundell-Wignall et al. (2009)). Besides, in order to curtail the excessive
risk-taking and expansion of banks resulting from the existence of public
safety nets in the US, when the first safety nets were introduced, they were
accompanied by a series of regulations that (i) prohibit deposit-taking banks
to underwrite or deal in securities, (ii) limit commercial banks' access to
deposit insurance, as well as (iii) set a saving deposit rate ceiling to avoid
destabilising competition among banks. | |
| 3. Competitive advantage for banks that benefit from the implicit
subsidy. | |
| There is a competitive advantage for banks
that benefit from the implicit subsidy in terms of lower funding costs. Banks,
however, are likely to benefit from such an implicit subsidy to differing
extents. Even if implicit subsidies are hard to estimate with great precision,
there are several findings that are recurring in the literature. According to
several studies, and as also confirmed by the JRC work, implicit subsidies
benefit the largest banks disproportionately (see Rime (2005), Noss and
Sowerbutts (2010), Schich and Lindh (2012) and Oxera (2011)) and therefore
larger banks are more likely to benefit from such an implicit subsidy. This
would entrench the too-big-to-fail banks, and induce a competitive barrier for
smaller banks. Another common finding in the literature, also confirmed by JRC
work, is that the implicit subsidy advantage is higher the greater the
creditworthiness of the sovereign in which the bank is headquartered.
Therefore, a level playing field across EU Member States is not guaranteed, as
banks in Member States with higher sovereign rating benefit disproportionately
more from such implicit subsidies. This distortion is likely to have become
more acute as the debt crisis in several Member States reflects increasing
disparities in the public finances across Member States. | |
| 4. Allocative inefficiency | |
| Another source of distortion is an
allocative (and productive and dynamic) inefficiency. The implicit subsidy
makes the financial sector artificially more lucrative and this lead to
increases in the size of the financial sector diverting resources (including
human capital) from other sectors of the economy. Therefore, from a static
perspective, banks that benefit from implicit subsidy due to lower cost of
capital (funding costs) will be in a position to over-expand. Furthermore, if
banks are more likely to be bailed-out if they are larger and more
interconnected, as also confirmed by empirical analysis, then banks would have
an incentive to increase both their scale and their exposures to other large
banks. As a result, an institution to obtain or maintain its TBTF status would
have an incentive to have an aggressive program of mergers and acquisitions and
expand their activities' portfolio as much as possible, making the institutions
even more gigantic, ever more complex (and thus harder to resolve) and more
politically influential. In addition to this TBTF bias, Kane (2009) suggests
that implicit subsidies may further create geographic distortions in the
financial market as financial firms have incentives to book risky positions in
jurisdictions where supervisory loopholes would allow maximum benefits of
subsidies. | |
| Furthermore, there are productive and dynamic
inefficiencies stemming from implicit subsidies. Stern and Feldman (2004) claim
that the possibility of a bank bailout makes it more likely that banks will not
operate in a cost efficient way and may also innovate less. | |
| Also if public interventions take a
specific form, such as in the form of bailing out debtors, they also create a
distortion in the liability/equity structure of banks leading to sub-optimal
levels of leverage (see Admati and Hellwig (2013)). | |
| 2.4.
Why do governments still intervene if public
intervention leads to high TBTF costs? | |
| As explained above, implicit public
interventions have very significant side effects. Despite these adverse
effects, policy makers often bail-out failed banks. Stern and Feldman (2004)
explain that the TBTF problem stem from a lack of credibility of policymakers'
commitment to not bail-out large banks. This lack of credibility is another
manifestation of the time inconsistency problem as discussed by Kydland and
Prescott (1977). Even if policymakers recognise that bail-out policies lead to
long run moral hazard and distortions, they face a commitment problem with
respect to their pledge that they will not intervene in cases of bank crises.
When a large bank is at the brink of failure, policymakers will want to renege
on their pledge in order to avoid systemic risk. In turn unsecured creditors
anticipating such policymakers' incentives will not monitor large banks
sufficiently leading to such TBTF problem. | |
| Besides, governments often like to leave
some discretion on their hands on their decision to intervene or not in order
to cater for unforeseen situations. Governments have often deliberately left an
ambiguity on whether they will intervene and they do not announce their
willingness to support institutions they consider TBTF. Even if this provides
some short term comfort to policymakers it also accentuates the time
inconsistency problem they face. | |
| Furthermore, several academics claim that
the incentives to intervene (and the associated implicit subsidy) are likely to
persist even if a clear resolution mechanism is in place (see Admati and
Hellwig (2013)). They argue that no bail-out commitments are not credible as
banks’ interconnectedness remains high and the (social) costs of a systemic
crisis are also too high. Also credit rating agencies such as Moody’s consider
that when they assess the likelihood of public intervention they must strike a
balance between "clear policy intent to impose losses on credits […] and
on the other hand, despite stated policy preferences, there are still cases
where governments will feel bound, or trapped, by the complexity and
interconnectedness of banks (and the painful economic repercussions that their
failure will entail) to continue to extend systemic support to troubled
institutions".[70] | |
| As other complementary policy initiatives,
structural reform is a way to (at least to some extent) address this time
inconsistency problem. By separating trading and deposit taking activities it
is made more credible that governments would not renege on their no bailout
pledges for the trading entities. One would expect a lower probability of
intervention for trading entities (for example due to the fact they will have
access to deposits). Therefore, with less of an incentive for policymakers to
renege on no bailout pledges then the TBTF problem would be (at least to some
extent) reduced. | |
| The complementarity of structural reform
with other reform proposals, and in particular with resolution, is discussed in
detail in Annex A3. | |
| 3.
Valuing the implicit guarantee | |
| There has been a lot of research on the
quantification of the implicit government guarantee to the banking sector.
Measuring the level of implicit subsides is important to provide insight on the
potential magnitude of their adverse impact (both for the taxpayers and in
terms of distortions in the market place). The implicit subsidy is not
transparent and therefore not observable and as a result it is hard to reach a
consensus on its size. The recurrent finding in the literature is that implicit
subsidies exist and are sizeable; with subsidies reaching levels of several
billion euros annually for large banking groups. However, the precise estimate
of the level of the implicit subsidies is highly dependent on the exact
methodology used as well as on the sample period/countries under consideration,
with estimates differing to a significant extent. There have been several
strands of literature on the valuation of the implicit subsidy, including the
funding advantage models, the contingent claims model, event study methodology,
and measuring market distortions. Also, different studies on implicit subsidies
focus either on bondholders, shareholders or depositors. Kane (2000) suggests
that the first place to look for implicit subsidies is in markets for uninsured
bank and bank-holding debt and indeed most literature focuses on the advantages
of banks on their funding through debt. There is however a number of studies on
equity benefits (typically through event studies) and some work on uninsured
depositors (Jacewitz and Pogach (2013)). | |
| In this section we first summarise the
findings of the literature in the field of quantifying the implicit subsides
and identifying its determinants and discuss the methodologies used. We also
discuss two studies of two large US banks. Before concluding we discuss the
work undertaken by JRC. Appendix 1 summarises the findings of the literature
and the methodology used in the literature. | |
| 1. Funding advantage models | |
| In this class of papers the subsidy is
valued as the aggregate reduction in the cost of bank funding following an
implicit government guarantee. Implicitly there is a comparison with a higher
counterfactual cost that the bank would face in the absence of this implicit
government support. Then multiplying the difference between the actual and
counterfactual cost of funding by the size of each bank's risk-sensitive
liabilities gives an estimate of the implicit subsidy. However, this approach
assumes that banks' liability structures are independent of the existence of
the implicit government guarantee but in practice when government support is
likely withdrawn banks might seek to reduce their more expensive
liabilities/shrink. There are two main approaches within funding advantage
models the size based approach and the rating based approach. | |
| a.
Size based approach | |
| Size based models test the hypothesis that
only large (TBTF) banks would be supported by governments and consequently
enjoy a reduced cost of funding compared with their smaller counterparts.
Consequently, these models assume that in the absence of government support
large banks would face the same cost of funding as their smaller peers. A
number of papers that follow this size based approach they use events to
identify the implicit subsidies and examine how large (TBTF) banks funding
costs diverge from the funding costs of small banks in the bond market. | |
| A simple example of this approach is Baker
and MacArthur (2009) that use US FDIC data for depository institutions and
assume that all banks with assets in excess of $100 billion (18 BHCs) will
receive government support in the event of their failure. Using bailout events
they find that larger banks have 49bps lower funding costs post such bailout
events, which translates to a government subsidy of USD 34.1 billion a year for
these 18 banks. Acharya, Anginer and Warburton (2013) find evidence that
expectations of state support are embedded in credit spreads on bonds issued by
more than 500 US financial institutions. They analyse the determinants of the
bond spread by regressing them on a number of institution (including size and
risk), bond, and macro characteristics. They consider that an institution is
TBTF if it is in the top 90th percentile in terms of size. They find that the
implicit subsidy provided large banks with an annual funding cost advantage of
approximately 28 bps before the financial crisis increasing to 120 bps during
the crisis. The total value of subsidy amounted to USD 20billion per year
before crisis reaching USD 200billion during the crisis. They also examine
events related to the recent financial crisis and study their impact in the
bond market. Following the governments' rescue of Bear Stearns larger financial
institutions experienced greater reductions in bond spreads than smaller
institutions and following Lehman Brothers collapse larger financial
institutions experienced greater increases in their spreads compared to smaller
institutions. They also show that the passage of Dodd-Frank in the summer of
2010 did not eliminate investors' expectations of government support. | |
| Similar to debt holders, uninsured
depositors face a potential loss in the event of bank failure, and therefore
should require less compensation for risk from a bank they feel will likely
receive a bailout. Jacewitz and Pogach (2013) consider that since uninsured
depositors face potential losses in the event of closure the market will ask a
smaller risk premium of banks for which it considers a government bailout to be
more likely. Their results confirm that largest banks receive a deposit
premium. They estimate differences in the cost of funding using the actual
deposit rates offered at the branch level between 2005 and 2008. They focus on
the premium paid on USD 100 000 money market deposit accounts and use the USD
25 000 money market deposit accounts as a threshold to account for non-risk
factors across banks (such as having a larger branch network, a broader range
of services etc.). The advantage of using such a difference in difference
approach is that they can eliminate many non-risk based bank characteristics as
well as many standard risk metrics. They find that largest banks paid 15-40 bps
lower than other banks for comparable deposits (deposits with at least USD 100
000). They estimate that if this advantage is extended to all consolidated
uninsured funds of banks it would represent 70% of their pre-tax profits. They
also show that this difference in risk premiums cannot be attributed to usual
balance sheet measures of risk. They conclude that since large banks' risks are
differentially priced, the competitive environment will tend to favour them. | |
| The main advantage of the size based
approach is that (at least in its simpler versions) it is relatively simple to
estimate. However, the main drawback is that the size based approach makes the
crude assumption that only large banks will receive government support.
Furthermore the related question is at what level should this threshold apply,
and why. A commonly used TBTF threshold in the literature is $100billion in
assets. But even ex post the history of the applications of bailouts makes a
precise definition of a TBTF threshold impossible.[71] These
models also typically do not take into consideration that size alone may not be
the only factor that determines whether a bank will get bailed out or not and
other factors such as interconnectedness are important. | |
| b.
Rating based approach | |
| Some credit rating agencies (including
Fitch, Moody's and Standard and Poor's) often issue two credit ratings for a
bank in their assessment of the probability of default: a stand-alone rating
and a higher support (all-in) rating. The all-in rating factors in the
agencies’ estimate of the external support that the bank under consideration
would receive from public authorities and parent companies while the former only
considers the intrinsic strength of the bank. More recently credit rating
agencies also publish adjusted stand-alone ratings that take into account also
the likely parental support (adjusted stand-alone rating). As a result, the
difference between the adjusted stand-alone and all-in ratings would reflect a
decrease in the cost of servicing one's debt and is functionally equivalent to
an implicit guarantee for the debt. This difference is often called
"uplift". Several studies exploit the rating approach to determine
the value of the implicit subsidy and/or to assess its determinants. | |
| Studies find consistently several notches
of uplift which translate into significant levels of implicit subsidy. The size
of the implicit subsidy depends on the sample used as well as the definition
used for rating sensitive liabilities, as only for these liabilities the
funding advantage would apply. Haldane (2012) looks at 29 institutions deemed
by FSB to be world's most systemically important. In pre-crisis the difference
between the stand alone and support ratings averaged 1.3 notches using Moody's
data (note that he uses stand-alone and not adjusted stand-alone ratings). He
argues that even small notches can translate into big implicit subsidies if
balance sheets are large. He estimates the implicit subsidies to be on average
around USD 70 billion per year for 2002-2007 (which corresponds to roughly 50%
of the average post-tax profits of these banks). By 2009, the ratings uplift
reached 3 notches and the average implied subsidy exploded to over USD 700
billion per year. Schich and Lindh (2012) also estimate the rating uplift using
Moody's data focusing on a sample of 118 large European banks between 2007
until March 2012. They also find that the implicit guarantee increased in the
wake of the global financial crisis (uplift of around 2.2 points in 2007 and
2012 which peaked in 2009 to 3.14 points). In March 2012 the estimated yearly
reduction in funding costs were around USD 35 billion in Germany, around USD 15
billion in France and USD 10 billion in the UK. Bijlsma and Mocking (2013)
using data from Moody's on 151 relatively large European banks show that the
size of the implicit subsidy reached almost EUR 150 billion for the sample of
these banks in mid-2011 to fall to around EUR 100 billion at July 2012. Ueda
and di Mauro (2012) use Fitch data on around 900 banks from 16 OECD countries
and find a funding advantage of around 60bp in 2007 and 80bp in 2009. | |
| Several papers also attempt to identify the
source of determinants of credit rating uplifts by regressing the uplifts on
several bank and other relevant characteristics (such as variables relating to
the rating of sovereigns in which banks are headquartered). Schich and Lindh
(2012) use cross section analysis for March 2012 with country fixed effects to
control for unobserved heterogeneity across countries. Their results show that
larger firms receive (on average) larger such subsidy implicit guarantees and
implicit subsidies are higher the larger the bank relative to its peers in the
same country. Estrella and Schich (2012) follow a similar approach but focus on
the effect of government rating on the uplift. They find that the higher the
sovereign rating the higher the uplift. A 2 notch increase/decrease in
sovereign/stand-alone rating leads to 1 notch uplift. Rime (2005) finds that
bank size has a positive and significant impact on all-in rating and such
impact is larger for banks with low individual ratings. | |
| JRC has also undertaken an empirical work
on implicit subsidies based on the ratings approach which is discussed below.
The full analysis is provided in Annex A4.2. | |
| An advantage of the rating approach is that
it controls for the relative risk of different banks' business models (as
incorporated in the ratings). Also it allows taking into account the likelihood
of receiving government support as agencies typically distinguish between stand
alone and support ratings. However, the ratings based approach has been
criticised due to reliance on subjective rating agency judgment and to be
informative it requires that credit rating agencies have good insight of banks'
risks and the probability of government support. For example, Goldman Sacks
(2013) considers that the link between credit ratings and funding costs may not
be as clear as ratings take a different time horizon giving more long term view
of credit fundamentals and typically lag market assessments. However, even if
subjective it would be hard to argue that credit ratings are not informative.
Credit rating agencies are important market participants and markets use credit
ratings in pricing debt instruments. Therefore while subjective their views are
likely to reflect market sentiment and views on the likelihood of government
support. Currently all three major credit rating agencies provide proxies for
government support.[72]
Furthermore, there is some evidence that ratings of credit agencies have
predictive power. Marques, Correa and Sapriza (2013) also investigate whether
the Moody's support ratings are able to predict actual bail-outs. They find
that banks that enjoyed a nonnegative support rating were more likely to be
rescued in 2008-2010 by 30 percentage points. | |
| 2. Contingent claims ("CC") models | |
| Contingent claims models determine the
implicit subsidy in an option pricing framework. The value of the subsidy is
seen as the expected annual payment from the government to the banking system
necessary to prevent default. The subsidy is modelled as the shortfall between
the value of banks' assets and some threshold based on their minimum capital
requirements at some future time (for example Oxera (2011) uses a one year
horizon). Failure is assumed to arise when total assets of all banks falls
below this minimum requirement. The value of government support is assumed to
be the sum necessary to restore the value of assets to this minimum amount,
weighted by the probability of their falling below that level. | |
| CC models require the modelling of the
dynamics of banks' future asset values and their statistical distribution. This
is similar to pricing an option with the banking system viewed as a residual
claimant on the government. The value of the implicit subsidy is similar to a
put option. If banks' assets are greater than the threshold minimum asset value
when the option expires then it would not be exercised. If the value of the
assets is below the trigger point its payoff is equal to the difference between
the two. There are two possible methods to model the dynamics and distribution
of future assets: the equity option price approach in which the distribution of
bank's equity values is estimated based on the prices of equity options and the
historical approach which bases its estimates on historical prices of bank
equity). | |
| Oxera (2011) uses an equity option price
approach. Equity options pay out if banks' equity experiences price changes of
different magnitude and they give an insight into investors' expectations of
relative likelihood of changes of different magnitudes in banks' equity prices.
The central base case estimate of the forward looking state support corresponds
to overall GBP5.9 billion annual transfers for 2010 in the UK for the five
largest banks. However, as Noss and Sowerbutts (2012) notes, the conclusions
are sensitive to a number of assumptions. For example, the timing of state
intervention; the implicit subsidy is modelled as the expected shortfall at a
horizon of one year (European option i.e. at year-end). But state support could
be extended at any time were the value of banks assets to fall below the
threshold. Noss and Sowerbutts (2012) suggest that it would be more realistic
to consider the subsidy as a look back option whose value is determined by
maximum shortfall at any time over a year's horizon (subsidy would rise to
GBP30billion). Other critical assumptions include the level of the discount
factor, flatter tail distribution of asset returns. Overall, the subsidy can
reach up to GBP120 billion under some assumptions. Under a historical approach
the estimated subsidy is lower at around GBP 30 billion Noss and Sowerbutts
(2012). Therefore estimates for the same period and banks range from GBP5.9
billion to GBP120billion depending on the underlying assumptions. | |
| Noss and Sowerbutts (2012) note further
drawbacks of these models. They note that CC models require modelling of the
future path of banks' assets and make simplifying assumptions (for example that
banks fail when assets fall to a value commensurate with banks' minimum capital
ratio). Also they consider that banks' equity prices may be distorted by
investor's expectation of support, increasing their value and thereby reducing
the size of the estimated subsidy. | |
| On the other hand, an advantage of the CC
models is the use of market price data. Oxera (2011) for example claims that
market prices should reflect aggregate expectations of actual investors in the
market and are available almost continuously. In this respect, CC models are
able to estimate directly the expected value transfer from government based on
likelihood of a systemic shock occurring and expected payment from state to
avoid systemic failure. On the contrary, funding cost advantage models look at
difference with and without support, albeit often it is not obvious how to
establish the relevant counterfactual. | |
| 3. Event studies | |
| Another stream of literature looks at how
specific events such as policy announcements related to TBTF policy or policy
interventions, as well as bank mergers affect market expectations on the
implicit subsidies by studying banks' equity prices. These of papers on event
studies have looked at equity prices of banks rather than debt prices. Equity
holders may benefit from implicit subsidies either due to an expectation of
bail-out as well as from an indirect effect as implicit subsidies will impact a
bank's stock price by reducing a bank's cost of funding thereby increasing its
profitability. | |
| A number of papers explore the impact of
events that affect market's expectations concerning TBTF policy. For example,
O'Hara and Shaw (1990) conduct an event study to estimate the value of TBTF subsidy
using the 1984 congressional testimony from the US Comptroller of the Currency
in which he indicated that the 11 largest US banks were subject to a TBTF
policy (whereby for these banks total deposit insurance would be provided).
They find that there was a significant positive average residual return of 1.3%
in these banks' equity value on the day of the announcement. Pop and Pop (2009)
find evidence that the announcement that shareholders would not incur losses in
the 2003 Resona Holdings bailout in Japan resulted in significant abnormal
returns on the larger Japanese banks. | |
| Other studies instead examine the impact of
mergers on public expectations of TBTF. The underlying idea is that when two
banks merge and as a result they become TBTF (or increase their likelihood of
being TBTF) they would earn a premium compared to other mergers. In particular,
any merger that strengthens market presumptions that a bank acquirer is TBTF
would lower that entity’s financing cost and this may be reflected as a benefit
for shareholders. Kane (2000) studies the mergers of the top 12 US banks
between 1991 and 1998 and finds that they gave greater value to shareholders
when the target was a deposit-taking institution which was large. He considers
that implicit subsidies have inflated incentives for giant banks to merge with
other banks and this way shift risk into taxpayers. Brewer and Jagtiani (2011)
use data from 1991-2004 to look for the premium paid in 8 US mergers that
bought organisation over USD 100billion in assets in the US (their defined
threshold for TBTF), in order to test the hypothesis that banks are willing to
pay more to become TBTF. They find that acquirers paid a total premium of
around USD 15 billion. Molyneux et al (2010)' results are similar for nine EU
countries with EU banks paying higher merger premiums if their targets are
larger. Penas and Unal (2004) study the impact of 66 US mergers. They find
that mergers that push the combined bank's asset size above the TBTF threshold
asset size (2% of assets of all depository institutions) realise the highest
returns whereas returns of megamergers (mergers among banks that are already
TBTF) or smaller bank mergers (that do not bring the combined entity above the
TBTF threshold) earn relatively lower adjusted returns. This can be explained
as megabanks are already TBTF while small banks do not become TBTF as a result
of the merger. These "medium mergers", which are most beneficial for
shareholders, are found to benefit from a funding cost advantage as they lead
to a 15 basis point decrease in credit spreads of new debt issues of the
acquiring bank post-merger.[73]
On the other hand, a study that does not find evidence of TBTF subsidy is
Benston, Hunter and Wall (1995) which analyse the prices that acquirers bid in
an earlier US sample, 1980-1989. They conclude that most of mergers in the
1980s were motivated by earrings diversification rather than TBTF
considerations. | |
| A caveat of event studies based on share
prices is to ensure that the events under consideration are truly exogenous and
therefore are not reflected in these prices pre-announcement (of the
intervention or the merger). To the extent that the studied event is not
exogenous the analysis would not be in a position to identify the claimed
effect. An additional caveat of these studies is that they can only identify
the market price changes and not the level of such implicit subsidies as the
banks in question may have been benefiting from the implicit subsidy even
before the examined event. Thereby these studies are likely to provide a lower
bound for the size of the implicit subsidies. On the other hand, some studies
do not adequately control for the efficiency effects of mergers and therefore
any identified impact may confound both market power/efficiency and TBTF
considerations (as in Kane (2000)) thereby possibly overestimating the TBTF
effect. Similar to the size based funding cost models, a problem inherent in
several of these studies is the need to make an assumption on the TBTF
threshold. | |
| 4. Distortions of market prices – CDS prices | |
| Another approach to measure the size of the
implicit subsidy is to analyse the distortions of market prices caused by the
TBTF policy as reflected in the CDS market. The underlying idea is that the
implicit subsidy would lower the CDS spreads for these banks as the default
probability would be lower. | |
| Völz and Wedow (2011) analyse an
international sample of banks and find that CDS prices tend to be distorted if
the banks are larger and therefore less market discipline is exercised on these
larger banks. A one percentage increase in mean size of a bank relative to the
country's GDP reduces the CDS spread by around 2 basis points. They also find
that this relationship has decreasing returns as banks would presumably become
too big to save (with the turning point located at around 2 times the home
country's GDP). Schweikhard and Tsesmelidakis (2012) consider that there is an
asymmetric treatment of debt and equity during bailouts which tend to favour
creditors, as typically equity holders are the first to be hit. In order to
exploit this asymmetry, they compare credit default swap (CDS) premiums to
their theoretical equity counterparts for around 500 US companies between
2003-2009. They find that while CDS and stock-market-implied CDS spreads are
closely aligned during the pre-crises period, during the 2007-2009 crisis the
stock-market-implied CDS prices for banks are significantly higher than market
CDS prices (that is there is higher stock-implied default risk compared to CDS
observations). This difference is also shown to be positively related to the
size of the banks and by revaluing the offering price of bonds in the US they
estimate the total subsidies to amount to around USD 130 billion over the
period 2008-2009. | |
| Industry studies | |
| There are some studies from the industry
that claim the TBTF banks do not actually enjoy a funding advantage due to the
implicit subsidy. | |
| Goldman Sachs (2013) for example argues
that while a small funding advantage was present during the financial crisis it
has totally disappeared post crisis. The funding advantage for US has been
modest, around 30 bps on average since 1999.[74]
They claim that large firms in other industries also benefit from a
comparable or even larger funding advantage, which suggests that size confers
benefits that appear distinct from the issue of government support. In
addition, they find that bonds of the largest banks provide investors with far
greater liquidity and this added liquidity which, coupled with the superior
loss history for large banks, can explain the funding advantage that the
largest banks have experienced. In other words, investors are willing to pay
for the benefits of liquidity and large banks have more liquid bonds. They make
a second point that the largest banks generate fewer realised losses than do
the failures of smaller banks per dollar of deposits. They provide the example
of the Troubled Asset Relief Program (TARP) in which the government made a 15%
profit on the assistance it provided to the six largest banks. | |
| However, their paper sets aside the issue
that TBTF subsidy is about the expectation of government support lowering the
cost of funds relative to what they would have been otherwise. Carney (2013)
argues that TBTF banks take on far more risk (see Schnabel 2004, 2009) and more
debt than smaller banks. He points out this study of Goldman Sachs does not
control for risk and leverage metrics and therefore the fact that that risky
debt-laden large banks pay only 10 basis point more on their debt would be an
evidence of implicit subsidies. Related to the returns to taxpayers, one would
need to look into more aggregate data and not only one program. Laeven and
Valencia (2012) find that recent financial crisis 2007-2009 has increased the
burden of public debt and size of government contingent liabilities, creating
concerns about fiscal sustainability in some countries. They estimate that
there are direct fiscal costs reaching 6% of GDP in advanced economies for
measures such as capitalisation of banks, provision of liquidity and guarantees
and asset purchases. Furthermore, Morrison (2011) claims that one should also
take into account that funds are diverted from alternative uses, potentially at
a significant opportunity cost and therefore the profit net of opportunity
costs will surely be much lower. Also, irrespective of whether to government
makes a loss or a benefit this should not have an impact on creditors and
therefore the distortions of the implicit subsidy. It would imply that bailouts
do not really create a subsidy for large banks as they instead make money for
taxpayers. | |
| Araten and Turner (2012) (JP MorganChase)
also provide an estimate of the funding cost advantage that large banks enjoy
and end up with lower estimate of implicit guarantees compared to other
studies. They look in globally Systemically Important Banks (G-SIBs defined as
institutions with more than USD 500 billion in assets) in the US and find
moderate cost advantages associated with the GSIB status of 9 bps taking into
account all funding cost sources (and if one considers only interest bearing
funding sources this increases to 18bps). The main funding advantage is with
regard to domestic deposits (23bps) but there are also smaller cost advantages
with respect to credit spreads on senior, unsecured debt (and higher costs for
Fed Funds). They explain that this relatively small difference in funding costs
is due to the difference in funding mix between GSIB and non-GSIBs as non-GSIBs
rely more heavily on deposits (that have relatively lower funding costs than
other categories). | |
| This analysis shows that there are
composition effects that however are not accounted for in their analysis. The
fact that larger banks are able to expand their balance sheet with lower share
of deposits makes comparisons of individual categories of funding less
informative if one does not control for the underlying structure of liabilities
of different banks. Also risk factors are not accounted for. Furthermore, Noss
and Sowerbutts (2012) suggest that this paper assumes that banks' funding
advantage due to TBTF status to be invariant over time and that a number of
endogenous variables are included (e.g. profitability which is itself affected
by spread). | |
| JRC work | |
| As highlighted above, the JRC has also
worked on the quantification of implicit subsidies. This analysis follows the
rating based methodology of funding cost models and in addition to quantifying
the implicit subsidy it also investigates the determinants of the government
support on a sample of 112 large EU banks representing around 60-70% of EU
banking total assets. Based on Moody's data on all-in ratings and stand-alone
data JRC first computes the uplift across these banks that is due to government
support and finds that it lies between 2 and 3 notches. Also, JRC has
constructed a yield curve to translate the uplift into an estimate of the total
funding cost advantage in euros. The estimate of the implicit subsidy for their
sample is UR 72-95 billion and EUR 59-82 billion in 2011 and 2012,
respectively, for the banks considered. In relative terms, the implicit subsidy
estimate is in the range of 0.5% to 0.8% of EU-27 GDP. However there is some
variation across countries as the estimates are largely dependent on the size
of the banking sector in each country and the sovereign credit rating, as well
as the sample construction. The importance of the subsidies is also illustrated
by the fact that it account between one-third and one-half of the aggregate
annual pre-impairment operating profit of the banks. | |
| The econometric analysis confirmed the
findings of the literature showing that the uplift is associated with the size
of the bank, the banks' stand-alone strength and the sovereign (in which the
bank is headquartered) ratings. Larger banks are more likely to receive a relatively
higher uplift. Banks are likely to be TBTF due to their size, their
interconnectedness or importance to the financial systemic. As size is likely
to be highly correlated to TBTF status, this indicates that larger banks are
likely to benefit more from government support. A common finding in the
literature is that the rating of the country in which banks are headquartered
is important. JRC's work confirms that banks that are headquartered in a
country with a strong sovereign credit rating are more likely to benefit from a
higher uplift for a bank, raising questions on the level playing field in the
internal market. Furthermore, a higher stand-alone rating increases the
likelihood of observing lower uplift. Components of the individual strength
rating of a company relate to the riskiness of the banks (see Moody's
methodology (2011)). Therefore, a bank that is considered more risky is likely
to receive a higher uplift. The results also show that banks with stronger
parents are more likely to receive support within the group rather than from
the government. | |
| JRC also extended the analysis by including
several balance sheet indicators to investigate whether the uplift is likely to
be affected by bank business model. Before commenting on the results of this extended
model, the Commission notes that it is demanding to require from a reduced form
model to provide unequivocal evidence on the importance of business model.
Overall, however, the Commission considers that the regression analysis
provides some evidence that the business model variables affect the level of the
uplift. Two variables that are significant are the variables that relate to the
bank’s level of interconnectedness. Banks that hold a larger proportion of net
loans to banks in their total assets and banks that rely more on wholesale
market for funding are more likely to benefit from a higher implicit guarantee.
Also, banks that are better capitalised benefit from lower uplift. | |
| The full report is provided in Annex A4.2. | |
| 4.
Conclusion | |
| There are several explicit or implicit
safety nets for banks to deal as even solvent banks are susceptible to bank
runs and given the importance of the banking sector for the real economy.
Governments often step in and bail-out banks as evidenced during the financial
crisis. To the extent that these guarantees are mispriced they lead to several
distortions. Anticipating public support for the banks, their creditors have
lower incentive to monitor banks' activities. As a result moral hazard arises
and banks' managers are willing to take higher risks. Implicit subsidies for
banks also imply artificially higher returns for the sector attracting
resources from other sectors of the economy. Furthermore, as certain types of
banks are more likely to benefit from the implicit subsidy this also distorts
the level playing field across banks. For example, large banks, which are more
likely to be TBTF, benefit disproportionally from implicit subsidies compared
to their smaller counterparts. Also, as the value of the implicit subsidy
depends on the credibility of the guarantor, banks headquartered in countries
with good public finances are more likely to benefit from such a subsidy. | |
| There are several studies on the
quantification of implicit subsidies. The results of these studies are highly
dependent on the methodology employed as well as the sample (banks, geographic
scope, time period) under consideration. Overall, however, they point out that
implicit subsidies are present, sizeable and can represent a significant
advantage for larger banks. Debt holders, depositors and shareholders are
likely to benefit from implicit subsidies. However, studies typically focus on
one type of stakeholder even though the overall benefits to TBTF banks might be
expected to accrue to several parties. Implicit subsidies are found to
represent a significant share of countries' GDP (typically more than 0.5%) and
of banks' profits (more than 30% in some studies). JRC findings confirm
previous findings of the literature: larger banks are likely to benefit relatively
more from implicit subsidies. Also, banks headquartered in a country with
higher rating are benefiting from a higher uplift. When investigating the role
of business model variables, it is found that the degree of banks’
inter-connectedness also affects the uplift, with more interconnected banks
enjoying a higher uplift. | |
| | |
| 5.
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| APPENDIX A: Summary of literature | |
| 2013 | |
| J Cariboni, H. Joensson, L. Kazemi Veisari, D.Magos, E. Papanagiotou, C. Planas | |
| Annex A4.2 : Size and determinants of implicit state guarantees to EU banks | |
| Executive summary | |
| The European
Commission is bringing forward a proposal for a structural reform of the EU
banking sector to tackle problems arising from banks being Too-Big-To-Fail
(TBTF), including too-important-to-fail, too-complex-to-fail and
too-interconnected-to-fail. It has been argued that banks that are viewed to be
TBTF might enjoy an implicit government guarantee, because governments will not
allow these banks to fail. This implicit guarantee thus improves these banks
perceived credit worthiness and is observed as an upgrade in their long term
credit ratings. As the bank’s funding cost (measured in basis points) depends
on its credit rating, the implicit guarantee gives rise to a funding cost
advantage: bank creditors do not demand full compensation for being exposed to
banks’ risks, because bank creditors expect government bailouts to avoid
troubled banks to fail. Multiplying the funding cost advantage with a share of
the outstanding debt results in a monetary estimate which can be viewed as an
implicit subsidy given to banks. | |
| The present report investigates the size
and determinants of the implicit state guarantee enjoyed by a sample of 112 EU
banks covering 60-70% of the total bank assets in the EU over the period
2011-2013. It also estimates the implicit subsidy. | |
| The implicit guarantee is derived from
Moody’s credit ratings. Long-term credit ratings take into account the bank’s
stand-alone financial strength, a rating upgrade due to possible support from a
parent or a cooperative group, and a rating upgrade due to potential government
support. This third component is used to measure the implicit government
guarantee. The implicit guarantee is translated into a
funding cost advantage by comparing the funding cost inferred from the
long-term credit rating of a bank with the funding cost inferred from its
stand-alone credit rating. | |
| Results can be summarized as follows: | |
| 1) Estimation
of the implicit guarantee using ratings | |
| For about 80% of the banks the rating uplift due to potential
government support corresponds to a one to three notches upgrade. For the
largest 25% of the banks this upgrade is up to 26%
higher than for the other banks. The average upgrade
due to implicit guarantee is relatively stable over the period under study,
while a decrease in the average long term credit rating can be observed. | |
| 2) Estimation
of the implicit subsidy | |
| An estimate for
the total implicit subsidy is EUR 72-95 billion and EUR 59-82 billion in
2011 and 2012, respectively, for the banks considered. In relative terms, the
implicit subsidy estimate is in the range of 0.5% to 0.8% of EU-27 GDP. We also find that the total implicit subsidy is between one-third and one-half of the aggregate annual
pre-impairment operating profit of the banks. | |
| 3) Determinants
of the implicit guarantee | |
| In our sample of EU banks,
results of an econometric analysis show that the implicit
guarantee
(measured through the rating upgrade) appears to be driven by: | |
| ·
The
bank individual strength: a higher individual strength rating increases the
probability of observing lower implicit guarantee; | |
| ·
The
parental support: banks with stronger parents receive a lower implicit
guarantee. | |
| ·
The
credit rating of the country where a bank is headquartered: being headquartered
in a country with a strong sovereign credit rating increases the probability of
observing a higher implicit guarantee. This evidence
also appears if the debt to GDP ratio is used as a proxy for the sovereign
credit worthiness. | |
| ·
The
size of the bank: larger banks are more likely to enjoy a greater implicit
guarantee. | |
| Concerning the business model we find the following evidence: | |
| ·
More
inter-connected banks that hold a larger proportion of net loans to banks in
their total assets are more likely to benefit from a higher implicit
guarantee. | |
| ·
Banks
that rely more on the wholesale market for funding (i.e. a high wholesale
funding ratio) are also more likely to benefit from a higher implicit
guarantee. | |
| ·
Better
capitalized banks are more likely to receive a lower implicit
guarantee. | |
| Table of Contents | |
| Executive summary.. 81 | |
| 1.Introduction.. 85 | |
| 2.Literature review... 86 | |
| 2.1 Credit ratings as indicators of implicit state
guarantee.. 86 | |
| 2.2 Quantification of the implicit subsidy.. 87 | |
| 3.Estimation of the implicit guarantee 89 | |
| 3.1 Data description.. 89 | |
| 3.2 Descriptive statistics on the UPLIFT/UPLIFT*. 92 | |
| 4.Estimation of the implicit subsidy.. 103 | |
| 4.1 Methodology.. 103 | |
| 4.2 The rating-yield curve map. 103 | |
| 4.3 Proxies of rating sensitive liabilities. 107 | |
| 4.4 Implicit subsidy estimates. 108 | |
| 4.5 Comparing implicit subsidy with pre-impairment
operating profit, 113 | |
| 4.6 Relation between implicit subsidy and bank
characteristics. 113 | |
| 5.Determinants of the implicit guarantee.. 116 | |
| 5.1 Dataset and explanatory variables. 116 | |
| 5.2 Econometric methodology.. 122 | |
| 5.3 Empirical results without business model variables. 123 | |
| 5.4 Empirical results with business model variables. 128 | |
| 6.Conclusions. 133 | |
| References. 135 | |
| APPENDIX A: List of Banks. 137 | |
| APPENDIX B: Statistics on Moody’s rating data.. 140 | |
| APPENDIX C: Comparison with the existing literature.. 145 | |
| APPENDIX D: UPLIFT* for selected large EU groups. 151 | |
| Annex E: Descriptive statistics of the sample used for
building the rating-yield map. 152 | |
| APPENDIX F: Description of the proxies for the
rating-sensitive liabilities 154 | |
| APPENDIX G: Implicit subsidy versus pre-impairment
operating profit 156 | |
| APPENDIX H: Implicit subsidy versus bank characteristics. 158 | |
| APPENDIX I: SNL business model variables description.. 161 | |
| APPENDIX J: Marginal effects in Probit regression.. 163 | |
| 1.
Introduction[75] | |
| The European
Commission is bringing forward a proposal for a structural reform of the EU
banking sector to tackle problems arising from banks being Too-Big-To-Fail
(TBTF), including too-important-to-fail, too-complex-to-fail and
too-interconnected-to-fail. It has been argued that banks that are viewed to be
TBTF might enjoy an implicit government guarantee, because governments will not
allow these banks to fail. This implicit guarantee thus improves these banks
perceived credit worthiness and is observed as an upgrade in their long term
credit ratings. As the bank’s funding cost (measured in basis points) depends
on its credit rating, the implicit guarantee gives rise to a funding cost
advantage: bank creditors do not demand full compensation for being exposed to
banks’ risks, because bank creditors expect government bailouts to avoid
troubled banks to fail. Multiplying the funding cost advantage with a share of
the outstanding debt results in a monetary estimate which can be viewed as an
implicit subsidy given to banks. | |
| The aim of this
report is two-fold. The first aim is to estimate the size of the implicit government
guarantee (measured through the rating upgrade) of EU banks and to investigate its determinants via an econometric
analysis. The second aim is to estimate the implicit subsidy due to this
guarantee. | |
| To measure the size of the implicit
guarantee, we rely on the rating-based approach using Moody’s credit
ratings. Long-term credit ratings take into account the bank’s stand-alone
financial strength rating, a rating upgrade due to possible support from a
parent or a cooperative group, and a rating upgrade due to potential government
support. This third component is used to measure the implicit government
guarantee. The implicit guarantee is translated into a
funding cost advantage by comparing the funding cost inferred from the
long-term credit rating of a bank with the funding cost inferred from its
stand-alone credit rating. | |
| Studies in the
literature (Schich and Lindh (2012) and Schich and Kim (2012)) suggest that the
implicit guarantee depends on the strength of the sovereign where the bank is
headquartered and also on the size of the bank. This document extends the set
of possible drivers of the implicit guarantee and investigates whether bank
business profile also plays a role in the size of the implicit guarantee. | |
| The rest of
this document is structured as follows. Section 2 summarizes the available
literature. Section 3 describes the Moody’s ratings used to estimate the
implicit guarantee and presents some statistics. Section 4 focusses on the
quantification of the implicit subsidy. Section 5 presents the econometric
analysis performed to assess the determinants of the implicit guarantee and the
last section concludes. | |
| Some technical Annexes are enclosed to present additional statistics
on the datasets employed and to present the Probit model used for the
econometric analyses. | |
| 2.
Literature review | |
| The methodology followed in this work
relies on the previous work of Schich and Lindh (2012), Ueda and Di Mauro
(2012) and Schich and Kim (2012). A brief description of the methodology is
provided below. | |
| The three largest credit rating agencies
provide two types of ratings for a bank: | |
| ·
An
"all-in credit rating" (AICR) that factors in the possibility and
likelihood of external support that the bank receives when needed from its
parent, a cooperative or public authorities (including government support); | |
| ·
a
“stand-alone credit rating” (SACR) that abstracts from such support. | |
| The difference
between these two ratings is referred to as the rating UPLIFT: | |
| UPLIFT
= AICR – SACR. (1) | |
| The UPLIFT thus
factors in the effects of guarantees from the government and from other types
of support, such as parental and cooperative. Since 2011, Moody’s has also
started publishing an adjusted SACR (SACR*), that includes parental and
cooperative support but not government support. Using SACR*, an adjusted uplift
(UPLIFT*) can be calculated: | |
| UPLIFT* = AICR – SACR*. (2) | |
| The UPLIFT*
measures the increase in the rating due to government support. | |
| 2.1 Credit ratings as indicators of
implicit state guarantee | |
| Schich and
Lindh (2012) employ a dataset of 118 European banks from 17 European countries
for calculating the UPLIFT and the UPLIFT*. This study uses ratings from
Moody’s and covers the period between end 2007 and first quarter of 2012. A
general conclusion is that EU banks typically enjoy implicit guarantee and that
the sample of banks enjoying an implicit state guarantee extends beyond the
list of systemically important banks defined by the Financial Stability Board.
They find that implicit guarantees have increased during 2009 and 2010.
However, overall implicit state and parental support are persistent, as they
provide evidence that there is not a major difference in the UPLIFT for the
time period under study. When the UPLIFT* is examined on a country by county
basis it is shown that implicit support is present for all the countries under
study, although its magnitude varies across counties. Schich and Lindh (2012)
also attempt to provide an insight into the determinants of the UPLIFT* by
using a cross-section regression with country-fixed effects. They run a least
squares regression where the adjusted stand-alone credit rating (SACR*), the
domestic sovereign credit rating and the relative size of each bank are used as
explanatory variables. They conclude that: (i) the lower the adjusted
stand-alone credit rating (SACR*), (ii) the better the domestic sovereign
rating, and (iii) the larger the bank, the higher the implicit state guarantee.[76] | |
| In contrast to
Schich and Lindh (2012), who fit a linear probability model, Ueda and Di Mauro
(2012) employ ordered probit regressions with country-fixed effects. They use
ratings from Fitch in order to estimate implicit state guarantee for 895 global
banks in two points in time: 2007 and 2009. They also confirm that the funding
cost advantage increased substantially during the crisis: from 60 basis points
(bps) at the end of 2007 80 bps in end 2009. | |
| Bijlsma and
Mocking (2013) employ Moody’s ratings to calculate the UPLIFT for 151 European
banks for the time period 2006 to 2011. They conclude that the average UPLIFT
reached its maximum in 2010 (i.e. 3.6 notches) and then dropped to 2.5 notches
in 2012. Their results show that larger banks (above some threshold value based
on total assets) enjoy on average higher UPLIFT and a higher sovereign rating
of a bank's home country leads on average to a higher UPLIFT for that bank. | |
| Noss and
Sowerbutts (2012) report the average UPLIFT for four UK banks from 2007 to 2010
by using Moody’s ratings. They show that the average UPLIFT for the UK banks in
their sample has declined from about 3.5 notches in 2009 to one notch in 2010. | |
| Haldane (2010)
using Moody’s ratings reports that expected government support, for a sample of
about 16 UK banks and 26 global banks, has increased on average 2 notches
between 2007 and 2009. Moreover, his analyses also show that the UPLIFT is
higher for large than for small banks in the considered sample. | |
| In a subsequent
paper, Haldane (2012) reports the evolution of the UPLIFT for the 29 world’s
most systemically-important institutions calculated from Moody’s ratings. The
reported time period is from 2007 to 2012. Once more, in Haldane (2012) it is
confirmed that levels of support are higher after the crisis. Indeed, the
average UPLIFT has increased around 2.8 notches in 2012 from about 1.5 notches
in 2007. | |
| All available studies using the credit rating methodology thus
conclude that banks in the EU and worldwide benefit from a considerable
implicit state support, as reflected by an increase in their credit rating. | |
| 2.2 Quantification of the implicit
subsidy | |
| On the basis of bank bond data one can
construct a map between credit ratings and bond yields.
To estimate the funding advantage we compare the
difference between the bank's cost of funding given its all in credit rating
with the funding cost based on its stand-alone rating. This latter cost of
funding is assumed to be the funding cost the bank would experience if the
implicit government guarantee were not present. An estimate of the implicit
subsidy can be obtained by multiplying the funding advantage in basis points
with the amount of rating sensitive liabilities of the bank. One must be
cautious when making a comparison of results among different studies due to
differences in: i) the definition of rating sensitive liabilities, ii) the
sample of banks and the time period considered, iii) the sample of bonds used
in the building of the map, iv) the precise methodology used for the estimation
of the yield spreads. | |
| Haldane (2010) uses a proxy of rating
sensitive liabilities that excludes retail deposits but includes wholesale
borrowing. The estimated
subsidy of 16 UK banks is 11, 59 and 107 GBP billion in 2007, 2008 and 2009,
respectively. The five largest UK banks benefit primarily from this subsidy, as
the estimates for them are 9, 52, and 103 GBP billion in 2007, 2008 and 2009,
respectively. | |
| Noss and Sowerbutts (2012) define a proxy of rating sensitive liabilities as the sum of deposits from other banks and financial institutions,
some financial liabilities designated at fair value (debt securities,
deposits), and certain debt securities in issue (commercial paper, covered
bonds, other debt securities and subordinated debt). The implicit subsidy of
the major UK banks (Barclays, HSBC, Lloyds Banking Group, and Royal Bank of
Scotland) is estimated equal to around 5, 25, 130, and 40 GBP billion in 2007,
2008, 2009, and 2010, respectively. | |
| Schich and Lindh (2012) make use of a proxy for rating sensitive liabilities equal to the
“outstanding bonds and loans” issued in the market, which is readily available
from Bloomberg. Schich and Lindh (2012) calculate a lower bound of implicit
subsidy based on outstanding bonds and loans issued by the rated entity only,
and an upper bound where the debt of subsidiaries are also included. | |
| Bijlsma and Mocking (2013) estimate the relationship between bond yields and Moody’s long-term
deposit ratings using ordinary least squares regression. The amount of
long-term funding is used as a proxy for rating sensitive liabilities. The
total implicit subsidy ranges from around EUR 20 billion in early 2008 to peak
at almost EUR 150 billion in mid-2011. It falls to around EUR 100 billion in
the beginning of 2012. | |
| In conclusion,
irrespective of the methodology used, the sample of banks and the period
considered, the amount of the implicit subsidies is significant. | |
| 3.
Estimation of the implicit guarantee | |
| 3.1 Data description | |
| Countries and time period | |
| Our sample consists of 112 European banks from 23 countries (BE, BG,
CZ, DK, DE, IE, EL, ES, FR, IT, CY, LU, HU, NL, AT, PL, PT, RO, SI, SK, FI,
SE, UK).[77]
The sample represents between 60% and 70% of EU banking total assets as of end
of 2011[78].
The EU G-SIBs are all represented in the sample with the exception of Groupe
BPCE for which data on ratings are not available.[79] The time period under
study is from 2007 to 2012, and the data frequency is six months. For
comparison purposes, data for the first quarter of 2013 are also included in
the analysis. | |
| Ratings description | |
| The following
Moody’s ratings are used in the analysis: | |
| a)
Bank
Financial Strength Rating (BFSR): it represents the ratings
agency’s opinion of the banks intrinsic safety and soundness. It does not take
into account the probability that the bank will receive external support from
its parental company or public authorities. This is an estimate of SACR in
equation (1) above. | |
| b)
Baseline
Credit Assessment (BCA): the BFSR is mapped to the BCA
(Moody’s started publishing the BCA in 2011), which express the bank’s
intrinsic financial strength using the aaa – c scale (see Table
1).
BCA is therefore also an estimate of SACR in Equation (1) above. This approach
was also followed by Schich and Lindh (2012). | |
| c)
Adjusted
Baseline Credit Assessment (adjBCA): in contrast to the BCA, which
represents the bank’s stand-alone rating, the Adjusted BCA factors in the
effect of parental and cooperative support (SACR* in Equation (2) above). | |
| d)
Long
Term Issuer Rating (LT) used to estimate the all-in credit
rating (AICR) for each bank. In cases where the Long Term Issuer Rating is not
available, the Senior Unsecured or the Long Term bank Deposits ratings is used.
LT is reported on the Aaa – C scale. | |
| e)
Sovereign
Long Term Rating for the countries under study, necessary for the
econometric analysis in Section 5. | |
| Table 1: Moody’s
ratings: classes and mapping | |
| BFSR || BCA/adjBCA || LT issuer || Notch | |
| A || aaa || Aaa || 20 | |
| A- || aa1 || Aa1 || 19 | |
| B+ || aa2 || Aa2 || 18 | |
| B || aa3 || Aa3 || 17 | |
| B- || a1 || A1 || 16 | |
| C+ || a2 || A2 || 15 | |
| C || a3 || A3 || 14 | |
| C- || baa1 || Baa1 || 13 | |
| C- || baa2 || Baa2 || 12 | |
| D+ || baa3 || Baa3 || 11 | |
| D+ || ba1 || Ba1 || 10 | |
| D || ba2 || Ba2 || 9 | |
| D- || ba3 || Ba3 || 8 | |
| E+ || b1 || B1 || 7 | |
| E+ || b2 || B2 || 6 | |
| E+ || b3 || B3 || 5 | |
| E || caa1 || Caa1 || 4 | |
| E || caa2 || Caa2 || 3 | |
| E || caa3 || Caa3 || 2 | |
| E || ca || Ca || 1 | |
| E || c || C || 0 | |
| Source: Moody’s
2012b. | |
| Figure 1 gives a schematic representation of
the various components of the overall bank rating according to Moody’s
methodology. | |
| Figure 1: Components of
the overall bank rating according to Moody’s methodology | |
| Variables created and the corresponding
time periods | |
| a)
As
a first step all ratings of each individual bank are transformed into a
numerical scale varying from zero to 20, with 20 describing the best rating
category (see table above).[80] | |
| b)
The
UPLIFT is calculated as the difference between the LT and the BCA (as they are measured
in the same rating scale). However, as Moody’s started publishing BCA only in
2011 for dates prior to 2011 the BFSR is employed. BFSR is then transformed
into BCA according to Table 1. In cases where a specific BFSR rating
corresponds to more than one BCA rating the average of those is considered
(e.g. C- corresponds to the ratings Baa1 and Baa2). | |
| c)
The
UPLIFT* is calculated as the difference between the LT and the adjBCA for the
period 2011-2012 (4 semi-annual observations)[81]. | |
| d)
The
difference between adjBCA and BCA, which can be interpreted as an implicit
measure for parental support quality, is also computed. | |
| Appendix B presents detailed statistics for the various ratings
considered for various points in time. | |
| 3.2 Descriptive statistics on the
UPLIFT/UPLIFT* | |
| Figure 2 shows the evolution over time of
the BCA and the UPLIFT. Results suggest that UPLIFT is significant and has been
around 3 notches throughout the period. Results are in line with previous
literature[82]
and show that the stand-alone rating has decreased during the last years, while
the UPLIFT is more stable. One can thus conclude that the UPLIFT represents an
increasing share of the total rating and that the ratio of the UPLIFT over the
individual bank strength is increasing over time. The UPLIFT peaked between
2009 and 2011. | |
| Figure 2: Evolution of the
average BCA (estimate of Stand Alone Credit Rating) and average UPLIFT over
time | |
| Source: Moody’s and
own calculations | |
| Note: UPLIFT is estimated as the
difference in notches between AICR and SACR. Prior to 2011 the BFSR to BCA
mapping procedure is employed. | |
| Table 2 presents the statistics of the
UPLIFT* and | |
| Figure 3 shows the evolution of the UPLIFT* for the available points in time.
UPLIFT* is significant and around 2 notches in the period between June 2011 and
March 2013. Note that as adjusted stand-alone rating (adjBCA) are published
only since 2011, the UPLIFT* cannot be computed in earlier periods. | |
| Table 2: Summary
statistics for UPLIFT* | |
| || # Observations || Simple Average || St. dev || min || max | |
| June 2011 || 89 || 2.34 || 1.35 || 0 || 6 | |
| December 2011 || 104 || 1.91 || 1.33 || 0 || 7 | |
| June 2012 || 110 || 1.88 || 1.33 || 0 || 6 | |
| December 2012 || 112 || 1.96 || 1.50 || 0 || 8 | |
| March 2013 || 112 || 2.01 || 1.77 || 0 || 11 | |
| Figure 3: Evolution of the
average adjBCA (estimate of Stand Alone Credit Rating and parental/cooperative
support) and average UPLIFT* over time | |
| Source: Moody’s and own calculations | |
| Note: UPLIFT* is estimated as the difference in notches
between AICR and SACR*. | |
| The weighted
averages of the adjBCA and UPLIFT*, which are obtained by weighing each
observation according to the bank’s total assets, is shown in Figure 4. Although direct comparisons across
time periods cannot be made (due to small differences in the sample of banks
available in the dataset in each period), one can observe that the weighted
average UPLIFT* variable is greater than the simple average UPLIFT* indicating
that larger banks are benefiting from a higher government support. | |
| Figure 5 presents the contribution of the parental support (defined as the
difference between the adjusted stand-alone rating (adjBCA) and the stand-alone
rating (BCA)) to the long term rating. One can conclude
that in contrast to the average stand-alone rating (BCA), which has decreased
between June 2011 and March 2013, the average parental support has slightly
increased. | |
| Figure 4: Evolution of the weighted average adjBCA (estimate
of Stand Alone Credit Rating and parental/cooperative support) and weighted
average UPLIFT* over time [83]. March 2013 is missing
since total assets are not available. | |
| Source: SNL,
Moody’s and own calculations | |
| Note: UPLIFT* is estimated as the difference in notches
between AICR and SACR*. | |
| Figure 5: Evolution of the
average BCA (estimate of Stand Alone Credit Rating), average UPLIFT* and
average parental support over time | |
| Source: Moody’s and
own calculations | |
| Note: UPLIFT* is estimated as the difference in notches
between AICR and SACR*, parental support is calculated as the difference
between SACR* and SACR. | |
| The average
UPLIFT* varies between countries implying different levels of support, as can
be seen in
Figure 6. Belgium, France, Austria and Germany
are among the countries for which the estimated UPLIFT* is consistently higher,
which is in line with the findings of Schich and Lindh (2012). When comparing Member States one should consider that this
analysis includes only the banks in the sample and that simple averages are
provided. | |
| Figure 7 presents the change of the average UPLIFT* between June 2011 and
March 2013. | |
| Figure 6: Simple average UPLIFT* for 23 European
MS (March 2013), in notches. In parentheses one can read the number of banks in
the sample for each country. | |
| Source: Moody’s and
own calculations | |
| Note: UPLIFT* is
estimated as the difference in notches between AICR and SACR* | |
| Figure 7: Changes of
average UPLIFT* between June 2011 and March 2013 for 23 European MS | |
| Source: Moody’s and own calculations | |
| Note: UPLIFT* is
estimated as the difference in notches between AICR and SACR* | |
| The UPLIFT* is also higher for larger
banks. The relative difference between the average UPLIFT* of the 25% largest
banks in the sample and of the remaining ones is between 7% and 26%, depending
on the point in time (see Figure 8). For the 10% largest banks the
difference is 5% to 23% (see Figure 9). The relationship between size and
UPLIFT* is better examined through the regression analysis in Section 5, which
also control for other variables that may affect the UPLIFT*. | |
| Figure 8: Average UPLIFT*
for the 25% largest banks (total assets) over time | |
| Source: SNL,
Moody’s and own calculations | |
| Note: UPLIFT* is estimated as the difference in notches between AICR
and SACR* | |
| Figure 9: Average UPLIFT*
for the 10% largest banks (total assets) over time | |
| Source: SNL, Moody’s
and own calculations | |
| Note: UPLIFT* is
estimated as the difference in notches between AICR and SACR* | |
| Appendix D presents
scatterplots for each point in time of the UPLIFT* versus the total assets at
the four different time periods. No clear discernible pattern can be
identified. | |
| Figure 10, Figure 11 and Figure 12 are scatters plots of the average
UPLIFT* against the countries’ sovereign rating at different points in time.
There is a positive relationship between the country’s sovereign rating and the
UPLIFT* in all periods of the analysis. The fact that for countries such as CY,
IT, ES one can observe a shift left down through time points towards a positive
relationship between the two variables (see also Section 5). | |
| Figure 10: Scatter plot
of the average UPLIFT* and country’s sovereign rating for June 2011 | |
| Source: Moody’s and
own calculations | |
| Note: UPLIFT* is
estimated as the difference in notches between AICR and
SACR*. | |
| Figure 11: Scatter plot of the average UPLIFT* and country’s
sovereign rating for December 2012 | |
| Source: Moody’s and
own calculations | |
| Note: UPLIFT* is
estimated as the difference in notches between AICR and SACR*. | |
| Figure 12: Scatter plot of the average UPLIFT* and country’s
sovereign rating for March 2013 | |
| Source: Moody’s and own calculations | |
| Note: UPLIFT* is
estimated as the difference in notches between AICR and SACR* | |
| 4.
Estimation of the implicit subsidy | |
| We aim at
estimating the funding cost advantage of banks due to an implicit support from
the sovereign where the reporting entity is headquartered, for the sample of
banks used in the above analysis of the UPLIFT* based on balance sheet data for
the end-of-year of 2011 and 2012. | |
| 4.1
Methodology | |
| The estimation is done in two steps.
Firstly, we compare the funding cost implied by the long-term credit rating of
a bank with the counterfactual funding cost based on its stand-alone credit
rating, following Schich and Lindh (2012) and Noss and Sowerbutts (2012). We
assume that the difference of these two values approximates the potential
funding cost advantage (in basis points) due to the implicit subsidy from the
sovereign. Secondly, we multiply the funding cost
advantage with a share of the outstanding debt. | |
| To perform this analysis we use: | |
| -
The
banks’ adjust stand-alone rating (the adjusted BCA) and the all-in (long-term)
rating; | |
| -
A
rating-yield curve to map the credit ratings to yield spreads; | |
| -
A
proxy of the share of each banks liabilities that can be assumed to be rating
sensitive in the sense that the cost depends on the credit rating. | |
| 4.2 The
rating-yield curve map | |
| The rating-yield curve is built by taking
weekly observations of market yields for a sample of European banks from 18
countries. The sample consists of 77 banks in 2011 and 82 banks in 2012[84]. We have built one
rating-yield curve for the second half-year of 2011 (2011H2) and one for the
second half-year of 2012 (2012H2). The data used comes from DG ECFIN’s Bank
Watch. The yields given in the Bank Watch data are the market yields for bonds
with a maturity of 5 years. Note that the sample used to build the rating-yield
map and the sample used to estimate the implicit subsidy (and the UPLIFT*) is
not the same. Overall 54 banks in 2011H2 and 57 banks in 2012H2 belong to both
samples. A description of the sample used to build the mapping between ratings
and yield spreads is given in Appendix E. | |
| The average yield spread for each rating
bucket is estimated for 2011H2 and 2012H2 and a non-linear curve is fitted to
the estimated average yield spreads (see Figure 13). It can be observed that the average
yield spreads (marked with diamonds) have decreased over the full spectrum of
rating categories from 2011H2 to 2012H2 and that the yield spread curve is
flatter for the latter time period.[85] | |
| Figure 13: Rating-yield spread curve for 2011H2
and 2012H2 | |
| Source: DG ECFIN’s
Bank Watch and own calculations | |
| Note: The diamonds
indicate the average 5-year market yield spreads per rating class. | |
| As mentioned previously, the sample used to
build the rating-yield curves and the sample used to estimate the implicit
subsidy overlaps partly (54 banks in 2011H2 and 57 banks in 2012H2). Thus, for
these banks we can compare the average market yield spreads with the yield
spreads given by our rating-yield curve mapping as presented in Figure 14. | |
| Figure 14: Estimated
yield spreads derived from long-term ratings versus average observed market
yield spreads (in basis points) | |
| Source: Bank Watch
and own calculations | |
| From Figure 14, one can see that the average yield spreads derived
from the mapping exercise and the actual market spreads are more or less in
line with each other in both 2011 and 2012. For these banks present in both
samples, the average market yield spreads were 21 basis points and 8 basis
points lower than the yield spreads estimated from the rating-yield mapping in
2011 and 2012, respectively. This indicates that the market gave on average a
higher funding advantage to these banks than our rating-yield spread map
indicates, as banks were on average able to secure funding at lower yield
spreads than what we predict.[86] It is therefore likely that we are
slightly conservative in our estimate of the implicit subsidy with respect to
the calculation of the yield curve. There are, however, some cases where the
difference between the observed market yield spreads and the estimated yield
spreads are significant.[87] | |
| From the above rating-yield spread curves
we estimate the difference between the yield spreads given by using the
long-term issuer rating and the yield spreads given by the adjusted BCA.[88] Scatterplots of the
yield spread difference versus bank size is shown in Figure 15 and | |
| Figure 16. Section
5 presents an econometric analysis investigating the relationship between
funding advantage as measured via the yield spread difference and bank size. | |
| Figure 15: Difference
between long-term issuer (all-in) rating yield spreads and adjusted BCA (estimate of Stand Alone Credit Rating
and parental/cooperative support) yield spreads in 2011H2 versus banks total assets | |
| Source: Bank Watch,
SNL, and own calculations. | |
| Figure 16: Difference
between long-term issuer (all-in) rating yield spreads and adjusted BCA
(estimate of Stand Alone Credit Rating and parental/cooperative support) yield
spreads in 2012H2 versus banks total assets | |
| Source: Bank Watch,
SNL, and own calculations. | |
| 4.3
Proxies of rating sensitive liabilities | |
| Banks fund their activities with various
sources of funding (e.g. bonds, deposits and loans) with different costs. The
cost of each of these sources of funding is assumed to be influenced by the banks
credit rating(s) differently. These various types of liabilities are therefore
expected to benefit from any potential implicit guarantee differently. We have
chosen to work with two different proxies of rating sensitive liabilities: | |
| ·
‘Total Debt’ as reported in SNL[89] (corresponding to
around 20% of total liabilities); and | |
| ·
‘Total Long-term Funding’ as reported in
Bankscope[90]
(corresponding to around 15% of total liabilities). | |
| A description of the sample used for
estimation of rating sensitive liabilities can be found in Appendix F. | |
| The data we are using for approximating the rating sensitive
liabilities is on a consolidated basis.[91] It includes, therefore, all debt issued by the reporting entity
(bank holding company, parent bank or subsidiary bank) and all of its
subsidiaries which are consolidated on the reporting entity’s balance sheet.
This estimation should be viewed as an upper bound of a large (parent) bank’s
rating sensitive liabilities.[92],[93] | |
| 4.4 Implicit subsidy estimates | |
| The total estimated implicit subsidy for
the banks in the sample based on Total Debt is EUR 95 billion and EUR 82.3
billion in 2011 and 2012, respectively. The estimated total amount based on
Total Long-term Funding is lower, EUR 71.5 billion and EUR 58.5 billion
in 2011 and 2012, respectively, as can be expected since the Total Long-term
Funding is for most banks lower than the Total Debt measure. In relative terms,
the implicit subsidy estimate is 0.8% and 0.6% of EU-27 GDP for the first
estimate and for the second estimate, respectively, for 2011. For 2012 the
figures are lower, 0.7% and 0.5%, respectively. | |
| Estimated implicit subsidy for the banks in
the sample is presented country by country in Figure 17- Figure 20 and in Table 3. The banks in France, Germany and UK
have the largest implicit subsidy estimates in absolute terms, regardless of
which estimate is used (Figure 17 and Figure 19), due to the fact that many of the
largest banks (measured by total assets) are headquartered in these countries
and also because the relatively larger number of banks from these countries included
in the sample. For France and Germany, the implicit subsidy estimates seem
stable during the two periods. In most countries there is a reduction in the
implicit subsidy, driven by a combination of reduction in the difference
between (the adjusted) standalone yield spread and all-in yield spread and a
reduction in reported total debt and long-term funding for some banks. A
notable exception is Portugal, for which relatively large increases of implicit
subsidy estimates can be observed (230-250% increase, respectively). [94] | |
| When measuring the implicit subsidy
relative to domestic GDP, Sweden and France (together with Portugal in 2012)
are in the top, inter alia, due to the significant domestic banks' size
compared to GDP in the sample (Figure 18 and Figure 20). | |
| The results are broadly in line with other
studies. However, one should be cautious when making a comparison of results
across studies as differences may arise due to: differences in definition of
rating sensitive liabilities, the estimation of yield spreads and the sample of
banks as well as the sample period. A detailed comparison is provided in Appendix C. | |
| Figure 17: Estimated
implicit subsidy per country (EUR billion) based on Total Debt (89 banks in
2011 and 90 banks in 2012) | |
| Source: Bank watch,
SNL and own calculations | |
| Figure 18: Estimated
implicit subsidy per country (relative to domestic GDP) based on Total Debt (89
banks in 2011 and 90 banks in 2012) | |
| Source: Bank watch,
SNL and own calculations | |
| Figure 19: Estimated
implicit subsidy per country (EUR billion) based on Total Long-term Funding (96
banks in 2011 and 102 banks in 2012) | |
| Source: Bank watch,
Bankscope and own calculations | |
| Figure 20: Estimated
implicit subsidy per country (relative to domestic GDP) based on Total
Long-term Funding (96 banks in 2011 and 102 banks in 2012) | |
| Source: Bank watch,
Bankscope and own calculations | |
| Table 3: Implicit subsidy country-by-country | |
| Country || Implicit subsidy (EUR billion) based on Total Debt || Implicit subsidy (EUR billion) based on Total Long-term Funding | |
| || 2011 || 2012 || 2011 || 2012 | |
| AT || 2.8 || 2.4 || 2.5 || 2.0 | |
| BE || 4.2 || 2.8 || 2.3 || 1.7 | |
| BG || 0.0 || 0.0 || 0.01 || 0.0 | |
| CY || 0.06 || 0.01 || 0.01 || 0.01 | |
| CZ || 0.07 || 0.09 || 0.04 || 0.04 | |
| DE || 18.1 || 17.0 || 12.2 || 10.8 | |
| DK || 1.3 || 1.1 || 1.2 || 1.0 | |
| EL || 0.2 || 0.1 || 0.2 || 0.1 | |
| ES || 4.3 || 2.9 || 5.4 || 4.9 | |
| FI || 0.7 || 0.6 || 0.3 || 0.3 | |
| FR || 30.1 || 31.0 || 20.0 || 17.2 | |
| HU || 0.0 || 0.0 || 0.0 || 0.0 | |
| IE || 0.3 || 0.1 || 0.3 || 0.1 | |
| IT || 6.3 || 4.4 || 6.0 || 4.2 | |
| LU || 0.4 || 0.2 || 0.3 || 0.1 | |
| NL || 2.1 || 1.9 || 0.9 || 1.7 | |
| PL || 0.1 || 0.1 || 0.0 || 0.1 | |
| PT || 0.6 || 2.1 || 0.5 || 1.8 | |
| RO || 0.00 || 0.01 || 0.00 || 0.01 | |
| SE || 9.3 || 6.7 || 5.7 || 4.4 | |
| SI || 0.0 || 0.1 || 0.0 || 0.1 | |
| SK || 0.1 || 0.0 || 0.1 || 0.0 | |
| UK || 13.9 || 8.6 || 13.5 || 7.9 | |
| Source: SNL,
Bankscope and own calculations | |
| 4.5 Comparing implicit subsidy with
pre-impairment operating profit[95], [96] | |
| We also compare the aggregated estimated
implicit subsidy with the aggregated pre-impairment operating profit. The total
pre-impairment operating profit was EUR 197.5 billion and EUR 175.5 billion, in
2011 and 2012, respectively. The aggregated implicit subsidy of the sample was
around 35-50% and 30-50% of pre-impairment operating profit in 2011 and 2012.
These figures underline the importance of the estimated implicit subsidies as they
account for a significant part of the pre-impairment operating profits of the
banks. A more detailed description of the calculations and a country-by-country
analysis is given in Appendix
G. | |
| 4.6
Relation between implicit subsidy and bank characteristics | |
| There is a positive relation between the
size of the implicit subsidy
and the size of the bank if both variables are measured in absolute terms (see Figure 21 and Figure 22). This could be expected since a
large bank would have a larger amount of debt. Comparing the ratio of the implicit subsidy relative to the bank’s
total assets, such a positive relation is not discernible (see Appendix H). | |
| We have investigated also the relation
between implicit subsidy and
various bank characteristics (leverage, share of total assets held for trading,
Tier1 capital and RWA) and found no apparent pattern. Graphs are provided in Appendix H. | |
| Figure 21: Implicit subsidy versus total assets (end of 2011) | |
| Source: Bank Watch,
SNL and own calculations | |
| Note: The outlier
at the top left is Dexia Credit Locale SA. | |
| Figure 22: Implicit subsidy versus total assets (end of 2012) | |
| Source: Bank Watch,
SNL and own calculations | |
| 5. Determinants
of the implicit guarantee | |
| Our objective
is to test the following three hypotheses: | |
| ·
The
implicit guarantee is larger in EU countries with high sovereign ratings.
Governments with higher ratings should be in a better position for providing
support to the banking sector. | |
| ·
For
a given stand-alone rating, the implicit guarantee is greater for large banks.
Large banks are often considered TBTF and therefore could be more likely to
benefit from an implicit state support. | |
| ·
The
business profile has an impact on the implicit guarantee. Retail-oriented,
wholesale and investment banks may have benefitted from a different implicit
subsidy. | |
| These hypotheses are checked via
significance tests in Probit regressions. We shall verify that the model
confirms the expectation that weak banks with low stand-alone rating and weak
parental support receive a larger implicit subsidy compared to strong banks. | |
| Section 5.1 describes our dataset, Section
5.2 details the econometric methodology, Section 5.3
present the empirical results for the first two hypotheses about the sovereign
rating and the bank size. Section 5.4 reports results about the effect of the
business profile. | |
| 5.1 Dataset and explanatory variables | |
| Our database is
made up of Moody’s ratings for 112 EU banks for four semesters over the years
2011-2012. The implicit guarantee is reflected in the UPLIFT*. This variable is
obtained as the difference between the long-term and the stand-alone rating
that Moody’s assigns to each bank. The long-term rating takes into
consideration the possibility of a government support. The bank stand-alone
rating is measured by Moody’s Baseline Credit Assessment (BCA) variable.
Moody’s also makes available a stand-alone rating that includes the possibility
of a parental support (adjBCA). We use the difference P between these two
variables as an indicator of the parental support quality, i.e. P = adjBCA –
BCA. Moody’s rating of the sovereign debt is labelled Sov. | |
| The banks in
our dataset have received an UPLIFT* from 0 to 7 notches. The empirical
distribution of the UPLIFT* is displayed in Table 4 below whereas the cumulative
distribution is shown in Figure 23. | |
| Table 4: Empirical distribution of the UPLIFT* for
112 EU banks over 2011-2012 | |
| UPLIFT* || 0 || 1 || 2 || 3 || 4 || 5 || 6 || 7 | |
| Frequency || 15% || 24% || 23% || 29% || 4% || 4% || 1% || 1% | |
| Figure 23: Cumulative
density function of the UPLIFT* over 2011-2012 | |
| Box-plots of BCA, P, and Sov according to
each UPLIFT* category are displayed in Figure 24 below. One can observe that banks
with relatively low stand-alone and parental support enjoy high levels of
UPLIFT*. Similarly banks headquartered in countries with high sovereign ratings
enjoy a higher UPLIFT*. | |
| Figure 24: Box-plots for
stand-alone rating (BCA), parental support rating (P) and sovereign debt rating
(Sov) | |
| Notes: in the Box-plots the central mark corresponds to
the median, the edges of the box are the 25th and 75th percentiles, and the red
crosses point to outliers. | |
| The banks size
and profile are described using publicly available balance sheet information
collected from the SNL database. The currency unit is euro. | |
| The bank size
is measured by the logarithm of the total assets, logTA = logarithm(Total
Assets). | |
| Following
existing literature (see Ayadi et al. 2012, Blundell-Wignal and Roulet, 2013
and IMF, 2013), we describe the bank business profile using the following
variables: | |
| 1.
AHTTA:
the ratio of assets held for trading to total assets. | |
| 2.
STFTA:
the ratio of short-term funding to total assets. | |
| 3. DEPCTA:
the ratio of customers deposits to the total assets. | |
| 4.
NETLOANSCTA:
the share of net loans to customers in total assets. | |
| 5.
DEPBTA:
the ratio of bank deposits to the total assets. | |
| 6.
NETLOANSBTA:
the share of net loans to banks in total assets. | |
| 7.
WR:
the wholesale funding ratio calculated by dividing Total Financial Liabilities
minus Customers Deposits by Total Financial Liabilities. This measures the
share of funding coming from the wholesale market. | |
| 8.
FeeToOpInc:
the ratio of net fees and commissions to operating income. | |
| 9.
NetToOpInc:
the ratio of net interest income to operating income. | |
| 10.
DEVToFL:
the ratio of derivatives liabilities to total financial liabilities. | |
| 11.
TOTDERTA:
Derivatives assets plus derivatives liabilities compared to total assets. | |
| 12.
EquiTA:
the ratio of total equity to total assets. | |
| 13.
RWATA:
the ratio of risk-weighted- assets to total assets. | |
| 14.
T1RWA:
Tier 1 ratio, which is the amount of Tier 1 capital over risk-weighted-assets. | |
| 15.
T1T2RWA :
Tier 1 plus Tier 2 ratio. | |
| Broadly
speaking, investment-oriented banks are characterized by high volumes of assets
held for trading and gross market value of derivatives compared to their total
assets (AHTTA and TOTDERTA). Accordingly, the ratio of derivatives liabilities
to total financial liabilities (DEVToFL) is expected to be high. Market
operations make net fees and commissions contribute significantly to the
operating income (FeeToOpInc). | |
| Wholesale banks
are highly inter-connected with other financial institutions. They are thus
characterized by a large share of bank loans in their total assets (NETLONSBTA)
and of bank deposits in their liabilities (DEPBTA). They are expected to have a
large wholesale funding ratio (WR). They should rely relatively more on
short-term funding (STFTA), which has been identified as having played a key
role in the financial crisis. | |
| Retail banks
have a relatively high share of customer loans in their total assets
(NETLOANSCTA) and of customer deposits in their liabilities (DepCTA). Net
interest income (NetToOpInc) is expected to contribute significantly to their
operating income. | |
| The ratio of
total equity to total assets (EquiTA) is a simple proxy for leverage:
risk-averse banks are characterized by a high level of total equity compared to
their total assets. | |
| Finally, we
include two regulatory capital ratios: Tier 1 ratio (T1RWA) and total
regulatory capital ratio (T1T2RWA). We also consider the average risk-weighted
assets (RWATA) which should reflect the risk profile of the bank as measured by
the Basel regulation, although some researchers have questioned the
appropriateness of RWATA as risk-indicator (see Blundell-Wignal and Atkinson,
2011, and Ayadi et al., 2012).
For instance Ayadi et al. (2012) consider RWATA to be a good indicator of the
underlying risk for both wholesale and retail banking but not for investment
banks. One possible reason they put forward is that investment banks may
perform regulatory arbitrage through RWATA optimization. | |
| These
variables, together with logTA, are displayed in Figure 25 and Figure 26 in the next two
pages.[97] | |
| Figure 25: Box-plots for various balance sheet indicators | |
| Notes: logTA: logarithm of total assets; AHTTA: assets
held for trading as a share of total assets; RWATA: risk-weighted assets as a
share of total assets; STFTA: short-term funding as a share of total assets;
DepCTA: customer deposits as a share of total assets; NETLOANSCTA: net loans to
customers as a share of total asset; DepBTA: bank deposits as a share of total
assets; NETLOANSBTA: net loans to banks as a share of total asset; WR: wholesale
funding ratio. In the box-plots
the central mark corresponds to the median, the edges of the box are the 25th
and 75th percentiles, and the red crosses point to outliers. | |
| Figure 26: Box-plots for
various balance sheet indicators | |
| Notes: FeeToOpInc: the ratio of net fees and
commissions to operating income; NetToOpInc: the ratio of net income to
operating income; DEVTOFL: the ratio of derivatives liabilities to total
financial liabilities; EquiTA: total equity over total assets; TOTDERTA: total
derivatives in proportion of total assets; T1RWA: Tier 1 ratio; T1T2RWA: Tier 1
plus Tier 2 ratio. In the
box-plots the central mark corresponds to the median, the edges of the box are
the 25th and 75th percentiles, and the red crosses indicate outliers. | |
| The box-plots in the two figures suggest
that: | |
| ·
The
larger the log of total assets, the larger the UPLIFT*. | |
| ·
A
high share of asset held for trading to total assets ratio (AHTTA) tends to be
associated with an UPLIFT* equal to 2, 3, or 4. | |
| ·
High
values of risk-weighted assets to total assets (RWATA) tend to be associated
with a low UPLIFT*. | |
| ·
The lower the share of customer deposits
in total assets (DEPCTA) the larger the UPLIFT*. | |
| ·
High
proportions of net loans to customers in total assets (NETLOANSCTA) tend to be
associated with a low UPLIFT*. | |
| ·
The
larger the proportion of net loans to banks in total assets (NETLOANSBTA) the
larger the UPLIFT*. | |
| ·
The
larger the wholesale funding ratio (WR) the larger the UPLIFT*. | |
| ·
Large
ratios of derivatives liabilities to total financial liabilities (DEVToFL) seem
to be associated with a large UPLIFT*. | |
| ·
Larger
amounts of total equity compared to total assets (EquiTA) are associated with a
smaller UPLIFT*. | |
| ·
Large
amounts of derivatives assets plus derivatives liabilities compared to total
assets (TOTDERTA) seem to be predominantly associated with an UPLIFT* equal to
three notches. | |
| For short-term funding (STFTA), banks
deposits (DepBTA), net fees and commissions to total income ratio (FeeToOpInc),
net interest income to operating income ratio (NetToOpInc), and the two
regulatory variables (T1RWA and T1T2RWA), no systematic impact on the UPLIFT*
can be read. | |
| Some of these variables are highly
correlated (>0.80): asset held for trading to total assets (AHTTA) and derivatives
assets plus derivatives liabilities to total assets (TOTDERTA) at 0.93, AHTTA
and derivatives liabilities to total financial liabilities (DEVToFL) at 0.88,
customer deposits to total assets (DEPCTA) and wholesale funding ratio (WR) at
-0.99, TOTDERTA and DEVToFL at 0.96, as well as the two regulatory capital
ratio (T1RWA and T1T2RWA) at 0.90. Although not reported in the variable list,
also the logarithm of total deposits is correlated with the logarithm of total
assets at 0.96. Since regression analysis does not allow to discriminate
between two explanatory variables that are so highly correlated, we shall not
use simultaneously any two of these variables. | |
| 5.2 Econometric methodology | |
| The dependent variable UPLIFTi*,
i=1,...,N, belongs to 8 categories that for convenience we index with value
j=0,…,m. Since our dependent variable is ordinal with several outcomes, we fit
an ordered Probit model. Grouping the explanatory variables into the vector xi,
we define the latent variable yi* such as: | |
| UPLIFTi* = 0 if yi* = xi'
β + εi < μ1 | |
| UPLIFTi* = j if μj < yi*
= xi' β + εi < μj+1
j=1,…,m-1 | |
| UPLIFTi* = m if μm
< yi* = xi' β + εi | |
| where the constants μ1,…,
μm, are the cut-offs. The Probit model assumes that the shocks
ε follow a standard normal distribution. Under this assumption the
probability that the UPLIFT* for bank i falls into category j is equal to: | |
| P(UPLIFTi*=0|xi)
= P(yi* < μ1) = Φ(μ1
- xi' β) | |
| P(UPLIFTi*=j|xi)
= P(μ j < yi* < μj+1) | |
| = P(μj < xi' β + εi
< μj+1) | |
| = P(μj - xi' β < εi
< μj+1- xi' β) | |
| = Φ(μj+1- xi' β) - Φ(μj- xi' β) | |
| P(UPLIFTi*=m|xi) = P(μm < yi* ) = 1- Φ (μm - xi' β) | |
| where Φ() represents the standard
normal cumulative distribution. The likelihood function is such as: | |
| P(UPLIFT1*,…,
UPLIFTN*|x1,…, xN) = Πi=1N
Πj=0m P(UPLIFTi*=j|xi) 1(UPLIFTi*=j) | |
| where 1(UPLIFTi*=j)=1 if
UPLIFTi*=j and 0 otherwise. The probability P(UPLIFTi*=j)
is given in the previous system of equation. Maximizing the likelihood function
gives estimates of the coefficients β as well as of the cut-off values
μ1,…, μm. | |
| The hypothesis
of independent ε-shocks implies that the UPLIFT* assigned to a bank given
its own characteristics and the rating of the country where it is headquartered
does not depend neither on the rating of the other countries nor on the profile
of the other banks. In other words, the model considers that Moody’s evaluates
EU banks one by one and not altogether at the same time. | |
| 5.3 Empirical results without business
model variables | |
| Our first model relates the UPLIFT* to the
stand-alone rating, the parental support, the sovereign debt rating, and the
bank size. Business model variables are left out in this preliminary round.
Putting together data for the two semesters of 2011 and 2012 gives a maximum
number of 448 observations. Because the variables have missing values at
different places, in each regression the effective number of observations
depends on the subset of variables selected. The Probit regression results are
described in Table 5. | |
| | |
| Table 5: Model 1, N=364 observations | |
| Variable || Coefficient || t-statistics | |
| Stand-alone rating (BCA) || -.382 || -12.12 | |
| Parental support (P) || -.549 || -8.69 | |
| Sovereign rating (Sov) || .367 || 15.03 | |
| Size of bank (logTA) || .230 || 5.37 | |
| Log-lik || -426.55 | |
| Log-lik/N || -1.17 | |
| The cut-offs are estimated as (μ1,…,μ7)=(3.75,
5.22, 6.30, 7.93, 8.34, 9.18, 10.09) with standard error around 0.80. Table 6
also reports the log-likelihood and the average log-likelihood by observation
at the aim of model comparison. Model 1 fit is shown in Table 6 below. It reports the empirical
distribution of UPLIFT* over the 364 observations used in Model 1 together with
the unconditional distribution of UPLIFT* as predicted by the model.[98] | |
| Table 6: Model 1
goodness of fit | |
| UPLIFT* || 0 || 1 || 2 || 3 || 4 || 5 || 6 | |
| Frequency || 0.12 || 0.26 || 0.24 || 0.30 || 0.04 || 0.03 || 0.01 | |
| Model prediction || 0.08 || 0.27 || 0.29 || 0.30 || 0.03 || 0.03 || 0.01 | |
| As can be seen from Table
6,
Model 1 fits the data reasonably well: the largest discrepancy between
empirical and predicted probability is equal to 5 percentage points (pp) for
the class UPLIFT*=2. For all other classes the discrepancy is less than 4 pp.
We now turn to the interpretation of the Probit results. | |
| The sign of the coefficients in Table 5 suggests that: | |
| ·
Banks
with higher stand-alone rating (BCA) have a greater probability to get a small
UPLIFT*. As BCA also reflects the riskiness of a bank, the negative coefficient
implies that a more risky bank is likely to benefit from a greater UPLIFT*. | |
| ·
A
higher parental support (P) is associated with a smaller UPLIFT*. A bank
affiliated to a strong group can receive support within the group and is thus
less likely to require public support. | |
| ·
Banks
with higher sovereign rating have a greater probability to receive a large
UPLIFT*. A higher sovereign rating implies that the government is in a better
position to provide such support. | |
| ·
Big
banks enjoy a larger UPLIFT*: for a given stand-alone and parental rating, the
larger the bank the greater the UPLIFT*. | |
| To get a more quantitative picture, we
calculate the marginal effect, i.e. the impact on the UPLIFT* distribution of a
variation around the average of one of the bank characteristics, the other ones
being kept constant at their average value. In the linear regression, a
positive coefficient implies a positive impact of the variable. Instead in a
Probit regression the explanatory variables describe a probability distribution,
so the marginal effect of each variable is positive for some categories of the
UPLIFT* and negative for the others. Table 7 below reports such marginal effects
in Model 1 – see Appendix J for
methodological details. | |
| Table 7: Marginal
effects in Model 1 | |
| || || UPLIFT* | |
| || Average (st. error) || 0 || 1 || 2 || 3 || 4 || 5 | |
| P(UPLIFT*=j|AX) |||| .023 || .276 || .409 || .277 || .010 || .005 | |
| Stand-alone rating (BCA) || 10.56 || .021* || .112* || -.001 || -.117* || -.009* || -.005* | |
| Parental support (P) || 0.72 || .030* || .160* || -.002 || -.168* || -.010* || -.005* | |
| Sovereign rating (Sov) || 16.09 || -.020* || -.107* || .001 || .111* || .009* || .005* | |
| Size of bank (logTA) || 18.65 (1.52) || -.013* || -.067* || .001 || .070* || .005* || .003* | |
| Notes: * indicates numbers
that are significantly different from 0 at the 10% level. The standard error of
logTA is given between parentheses. The average values reported for BCA, P, and
Sov are related to the 0-20 coding (see Section 3.1). Notice that the
probability that the average bank gets one particular UPLIFT*, i.e.
P(UPLIFT*=j|AX), should not be compared with the unconditional probability
reported in Table
6. | |
| We observe that: | |
| ·
The
stronger the stand-alone rating (BCA) the lower the probability of a large
UPLIFT*: a BCA above average by one notch increases the probability that the
UPLIFT* does not exceed one notch by 13 pp, from 0.30 to 0.43[99]. Conversely, the
probability of an UPLIFT* strictly greater than two notches decreases by 13 pp
from 0.29 to 0.16. | |
| ·
A
parental support above average by one notch increases the probability that the
UPLIFT* does not exceed one notch by 19 pp, from 0.30 to 0.49. Conversely, the
probability of receiving an UPLIFT* strictly greater than two notches decreases
by 18 pp from 0.29 to 0.11. | |
| ·
A
sovereign rating above average by one notch increases the probability that
UPLIFT* is greater or equal to three notches by 13 pp, from 0.29 to 0.42.
Conversely, the probability of receiving an UPLIFT* of zero or one notch
decreases by 13 pp from 0.30 to 0.17. | |
| ·
The
average logTA is equal to 18.65 with standard error 1.52. There is considerable
heterogeneity among the banks in our dataset since this implies a variation by
350% on the original scale. Banks whose logTA variable is above the average
bank size by one standard error have a probability of receiving an UPLIFT*
greater than two notches by 12 pp (1.52*(.070+0.005+0.003)), from 0.29 to 0.41.
Conversely, the probability of receiving an UPLIFT* of no more than one notch
shrinks from 0.30 to 0.18, which is obtained as 0.30-(1.52*(.013+0.067)).
Hence, banks with larger amount of total assets benefit from a larger UPLIFT*. | |
| These inferences are in broad agreement
with the data features shown in Figure 24 to Figure 25. They seem to be robust to several alternatives. For instance,
re-weighting the observations using logTA (option “aw” in STATA) does not harm
the results. We have checked that the regression is
stable over the four semesters by adding time dummies: only the dummy for the
first semester of 2011 is significant. As the coefficients of the other
variables are almost invariant we do not consider time dummy variables. We also
tried country dummies but no improvement was obtained[100]. | |
| Some endogeneity may be present in Model 1.
First, as acknowledged in Moody’s (2012a) sovereign debt rating methodology,
the sovereign debt assessment takes into consideration the risks in the banking
sector of the country. Moody’s uses the latest data available, so there is
likely simultaneity. Second, the assessment of a bank is based on the bank’s
balance sheet and income statement (Moody’s, 2012b). Since the all-in rating[101] influences funding
costs, the all-in rating impacts on both the balance sheet and the income
statement. The impact on bank bond spreads have been analysed for instance in
Morgan and Stiroh (2005) and Resti and Sironi (2005). Next, Noss and Sowerbutts
(2012) argue that “The implicit guarantee … distorts banks’ risk-taking
incentives as investors no longer fully price the risks they are aware the
banks are taking, allowing banks to take more risk. A pernicious spiral can
therefore develop, where the existence of an implicit guarantee encourages
banks to take more risk” (see also Alessandri and Haldane, 2009). | |
| Such endogenous mechanisms (simultaneity
and feedback) imply a bias in the coefficients estimates. To correct for this
we substitute the country debt to GDP ratio for the sovereign rating[102] (see also Estrella
and Schich, 2012). In order to break any contemporaneous feedback we use a lag
for both the debt to GDP ratio and the balance sheet
variables. The lag removes Moody’s ratings in the first
semester of 2011 from the regression. | |
| Table 8 below shows
the results. | |
| Table 8: Model 1B with
Debt/GDP ratio substituted for the sovereign rating. Both Debt/GDP and logTA
are lagged, 283 observations | |
| Regressors || Coeff. || t-stat. | |
| Stand alone rating (BCA) || -0.158 || -5.72 | |
| Parental support (P) || -0.051 || -1.04 | |
| Lagged debt to GDP ratio || -0.022 || -7.38 | |
| Lagged size of bank (logTA) || 0.522 || 8.73 | |
| Log-lik || -392.77 | |
| Log-lik/N || -1.39 | |
| We observe that: | |
| ·
The
lagged Debt/GDP ratio has negative and highly significant coefficient, showing
that banks located in countries with high debt to GDP ratio have received a
lower UPLIFT*. | |
| ·
The
BCA coefficient is smaller in absolute value but still significant: the impact
of BCA is reduced but the direction is preserved. | |
| ·
The
parental support looses significance. | |
| ·
The
coefficient of the log of total assets lagged by one period is larger with high
significance. | |
| ·
Substituting
the lagged Debt/GDP ratio for the sovereign rating has an adverse impact on the
model fit: the log-likelihood by observation is 20% smaller. | |
| Hence, if an endogenous effect is present,
it may have harmed the inference about the impact of the parental support but
the model-based inference about the impact of the bank size appears rather
robust. As a further robustness check, we use the yield
benefit enjoyed by the bank as
dependent variable instead of UPLIFT*. Since the yield benefit is a continuous
variable and not a categorical one, a simple least-square regression is fitted.
Table 9 below shows the results. | |
| Table 9: Model 1C with
the yield benefit as dependent variable, 183 observations | |
| Regressors || Coeff. || t-stat. | |
| Stand alone rating (BCA) || -.329 || -9.34 | |
| Parental support (P) || -.253 || -3.37 | |
| Lagged debt to GDP ratio || -.022 || -5.69 | |
| Lagged size of bank (logTA) || .460 || 6.10 | |
| R2 || 0.34 | |
| Compared to Table 8 the coefficients estimates appear to
be stable enough, except for the parental support whose significance is
restored. Hence the empirical evidence about the impact of the sovereign rating
and of the bank size is robust to the use of either UPLIFT* or the yield
benefit as dependent variable. | |
| We take Model
1B specification in Table 8 as benchmark for examining the role of the various balance sheet variables. | |
| 5.4 Empirical results with business model
variables | |
| We evaluate the importance of the business
model variables first by checking their significance when added one by one to
Model 1B. All balance sheet variables are lagged by one period, still for
mitigating endogeneity. The short-term funding variable STFTA has been
discarded due to numerous missing observations that reduce the effective sample
size to one-third compared to the case where STFTA is left out. Out of the
fifteen candidates, this first stage identifies RWATA, DEPCTA, NETLOANSBTA, WR,
and EquiTA as variables with potential explanatory power. In a second round we
add these five variables altogether to Model 1B and remove the ones that appear
to be non-significant, namely RWATA and DEPCTA. We are left with the following
model: | |
| Table 10: Model 2 with
business variables, 264 observations | |
| Regressors || Coeff. || t-stat. | |
| Stand alone rating (BCA) || -.133 || -4.29 | |
| Parental support (P) || -.201 || -3.18 | |
| Lagged debt to GDP ratio || -.022 || -6.97 | |
| Lagged size of bank (logTA) || .366 || 5.01 | |
| Lagged net loans to banks (NETLOANSBTA) || 3.729 || 4.27 | |
| Lagged wholesale funding ratio (WR) || .970 || 2.42 | |
| Lagged total equity to total assets (EquiTA) || -6.127 || -2.14 | |
| Log-lik || -345.54 | |
| Log-lik/N || -1.31 | |
| The cut-offs are
estimated at (2.524, 3.750, 4.517, 6.128, 6.448, 6.840, 7.222). We observe that: | |
| ·
Model
1B and 2 have a similar fit. | |
| ·
The
coefficient of the stand-alone rating, the lagged debt to GDP ratio, and the
lagged log of total assets are stable compared to Model 1B in Table
8.
There is some instability in the coefficient of the parental support. | |
| ·
The
coefficient of the lagged ratio of net loans to banks to total assets
(NETLOANSBTA) is positive, showing that Moody’s gives a higher UPLIFT* to banks
that are more active in bank lending. | |
| ·
The
wholesale funding ratio (WR) has a positive impact on UPLIFT*: the larger WR,
the greater UPLIFT*. | |
| ·
The coefficient of the lagged equity to
total assets ratio (EquiTA) is negative: Moody’s gives a lower UPLIFT* to banks
that have a high EquiTA ratio. Hence better capitalized banks have a lower
UPLIFT*. This leverage variable can be seen as a proxy for the stand-alone
rating: for instance we could observe that its significance further increases
when the stand-alone rating is not included in the regression. | |
| Table 11 below
reports the goodness of fit by UPLIFT* category for Model 2. | |
| Table 11: Goodness of
fit of Model 2 | |
| UPLIFT* || 0 || 1 || 2 || 3 || 4 || 5 || 6 | |
| Frequency || 0.11 || 0.30 || 0.22 || 0.31 || 0.02 || 0.02 || 0.01 | |
| Model prediction || 0.08 || 0.30 || 0.27 || 0.31 || 0.02 || 0.01 || 0.00 | |
| The empirical frequencies vary slightly
because the effective common sample changes according to the missing values in
each explanatory variable. As expected, Model 1 and 2 have a similar fit. The
maximum error on the empirical frequencies is limited to 5 pp. | |
| Table 12 below
displays the marginal effects under Model 2. | |
| Table 12: Marginal effects on UPLIFT* categories for Model 2 | |
| || Average (st. error) || 0 || 1 || 2 || 3 || 4 || 5 | |
| P(UPLIFT*=j|AX) |||| .061 || .313 || .298 || .308 || .011 || .006 | |
| Stand alone rating (BCA) || 10.10 || .016* || .034* || -.002 || -.041* || -.003* || -.002* | |
| Parental support (P) || 0.76 || .024* || .052* || -.003 || -.062* || -.004* || -.003* | |
| Lagged debt to GDP ratio || 78.19 (30.98) || .003* || .006* || -.000 || -.006* || -.001* || -.001* | |
| Lagged size of bank (logTA) || 18.57 (1.49) || -.044* || -.095* || .006 || .115* || .009* || .006* | |
| Lagged net loans to banks (NETLOANSBTA) || 0.10 (0.08) || -.449* || -.963* || .065 || 1.168* || .091* || .056* | |
| Lagged wholesale funding ratio (WR) || 0.48 (0.22) || -.117* || -.251* || .017 || .304* || .023* || .014 | |
| Lagged total equity to total assets (EquiTA) || 0.06 (0.03) || .738 || 1.583* || -.108 || -1.919* || -.149 || -.092 | |
| Notes: * indicates numbers
that are significantly different from 0 at the 10% level. The standard error of
continuous variables is given between parentheses. | |
| Comments: | |
| ·
The
marginal effects of stand-alone rating (BCA) and parental support (P) are
broadly stable compared to Model 1B. We do not comment further on these
variables. | |
| ·
Also
the bank size has a similar impact over Model 1B and 2: both models foresee a
positive and significant effect on the probability to get an UPLIFT* greater
than 2 when total assets is above average. | |
| ·
Banks
located in a country where the debt to GDP ratio is above average by one standard
error have a probability of receiving an UPLIFT* greater than two notches that
shrinks by 25pp (30.98*(-.006-.001-.001)), while the probability of receiving
an UPLIFT* of no more than one notch increases by 28pp (30.98*(.006+.003)). | |
| ·
Banks
whose net loans to banks to total assets ratio is above average by one standard
error have a probability of receiving an UPLIFT* greater than two notches that
increases by 11pp (0.08*(1.168+.091+.056)), while the probability of receiving
an UPLIFT* of no more than one notch decreases by 11pp (0.08*(-.449-.963)). | |
| ·
Banks
whose wholesale funding ratio is above average by one standard error have a
probability of receiving an UPLIFT* greater than two notches that increases by
8pp (0.22*(.304+.023+.014)), while the probability of receiving an UPLIFT* of
no more than one notch decreases by about 8pp (0.22*(-.117-.251)). | |
| ·
Banks
whose total equity over total assets ratio is above average by one standard
error have a probability of receiving an UPLIFT* greater than two notches that
decreases by 6pp (0.03*(-1.919 -.149 -.092)), while the probability of
receiving an UPLIFT* of no more than one notch increases by about 7pp
(0.03*(.738+1.583)). | |
| This inference is in broad agreement with
the Box-plots in Figure 25 and Figure 26. | |
| We have also substituted the sovereign
rating for the debt to GDP ratio in Model 2. All coefficients remain
significant except the wholesale funding ratio whose impact becomes insignificant.
As a further robustness check, we have re-scaled the UPLIFT* variable by
stand-alone plus parental rating, i.e. UPLIFT*/(21–BCA-P), as in Bijlsma and
Mocking (2013). This re-scaled variable takes into account that the absolute
uplift is constrained by the adjusted BCA. Running a least-square regression,
we could observe that all variables in Model 2 remain significant as in Table
10. | |
| Furthermore, to check the robustness of
Model 2, we substitute the yield benefit for the UPLIFT*. Table 13 below shows the results. All coefficients remain significant except the total
equity to total assets ratio which looses significance. | |
| Table 13: Model 2B with the yield benefit as dependent variable. 166 observations | |
| Regressors || Coeff. || t-stat. | |
| Stand alone rating (BCA) || -0.297 || -7.81 | |
| Parental support (P) || -0.350 || -4.48 | |
| Lagged debt to GDP ratio || -0.020 || -5.30 | |
| Lagged size of bank (logTA) || 0.279 || 2.94 | |
| Lagged net loans to banks (NETLOANSBTA) || 3.014 || 2.83 | |
| Lagged wholesale funding ratio (WR) || 0.919 || 1.95 | |
| Lagged total equity to total assets (EquiTA) || -4.914 || -1.34 | |
| R2 || 0.393 | |
| 6. Conclusions | |
| This report investigates the size and
determinants of the implicit state guarantee, as measured by UPLIFT*, enjoyed
by a sample of EU banks. It also estimates in monetary terms the implicit
subsidy due to this guarantee. | |
| The size of the implicit guarantee is
measured using the rating-based approach based on Moody’s credit
ratings. Long-term credit ratings take into account the bank’s stand-alone
financial strength rating, a rating upgrade due to possible support from a
parent or a cooperative group, and a rating upgrade due to potential government
support. This third component (which in the report is denoted by UPLIFT*) is used
to measure the implicit government guarantee. The
implicit guarantee is translated into a funding cost advantage by comparing the
funding cost inferred from the long-term credit rating of a bank with the
funding cost inferred from its stand-alone credit rating. Multiplying the funding cost advantage with a share of the
outstanding debt results in a monetary estimate which can be viewed as an
implicit subsidy given to banks. | |
| Main conclusions on the size of the
implicit government guarantee (measured through the
UPLIFT*): | |
| ·
Statistics
on our Moody’s dataset on EU banks ratings, covering 112 banks from 23 EU
countries in the period 2011-2013, are in line with the few studies available
for the EU and confirm that many EU banks enjoy a government implicit guarantee
that increases their ratings. | |
| ·
In
the period 2011-2013 the largest part of the distribution of the UPLIFT* lies
between 1 and 3 notches on average. | |
| ·
The
top 25% banks in size (roughly 25 banks, where most of the EU G-SIBs are
represented) enjoy an implicit government guarantee larger than the remaining
banks in the sample. The relative difference between the average UPLIFT* of
largest banks and the remaining ones is between 7% and 26%, depending on the
point in time. | |
| ·
The
average upgrade due to implicit guarantee is relatively stable over the period
under study, while a decrease in the average long-term credit rating can be
observed. | |
| Main conclusions on the implicit subsidy: | |
| ·
The
reduction in banks' funding costs due to the implicit government guarantee
obtained via the rating-yield map is largely in line with previous literature
studies. | |
| ·
The
total implicit subsidy for the considered sample is estimated in the interval EUR
72 to 95 billion euro in 2011 and EUR 59 to 82 billion euro
in 2012. | |
| ·
In
relative terms, the implicit subsidy for ranges between 0.5% and 0.8% of EU-27
GDP. | |
| ·
The
estimated implicit
subsidy is 0.4-0.7%
GDP for DE, 0.9-1.5% for FR and 0.4% for UK as of end 2012. | |
| ·
The
estimated implicit
subsidy is
between 30% and 50% of the banks aggregated annual pre-impairment operating
profit. | |
| Main conclusions on implicit state
guarantee (measured through the UPLIFT*) drivers: | |
| In our sample of
EU banks, the UPLIFT* appears to be driven by: | |
| ·
The
bank individual strength: as expected, a higher individual strength rating
increases the probability of observing lower UPLIFT*; | |
| ·
The
parental support: as expected, banks with stronger parents receive a lower
UPLIFT*. | |
| ·
The
credit rating of the country where a bank is headquartered: being headquartered
in a country with a strong sovereign credit rating increases the probability of
observing a higher UPLIFT*. This evidence also appears if the debt to GDP ratio
is used as a proxy for the sovereign credit worthiness. | |
| ·
The
size of the bank: larger banks are more likely to enjoy a greater UPLIFT*. | |
| Concerning the business model we find the following evidence: | |
| ·
More
inter-connected banks that hold a larger proportion of net loans to banks in
their total assets benefit from a higher UPLIFT*. | |
| ·
Banks
that rely relatively more on the wholesale market for funding compared to other
banks (i.e. a high wholesale funding ratio) also benefit from a higher UPLIFT*. | |
| ·
Better
capitalized banks are more likely to receive a lower implicit
guarantee. | |
| References | |
| Alessandri P. and Haldane A., 2009, Banking
on the state, twelfth annual International Banking Conference on ‘The
international financial crisis: have the rules of finance changed?’, Federal
Reserve Bank of Chicago. | |
| Ayadi R., Arbak E., and de Groen W.P.,
2012, Regulation of European Banks and Business Models: Towards a New
Paradigm?, Centre for European Policy Studies, Brussels. | |
| Bijlsma M.J. and
Mocking R.J.M., 2013, The private value of too-big-to fail guarantees,
discussion paper 240, CPB Netherlands Bureau for Economic Policy Analysis, available at
www.cpb.nl/sites/.../dp240-private-value-too-big-fail-guarantees_0.pdf. | |
| Blundell-Wignall A.
and Roulet C., 2013, Business models of banks, leverage and the
distance-to-default, OECD Journal: Financial Market Trends, 103, 1-29. | |
| Blundell-Wignall A. and Atkinson, P., 2011,
Global SIFIs, Derivatives and Financial Stability OECD Journal:
Financial Market Trends, 1, 1-34. | |
| Estrella A. and Schich S., 2012, Sovereign
and Banking Sector Debt: Interconnections through guarantees, OECD Journal:
Financial Market Trends, Volume 2011, Issue 2. | |
| Haldane A. G., 2010, The $100 Billion
Question, BIS Review 40/2010. | |
| Haldane A. G.,
2011, Control Rights (and Wrongs), speech at the Wincott Annual Memorial
Lecture. | |
| Haldane A. G., 2012, On being the right
size, speech given on 25th October. | |
| International Monetary Fund, Global
Financial Stability Report, October 2013. | |
| Moody’s Investor Service, 2012a, Proposed
Refinements to the Sovereign Bond Rating Methodology. | |
| Moody’s Investor Service, 2012b, Moody’s
Consolidated Global Bank Rating. | |
| Morgan D. and Stiroh K., 2005, Too Big
to Fail after All These Years, Federal Reserve Bank of New York Staff
Reports. | |
| Noss J. and Sowerbutts R., 2012, The
implicit subsidy of banks, Financial Stability Paper No. 15, Bank of
England. | |
| Resti A. and Sironi
A., 2005, The Basel Committee Approach To Risk-Weights And External Ratings:
What Do We Learn From Bond Spreads?, Economic Working Paper nr. 548, Bank
of Italy. | |
| Schich S. and Lindh, 2012, Implicit
Guarantees for Bank Debt: Where Do We Stand?, OECD Journal: Financial
Market Trends, Volume 2012, Issue 1, downloadable at | |
| www.oecd.org/finance/financial-markets/Implicit-Guarantees-for-bank-debt.pdf | |
| Schich S. and Kim B.H., 2012, Developments
in the Value of Implicit Guarantees for Bank Debt: The Role of Resolution
Regimes and Practices, OECD Journal: Financial Market Trends, Volume 2012,
Issue 2, www.oecd.org/finance/Value_Implicit_Guarantees_Bank_Debt.pdf. | |
| Ueda K., and Di Mauro B.W., 2012, Quantifying
Structural Subsidy Values for Systemically Important Financial Institutions,
IMF Working Paper, WP/12/128. | |
| Appendix A:
List of Banks | |
| Country || Company Name, Short | |
| AT || UniCredit Bank Austria AG | |
| Erste Group Bank AG | |
| Raiffeisen Bank International AG | |
| Österreichische Volksbanken-AG | |
| Bank für Arbeit und Wirtschaft und Österreichische Postsparkasse AG | |
| BE || Belfius Banque SA | |
| BNP Paribas Fortis SA | |
| KBC Bank NV | |
| ING Belgium SA/NV | |
| BG || DSK Bank EAD | |
| Raiffeisenbank (Bulgaria) EAD | |
| CY || Cyprus Popular Bank Public Co. Ltd. | |
| Bank of Cyprus Public Company Limited | |
| Hellenic Bank Public Company Limited | |
| CZ || Česká spořitelna, a.s. | |
| Ceskoslovenska obchodni banka, a.s. | |
| Komercní banka, a.s. | |
| DK || Danske Bank A/S | |
| Nordea Bank Danmark A/S | |
| FI || Nordea Bank Finland Plc | |
| Pohjola Bank Plc | |
| Danske Bank Oyj | |
| FR || BNP Paribas SA | |
| Crédit Agricole SA | |
| Crédit Agricole Corporate and Investment Bank | |
| Natixis | |
| Crédit Foncier de France SA | |
| Société Générale SA | |
| Banque Fédérative du Crédit Mutuel SA | |
| Dexia Crédit Local SA | |
| DE || Deutsche Bank AG | |
| Commerzbank AG | |
| Hypothekenbank Frankfurt AG | |
| UniCredit Bank AG | |
| LBBW Landesbank Baden-Württemberg | |
| Deutsche Zentral-Genossenschaftsbank AG | |
| Bayerische Landesbank | |
| NORD/LB Norddeutsche Landesbank Girozentrale | |
| Deutsche Postbank AG | |
| HSH Nordbank AG | |
| Landesbank Hessen-Thüringen Girozentrale | |
| DekaBank Deutsche Girozentrale | |
| Westdeutsche Genossenschafts-Zentralbank AG | |
| GR || National Bank of Greece SA | |
| Eurobank Ergasias SA | |
| Alpha Bank AE | |
| Piraeus Bank SA | |
| HU || K&H Bank Zrt. | |
| MKB Bank Zrt. | |
| Erste Bank Hungary Zrt. | |
| IE || Depfa ACS Bank | |
| Bank of Ireland | |
| Allied Irish Banks, Plc | |
| Ulster Bank Limited | |
| IT || UniCredit SpA | |
| Intesa Sanpaolo SpA | |
| Banca IMI SpA | |
| Banca Monte dei Paschi di Siena SpA | |
| Unione di Banche Italiane SCpA | |
| Banco Popolare Società Cooperativa | |
| LU || Banque Internationale à Luxembourg SA | |
| BGL BNP Paribas SA | |
| Banque et Caisse d'Epargne de l'Etat, Luxembourg | |
| UniCredit Luxembourg SA | |
| NL || ING Bank NV | |
| Royal Bank of Scotland N | |
| ABN AMRO Bank NV | |
| Rabobank Nederland | |
| PL || Powszechna Kasa Oszczędności Bank Polski SA | |
| BRE Bank SA | |
| ING Bank Śląski SA | |
| Bank Zachodni WBK SA | |
| Bank Millennium SA | |
| Bank Handlowy w Warszawie SA | |
| Bank BPH SA | |
| PT || Caixa Geral de Depósitos SA | |
| Banco Comercial Português SA | |
| Banco Espírito Santo SA | |
| Banco Santander Totta SA | |
| Banco BPI SA | |
| RO || Banca Comerciala Romana SA | |
| Raiffeisen Bank SA | |
| SK || Všeobecná úverová banka, a.s. | |
| Tatra banka, a.s. | |
| Ceskoslovenska Obchodni | |
| SI || Nova Ljubljanska Banka d.d. | |
| Nova Kreditna banka Maribor d.d. | |
| Abanka Vipa d.d. | |
| ES || Banco Santander SA | |
| Banco Español de Crédito SA | |
| Banco Bilbao Vizcaya Argentaria, SA | |
| Bankia, SA | |
| CaixaBank, SA | |
| Banco Popular Español SA | |
| Banco de Sabadell, SA | |
| Bankinter SA | |
| Ibercaja Banco SAU | |
| SE || Nordea Bank AB | |
| Skandinaviska Enskilda Banken AB | |
| Svenska Handelsbanken AB | |
| Swedbank AB | |
| UK || Royal Bank of Scotland Plc | |
| HSBC Bank Plc | |
| Bank of Scotland Plc | |
| Lloyds TSB Bank Plc | |
| National Westminster Bank Plc | |
| Santander UK Plc | |
| Nationwide Building Society | |
| Barclays Bank PLC | |
| Standard Chartered Bank | |
| Appendix B: Statistics on Moody’s
rating data | |
| Table B.1 to
Table B.4 summarizes statistics on LT, BCA, BCAadj, Sov (country sovereign),
and BCAadj-BCA (p) for each time period (the categories from C to AAA are
translated into an index over the range 0-20). | |
| Table B.1: Summary statistics for
June 2011 | |
| Table B.2: Summary statistics for
December 2011 | |
| Table B.3:
Summary statistics June 2012 | |
| Table B.4. Summary
statistics December 2012 | |
| Appendix C: Comparison with the
existing literature | |
| This Appendix
attempts to compare summary statistics for the UPLIFT and UPLIFT* presented in
the literature with the results obtained in Section 3. We are also comparing
our implicit subsidy estimate with those available in the literature. We mainly
focus on Schich and Lindh (2012), Haldane (2010, 2011, and 2012) and Bijlsma
and Mocking (2013). Only a qualitative comparison can be performed since in the
available studies the samples as well as the ratings employed differ. | |
| C.1
Comparison of the UPLIFT and UPLIFT* | |
| C.1.1
Comparison with: Schich and Lindh (2012) | |
| Schich and
Lindh (2012) employ a dataset of 118 large European banks for calculating the
UPLIFT using Moody’s data. Their calculations are done on a yearly basis (from
2007 to 2011). The last trimester of 2012 is also taken into consideration. | |
| Comparing the results from Schich and Lindh
(2012) and Figure 2 one can
conclude that the UPLIFT is essentially the same (in this study we have on
average 0.5 notches higher UPLIFT for each time period). In more detail: | |
| || Average UPLIFT Schich and Lindh (2012) || Average UPLIFT (this study) | |
| 2007 || 2.21 || 2.69 | |
| 2008 || 2.40 || 2.90 | |
| 2009 || 3.14 || 3.73 | |
| 2010 || 3.12 || 3.59 | |
| 2011 || 2.18 || 2.63 | |
| 2012 || 2.20 (Mar-2012) || 2.73 (Dec-2012) | |
| In the same
study the authors calculate the average UPLIFT* for each country employed in
their sample for March-2012. For comparison purposes Figure C.1 presents the
average UPLIFT* for each county for June 2012. | |
| Figure C.1: Average UPLIFT* as of June
2012 from this study | |
| Source: Moody’s and own calculations | |
| Direct comparisons for the calculated
UPLIFT* between Schich and Lindh (2012) and this study cannot be made as: | |
| 1) For
most of the countries a different number of banks is considered. | |
| 2) The
banks included in Schich and Lindh (2012) cannot be identified. | |
| 3) The
authors of Schich and Lindh (2012) calculate the UPLIFT* as of March-2012,
while in Figure C.3 the UPLIFT* is calculated as of June-2012. For many banks
in the sample, ratings changed between March-2012 and June-2012 (see Table
C.1). | |
| Table C.1: Comparison of UPLIFT* samples | |
| Country[103] || UPLIFT* (this study) as of June 2012 || UPLIFT*from Schich and Lindh (2012) as of March 2012 || #Banks in this study || #Banks in Schich and Lindh (2012) || #of banks for which ratings changed after 31/03/2012 | |
| BE || 2.75 || ≈4 || 4 || 2 || 4 | |
| DK || 2.00 || ≈0.5 || 2 || 5 || 2 | |
| DE || 2.42 || ≈2.8 || 13 || 17 || 11 | |
| IE || 1.50 || ≈0.3 || 4 || 3 || 1 | |
| El || 1.00 || ≈1 || 4 || 5 || 0 | |
| ES || 0.78 || ≈1 || 9 || 10 || 9 | |
| FR || 3.10 || ≈2.8 || 10 || 7 || 9 | |
| IT || 1.60 || ≈1 || 6 || 13 || 4 | |
| LU || 2.50 || ≈4.5 || 4 || 2 || 3 | |
| NL || 3.00 || ≈1.4 || 4 || 8 || 3 | |
| AT || 2.60 || ≈3.7 || 5 || 6 || 4 | |
| PT || 1.00 || ≈0.4 || 5 || 6 || 2 | |
| FI || 2.33 || ≈1.9 || 2 || 2 || 3 | |
| SE || 3.00 || ≈1.9 || 4 || 6 || 2 | |
| UK || 2.11 || ≈1.5 || 9 || 14 || 6 | |
| Average || 2.11 || ≈1.91 || || || | |
| From the results presented in Table C.1 it can be concluded that for the
countries for which a large number of banks is included in both samples (e.g.
Germany, France and Spain) the average UPLIFT* is similar. Moreover, for Greece
we observe that the average UPLIFT* is the same, while for Ireland, if we
exclude one bank (which had an UPLIFT* equal to 5) we obtain the same UPLIFT*.
For the countries for which there is large difference in the number of banks
(e.g. Denmark, Netherlands and Italy) no conclusions can be drawn. | |
| C.1.2
Comparison with Haldane (2012) | |
| There are two main issues when comparing
our study with Haldane (2012): | |
| 1) Haldane
(2012) reports the UPLIFT for 29 institutions deemed by the Financial Stability
Board (FSB) to be the world’s most systemically-important. Thus non-EU banks
are in the sample. | |
| 2) The
ratings used in the present study and in Haldane (2012) are different. Haldane
(2012) must rely on the Bank Financial Strength rating (BFSR), as UPLIFTs prior
to 2011 are reported (the first announcement of the BCA, at least for the
European banks, was in 2011). In contrast, this study relies on the BCA Moody’s
rating and the rating scales of the two differ. | |
| As discussed above, no direct comparisons
can be made, as our sample includes only 13 EU G-SIBs banks. However, in order
to have an intuition of the direction in which their average UPLIFT moves over
time, we summarize in Table C.2 the evolution of the average
UPLIFT. | |
| Table C.2: Statistics of the sample used in the present study | |
| || UPLIFT | |
| 2011st || 2.62 | |
| 2011nd || 2.08 | |
| 2012st || 2.38 | |
| 2012nd || 2.23 | |
| Comparing Table C.2 and the results presented in
Haldane (2012) one can conclude that in both studies between 2011 and 2012 the
UPLIFT for the G-SIBs is between 2 and 3 notches. | |
| C.1.3
Comparison with Bijlsma and Mocking (2013) | |
| Bijlsma and Mocking
(2013) is based on a sample of 151 European banks which partly overlaps with
the banks in our sample. As in Haldane (2012), Bijlsma and Mocking (2013) use
the BFSR to calculate the UPLIFT. The authors conclude that banks enjoy an
average UPLIFT of 2.9 for 2011 and 2.5 for 2012 respectively. | |
| In Table C.3 summary statistics for the average UPLIFT calculated for the sample
used in the present study are presented. | |
| Table C.3: UPLIFT statistics (present study) | |
| Dec-2011 || Dec-2012 | |
| Mean || 2.63 || Mean || 2.73 | |
| Minimum || 0 || Minimum || 0 | |
| Maximum || 8 || Maximum || 8 | |
| Count || 108 || Count || 112 | |
| Although averages for the UPLIFT points in
time are similar, one must be cautions on making exact comparisons as the
rating scales for BFSR and BCA differ. | |
| C.2
Comparison of implicit subsidy estimates | |
| One must be cautious when making a
comparison of our results with the results presented in other studies on the
implicit subsidy. Due to differences in definition of rating sensitive
liabilities, the estimation of the yield spreads and the sample of banks the
estimates will most likely not perfectly match. Schich and Lindh (2012), for
example, report banks’ implicit subsidies for France, UK and Germany to be 1%,
0.4% and 1.4% of domestic GDP, respectively, for March 2012 (when using their
upper bound estimates). Our estimates of the implicit subsidy for banks in
France and UK are around 0.9-1.5% and 0.4% in 2012H2, which is in line with
their results. For Germany we report an implicit subsidy of 0.5-0.7% (of
domestic GDP) in 2012H2, which is half the Schich and Lindh (2012) estimate.
Bijlsma and Mocking (2013) estimate the implicit subsidy to be in the range of
0.5-1.5%, 0.5-1.2% and 0.5-1.2% of domestic GDP for France, UK and Germany,
respectively, in 2011. We estimate the implicit subsidy to be around 1-1.5%,
0.8% and 0.5-0.7% for the banks in these countries in 2011H2. | |
| In Haldane (2010), the estimation of the
average total annual subsidy of the five largest UK banks equals GBP 55 billion
for the period 2007-2009. The proxy used in this study for rating-sensitive
liabilities excludes retail deposits but includes wholesale borrowing. Haldane
(2011) reports an average total annual subsidy of USD 74 billion for the period
2007-2010 for the four largest UK banks. In 2010, the total annual subsidy is
estimated to USD 58 billion. The proxy for rating-sensitive liabilities is not
explicitly defined. | |
| Noss and Sowerbutts (2012) reports implicit
subsidy estimates (with the ratings based approach) to around 5, 25-30, around
130, and around 40 GBP billion in 2007, 2008, 2009, and 2010, respectively. | |
| In our study, we estimate the implicit
subsidy for the four largest UK banks (RBS, HSBC, Lloyds and Barclays) to be
around EUR 12 and EUR 7 billion in 2011 and 2012, respectively, when using the
long-term funding proxy for rating-sensitive liabilities. Adding Santader UK to
the others, we get EUR 13.6 and EUR 7.7 billion in 2011 and 2012, respectively.
For the implicit subsidy estimates based on the total debt proxy, we do not
have any data for Barclays. However for the other four banks, we estimate the
implicit subsidy to be EUR 13.4 and EUR 8.4 billion in 2011 and 2012,
respectively. | |
| Appendix D: UPLIFT* for selected large
EU groups | |
| Source: SNL,
Moody’s and own calculations | |
| Note: BNP Paribas
(BNP), Deutsche Bank AG (DB), Credit Agricole SA (CA), Royal Bank of Scotland
(RBS), Banco Santander S.A. (Ban.San), Societe Generale SA (SG), Lloyds TSB
Bank (Ll), HSBC Bank PLC (HSBC), ING Bank NV (ING), UniCredit SpA (UC), Nordea
Bank AB (Nord), Bank of Scotland PLC (BS), Barclays (Bar), Standard Chartered
(St.Ch.) | |
| Appendix E: Descriptive statistics of
the sample used for building the rating-yield map | |
| The rating-yield curve is built by taking
weekly observations of market yields for a sample of European banks from 18
countries. We have built one rating-yield curve for 2011H2 and one for 2012H2. | |
| The data on bond yield spreads and
long-term credit ratings are taken from DG ECFIN’s Bank Watch.[104] The yield spreads
are with respect to German 5 year bonds (Bobls).[105] The maturity of the
bank bonds may vary between 4.5 and 5.5 years.[106] | |
| Descriptive statistics for the two
semesters (2011H2 and 2012H2) are presented in Table E.1. For both semesters,
the number of weeks is 22. The 2011H2 sample contains 74 banks, while the
2012H2 sample covers 80 banks. The total number of observations is 1590 and
1760 in 2011H2 and 2012H2, respectively. | |
| The average yield spreads has fallen for
each rating bucket in 2012H2 compared to 2011H2. In Table E.1, one can also
observe that the majority of observations (covering 85% of the observations) in
2011H2 was in rating classes Aa2 to Baa2, while in 2012H2 it is Aa3 to Ba1 that
have the majority of observations, illustrating that banks have been
downgraded. | |
| Table
E.1. Descriptive statistics of sample for the
rating - yield spread map | |
| || 2011H2 || 2012H2 | |
| Rating || Average yield spread || Average number of banks / week || Total number of observations || Average yield spread || Average number of banks / week || Total number of observations | |
| Aaa || 66.65 || 1.0 || 22 || 7.9 || 1.0 || 22 | |
| Aa1 || 124.83 || 1.4 || 30 || 56.5 || 1.3 || 29 | |
| Aa2 || 184.20 || 11.2 || 246 || #N/A || 0.0 || 0 | |
| Aa3 || 238.33 || 14.0 || 309 || 79.4 || 5.2 || 115 | |
| A1 || 225.57 || 12.1 || 267 || 129.4 || 4.0 || 88 | |
| A2 || 370.34 || 13.0 || 287 || 145.8 || 14.5 || 318 | |
| A3 || 258.94 || 7.1 || 157 || 151.6 || 13.7 || 301 | |
| Baa1 || 343.27 || 0.9 || 20 || 231.8 || 4.0 || 88 | |
| Baa2 || 528.24 || 3.3 || 72 || 384.2 || 11.5 || 252 | |
| Baa3 || 526.34 || 1.9 || 42 || 389.6 || 9.9 || 218 | |
| Ba1 || 1098.61 || 2.9 || 64 || 801.3 || 5.7 || 126 | |
| Ba2 || 1061.65 || 1.5 || 32 || 500.9 || 2.4 || 53 | |
| Ba3 || 1222.25 || 0.5 || 10 || 544.4 || 3.9 || 85 | |
| B1 || #N/A || 0.0 || 0 || 698.1 || 1.1 || 25 | |
| B2 || #N/A || 0.0 || 0 || #N/A || 0.0 || 0 | |
| B3 || 1438.38 || 0.5 || 12 || #N/A || 0.0 || 0 | |
| Caa1 || #N/A || 0.0 || 0 || #N/A || 0.0 || 0 | |
| Caa2 || 2114.92 || 0.9 || 20 || 1506.7 || 1.8 || 40 | |
| Caa3 || #N/A || 0.0 || 0 || #N/A || 0.0 || 0 | |
| Ca || #N/A || 0.0 || 0 || #N/A || 0.0 || 0 | |
| C || #N/A || 0.0 || 0 || #N/A || 0.0 || 0 | |
| Total || || 72.3 || 1590 || || 80.0 || 1760 | |
| Appendix F: Description of the proxies
for the rating-sensitive liabilities | |
| The estimation of implicit
subsidy is based on two alternative approximations of
rating sensitive liabilities: Total Debt from SNL and Total Long-term Funding
from Bankscope. | |
| Estimate 1: Total Debt | |
| Total Debt is part of the total financial
liabilities, as reported in SNL. ‘Total Financial Liabilities’ consist of: | |
| ·
Total
Deposits: Total Deposits from Banks + Total Customer Deposits; | |
| ·
Total
Debt: Total Subordinated debt + Senior Debt; | |
| ·
Derivative
Liabilities[107];
and | |
| ·
Other
Financial Liabilities (incl. Securities Sold, not yet purchased). | |
| In our sample, SNL reports Total Debt for
90 banks for both 2011 and 2012. | |
| Estimate 2: Total Long-term Funding | |
| Total long-term funding is part of the
total funding, as reported in Bankscope. ‘Total Funding’ consists of: | |
| ·
Total
Deposits, Money Market and short-term funding = Total Customer Deposits +
Deposits from Bank + Other Deposits and Short-term Borrowings | |
| ·
Total
Long-term funding = Senior Debts Maturing after one Year[108] + Subordinated Borrowing[109] + Other Funding; | |
| ·
Derivatives[110]; and | |
| ·
Trading
Liabilities[111]. | |
| In our sample, Bankscope reports Total
Long-term Funding for 96 banks for 2011 and for 97 banks for 2012. | |
| Comparing the two approximations | |
| In total, we have values for both Total
Debt and Total Long-term Funding for 87 banks. | |
| On average Total Long-term Funding
represents 80% of Total Debt.[112]
However, there is quite some variability in the sample and for several banks
the ratio is above 100%. Based on this comparison we would expect the implicit subsidy estimate based on Total
Long-term Funding to be lower than the estimate based on Total Debt. | |
| Appendix G:
Implicit subsidy versus pre-impairment operating profit | |
| The aggregated pre-impairment operating
profit by country is presented in Figure G.1. The total
pre-impairment operating profit for the whole sample was EUR 197.5 billion and
EUR 175.5 billion, in 2011 and 2012, respectively. The implicit subsidy in 2011
is estimated to be EUR 68 – 94 billion for the banks in our sample with profit
data available in SNL. For 2012, the estimate is EUR 56 – 82 billion. So the implicit subsidy was 35-50% and 30-45% of
pre-impairment operating profit in 2011 and 2012, respectively. | |
| Figure G.1: Aggregated pre-impairment operating profit (EUR billion)
country-by-country | |
| Source: SNL and own
calculations | |
| Country-by-country the implicit subsidy as
a percentage of pre-impairment operating profit is highest for Sweden, Germany,
Belgium, France and UK, see Figure G.2 and Figure G.3. The numbers indicate
that the implicit subsidy can be quite significant for the banking system. One
should of course be careful when analysing these results and ideally the
implicit subsidy as well as the profit should be estimated over a longer period
of time. | |
| Figure G.2:
Aggregated implicit subsidy (% of Pre-impairment Operating Profit) based on
Total Debt | |
| Source: SNL and own
calculations | |
| Figure G.3:
Aggregated implicit subsidy (% of Pre-impairment Operating Profit) based on
Total Long-term funding | |
| Source: SNL and own
calculations | |
| Appendix H:
Implicit subsidy
versus bank characteristics | |
| The present Appendix summarizes the
comparison of the relative size of the implicit subsidy with several balance
sheet variables. We report here the graphs for the implicit subsidy estimate
based on ‘Total Debt’ as reported by SNL for 2012. The general conclusions
remain valid also for 2011 and the other implicit subsidy estimate. | |
| From Figure 21 we have observed that there
is a positive relation between the size of the bank (total assets) and the size
of the implicit subsidy. This result comes from the fact that the larger the
bank is the larger is the amount of debt on its balance sheet. Taking the size
of the balance sheet into account, we rescale the implicit subsidy by total
assets, to facilitate comparison between the banks in our sample. | |
| Comparing the ratio of implicit subsidy to
total assets with the size of the bank, the positive relation reported in
Figure 21, is not that profound anymore (see Figure H.1). | |
| There seems to be no or a week positive
relation between the ratio of implicit subsidy to total assets and several risk
measures (leverage, Tier 1 Capital (as % of total assets) and risk weighted
assets (as % of total assets)), as reported in Figure H.2-H.4. | |
| Finally, the share of trading (Assets Held
for Trading as a % of Total Assets) seems not to influence the relative size of
implicit subsidy (see Figure H.5). | |
| Figure H.1:
Implicit subsidy (as a % of Total Assets) versus Total Assets (end of 2012) | |
| Figure
H.2: Implicit subsidy (as a % of Total Assets)
versus leverage (Total Assets over Total Equity) (end of 2012) | |
| Figure H.3:
Implicit subsidy (as a % of Total Assets) versus Tier 1 Capital (as a % of
Total Assets) (end of 2012) | |
| Figure
H.4: Implicit subsidy (as a % of Total Assets) versus
Risk Weighted Assets (as a % of Total Assets) (end of 2012) | |
| Figure H.5:
Implicit subsidy (as a % of Total Assets) versus Assets Held for Trading (end
of 2012) | |
| Appendix I: SNL business model
variables description | |
| ·
Total
assets: All assets owned by the company as of the date indicated, as carried on
the balance sheet and defined under the indicated accounting principles. | |
| ·
Assets
Held for Trading: Trading portfolio assets are: assets acquired principally for
the purpose of selling in the near term, assets that on initial recognition are
part of a portfolio of identified financial instruments that are managed
together and for which there is evidence of a recent actual pattern of
short-term profit-taking, or derivative assets (except for a derivative that is
designated as an effective hedging instrument). | |
| ·
Total
Deposits from Customers: Amounts in customers' banking deposits; any accounts
subject to federal banking deposit insurance, including any portions in jumbo
deposits that are not insured but subject to the FDIC deposit regulations. | |
| ·
Total
Deposits from Banks: Total deposits from banks. | |
| ·
Total
Equity: Equity as defined under the indicated accounting principles. Includes
par value, paid in capital, retained earnings, and other adjustments to equity.
Minority interest may be included, per relevant accounting standards. | |
| ·
Risk
Weighted Assets: Total risk-adjusted assets as reported by the company. For
European banks, this includes transitional capital adjustments when available. | |
| ·
Tier1
Capital: For OTS-regulated institutions it represents the amount of core
capital as defined under the latest OTS guidelines at period-end. For
FDIC-regulated institutions it represents the amount of Tier 1 capital as
defined by the latest regulatory agency guidelines. | |
| ·
Tier2
Capital:
Tier
2 eligible capital as defined by the bank's domestic central bank. | |
| ·
Net
Loans to Banks: Net loans and advances made to banks after deducting any
allowance for impairment. | |
| ·
Net
Loans to Customers: Total loans to customers, net of reserves for loan losses.
Includes any loans held at amortised cost, available for sale, fair value
through profit and loss and trading. For U.S. GAAP companies, this is total
loans and finance leases outstanding, including those held for sale. | |
| ·
Total
Financial Liabilities: Total interest accruing liabilities | |
| ·
Operating
Income: Total operating income from banking, insurance and asset management | |
| ·
Net
Interest Income: Interest income less interest expense before the provision for
loan losses. | |
| ·
Net
Fee & Commission Income: Revenue from services to customers, net of expense
from third parties related to services provided to the company. | |
| ·
Derivative
Liabilities: Total negative replacement values of hedging and non-hedging
derivatives. A derivative is a financial instrument with all of the following
three characteristics: its value changes in response to the change in an
underlying variable; it requires no initial net investment or an initial net
investment that is smaller than would be required for other contracts that
would be expected to have a similar response to changes in market factors; it
is settled at a future date. For European Insurers, this also includes
liabilities held at fair value through profit and loss. | |
| ·
Short
Term Funding: Principal amount of debt payable within the next calendar year,
including the current portion of long-term debt. | |
| ·
Derivatives
Assets: Derivatives Held for Trading (Derivatives with positive replacement
values not identified as hedging or embedded derivatives. A derivative is a
financial instrument with all of the following three characteristics: its value
changes in response to the change in an Underlying variable; it requires no
initial net investment or an initial net investment that is smaller than would
be required for other contracts that would be expected to have a similar
response to changes in market factors; it is settled at a future date.) and
Derivatives Identified as Positive Hedges (Derivatives with positive
replacement values accounted for under fair value hedge accounting, cash flow
hedge accounting, or hedging of a net investment in a foreign operation. This
includes fair value changes associated with hedging instruments.) | |
| Appendix J:
Marginal effects in Probit regression | |
| Let AX represents the average bank characteristics with ℓ-th
average characteristic denoted as AXℓ. We wish to measure the impact that
a change of the ℓ-th characteristic by dAXℓ (or ΔAXℓ if
the variable is discrete) has on the probability that the average bank receives
an UPLIFT* equal to j=0,…,m, the other variables being held constant. A
first-order approximation around AX gives: | |
| P(UPLIFT*=j|AX + dAXℓ) = P(UPLIFT*=j|AX) + dAXℓ
[dP(UPLIFT*=j|AX)/dAXℓ] | |
| where dP(UPLIFTi*=j|AX)/dAXℓ represents the derivative of the
probability that the average bank UPLIFT* belongs to category j when the
characteristic ℓ changes by an amount equal to dAXℓ (the so called
marginal effect). In the Probit framework, this derivative verifies: | |
| dP(UPLIFT*=0|AX)/dAXℓ = - βℓ
Φ(μ1 - AX' β) | |
| dP(UPLIFTi*=j|AX)/dAXℓ = - βℓ [Φ (μj+1-
AX' β) - Φ (μj- AX' β)] , j = 1,…,m-1 | |
| dP(UPLIFTi*=m|AX)/dAXℓ = βℓ Φ
(μm - AX' β) | |
| where βℓ is the coefficient associated to the ℓ-th
characteristic and Φ is the standard normal density. The discrete case is
trivially obtained. Hence, when the explanatory variables depart from average
values, negative values of βℓ emphasize the lower tail and positive
values the upper one. It can be verified that the marginal effects of
dAXℓ on the probability to belong to each category j=0,…,m sum to 0 over
all categories, which does not occur under the linear probabilistic model. | |
| [1] For further details about the historical evolution of
national banking systems, see e.g. D. Casserley et al (2010), “Should
commercial and investment banking be separated: the historical background to
the current debate”, McKinsey&Company; A.D. Morrison, “Universal Banking”,
R. DeYoung “Banking in the United States”, and J. Goddard et al, “Banking in
the European Union” in A.N. Berger et al, The Oxford Handbook of Banking
(2010); and C.A.E. Goodhart (2013), “The optimal financial structure”, LSE
Financial Markets Group Paper Series, Special paper No. 220, March 2013.
Additional specific references are provided as appropriate. | |
| [2] Note that the German Banking Act contains a provision on the
limitation of qualified holdings in non-financial enterprises for
deposit-taking credit institutions (Section 12 of the German Banking Act
(Kreditwesengesetz)). | |
| [3] For further detail, see National Bank of Belgium (2012), Interim
report: Structural banking reforms in Belgium, June 2012. | |
| [4] Examples of other types of transactions include the sale of
securities or other assets by a bank to an affiliate, payment of money or
furnishing of services by a bank to an affiliate, transactions in which an
affiliate acts as an agent or broker for a bank (or for any other person if the
bank is a participant in the transaction), and any transaction by a bank with a
third party if an affiliate has a financial interest in the third party or if
an affiliate is a participant in the transaction. | |
| [5] This means that each covered transaction must be conducted on
terms and under circumstances, “including credit standards, that are
substantially the same, or at least as favourable to such bank or its subsidiary,
as those prevailing at the time for comparable transactions with or involving
other non-affiliated companies.” If comparable transactions do not exist,
then the transaction must be conducted on terms and under circumstances “that
in good faith would be offered to, or would apply to, non-affiliated companies.” | |
| [6] Federal Reserve System (2002), Regulation W: Transactions
between Member Banks and their Affiliates, 67 FR 76560, December 12, 2002. | |
| [7] See e.g. Omarova (2011), “From Gramm-Leach-Bliley to Dodd-Frank:
the Unfulfilled promise of Section 23A of the Federal Reserve Act”, on which
the above description builds heavily. | |
| [8] US Government Accountability Office (2011), “Proprietary
trading: Regulators Will Need More Comprehensive Information to Fully Monitor
Compliance with New Restrictions When Implemented”, GAO-11-529. | |
| [9] The GAO concluded that banks have conducted proprietary
trading at stand-alone proprietary trading desks and may have done it elsewhere
in the firm, given the difficulty to delineate proprietary trading and
market-making (e.g. traders may accumulate positions in a particular assets at
levels that exceed the amount of the firm’s typical or necessary inventory in
that asset used to facilitate customer trades). As US banks do not maintain records
on proprietary trading done elsewhere, the GAO study focused on the activities
of stand-alone desks only. | |
| [10] Ibid, p. 23. | |
| [11] This included more than 18,400 ‘form letters’, i.e. letters
signed by different associations or individuals that follow an identical
template. | |
| [12] According to Fitch Ratings, the total notional value of
derivatives for the four commercial banks that would be most affected –
JPMorgan Chase, Bank of America, Citigroup and Wells Fargo – was USD193bn at
the end of 2011. Of these 95% would be permissible derivatives and hence would
not need to be pushed out. | |
| [13] H.R. 992, the Swaps Regulatory Improvement Act, as introduced
by a bipartisan set of members of the House of Representatives. If enacted, it
would effectively only push out those ‘structured finance swaps’, i.e. a swap
or security-based swap based on an asset-backed security, that are not of
credit quality and that are not used for hedging or risk management purposes. | |
| [14] S. 798, TBTF Act, introduced by Senators Brown (D) and Vitter
(R) on 24 April 2013. | |
| [15] H.R. 5714, SAFE Banking Act of 2012, introduced by Congressman
Miller (D) and Sherman (D) on 10 May 2012. | |
| [16] S. 1282, A bill to reduce risks to the financial system by
limiting banks’ ability to engage in certain risky activities and limiting
conflicts of interest, to reinstate certain Glass-Steagall Act protections
that were repealed by the Gramm-Leach-Bliley Act, and for other purposes,
introduced by Senators Warren (D), McCain (R), and others on 11 July 2013. | |
| [17] HM Treasury (2012), Sound banking: delivering reform, October
2012. | |
| [18] Financial Services (Banking Reform) Bill, No. 130, 4 February
2013. An overview of the UK legislative process, including proposed amendments,
can be found on the Parliament’s website: http://services.parliament.uk/bills/2013-14/financialservicesbankingreform.html | |
| [19] UK Government – White Paper on
banking reform, June 2012. | |
| [20] UK Parliamentary Commission on
Banking Standards, First and Second Report, December 2012 and February 2013. | |
| [21] Independent Commission on Banking (2011), Final report:
recommendation, September 2011, p. 53. | |
| [22] PCBS (2012), First report, p. 69 onwards. | |
| [23] PCBS (2013), Second report, p. 5-12. | |
| [24] PCBS (2012), First report, p. 95. | |
| [25] PCBS (2013), Second report, p. 20, as well as Amendment R, p.
65. | |
| [26] However, the 1986 Building Societies Act already restricts the
activities building societies can provide and the government has indicated that
a forthcoming review will further bring the Act in line with the ring-fencing
requirement. | |
| [27] In December 2011 the UK
Government indicated that it would consider exempting non-EEA operations from
the PLAC requirement if banks could show that those operations posed no risk to
the EEA. It subsequently reversed the burden of proof, with such exposures
being automatically exempt unless authorities can show that they pose a risk.
This has been contested by the PCBS, arguing that banks should carry the burden
of proof. This has in principle been accepted by the government and will be
reflected in secondary legislation. | |
| [28]
PCBS (2013), Second report, p. 28. | |
| [29]
« Projet de loi de séparation et de régulation des activités
bancaire », 19 December 2012. | |
| [30] Information about the debate and amendments can be found on the
website of the Assemblée nationale: http://www.assemblee-nationale.fr/14/dossiers/separation_regulation_activites_bancaires.asp | |
| [31] Note that following discussions in the Assemblée nationale, the
draft law features three new paragraphs on this distinction: | |
| « L'Autorité de contrôle
prudentiel et de résolution contrôle que la distinction de l'activité de tenue
de marché, mentionnée aux 1° et 2°, par rapport aux autres activités est bien
établie en se fondant, pour les activités mentionnées au 1°, notamment sur des indicateurs
précisant les conditions de présence régulière sur le marché, l'activité
minimale sur le marché, les exigences en termes d'écarts de cotation proposés
et les règles d'organisation internes incluant des limites de risques. Les
indicateurs sont adaptés en fonction du type d'instrument financier négocié et
des lieux de négociation sur lesquels s'effectue l'activité de tenue de marché.
Le teneur de marché fournit sur base régulière les indicateurs à l'Autorité de
contrôle prudentiel et de résolution et à l'Autorité des marchés financiers. | |
| « Pour les activités visées
au 2°, l'établissement doit pouvoir justifier d'un lien entre le besoin des
clients et les opérations réalisées pour compte propre. L'Autorité de contrôle
prudentiel et de résolution apprécie cette activité au regard notamment de la
fréquence des opérations réalisées. | |
| « Un arrêté du ministre de
l'économie, après avis de l'Autorité des marchés financiers et de l'Autorité de
contrôle prudentiel et de résolution, fixe la liste des indicateurs visés au I
du présent article. » | |
| [32] Ministère
de l’Economie et des Finances (2012), Projet de loi de séparation et de
régulation des activités bancaires : Étude d’Impact, p. 17. | |
| [33] See footnote 29. | |
| [34] For example, BNP Paribas is estimated to have less than 2 % of
its corporate- and investment-banking revenues affected by the government
plans. See Chevreux Daily B.A.N.K. Keynote on bank reform, 3 December 2012. | |
| [35] See e.g. BofA Merrill Lynch Global Research (2012), “French
banks: French bank regulatory reform evolutionary not revolutionary”, December
2012. | |
| [36] The impact assessment accompanying the proposal indicates that
the threshold will be set so as to capture the largest French banks.
Accordingly four banks (BNPP, SG, CA, BPCE) with trading activities ranging
from 20-40% of total assets are likely to be subject to the requirements. | |
| [37] Entwurf eines Gesetzes zur Abschirmung von Risiken und zur
Planung der Sanierung und Abwicklung von Kreditinstituten und Finanzgruppen,
6 February 2013. The draft law can be found on the
website of the Parliamentary Material Information System http://dipbt.bundestag.de/dip21/brd/2013/0094-13.pdf. | |
| [38] Information about the debate and amendments can be found on the
website of the Parliamentary Material Information System http://dipbt.bundestag.de/extrakt/ba/WP17/508/50871.html. | |
| [39] Gesetz zur Abschirmung von Risiken und zur Planung der
Sanierung und Abwicklung von Kreditinstituten und Finanzgruppen of 7 August
2013 (BGBl. I, page 3090). | |
| [40] I.e. the networks of credit cooperatives and savings banks. | |
| [41] According to the HLEG, these
permitted activities would “include, but need not be limited to, lending to
large as well as small and medium-sized companies; trade finance; consumer
lending; mortgage lending; interbank lending; participation in loan syndications;
plain vanilla securitisation for funding purposes; private wealth management
and asset management; and, exposures to regulated money market (UCITS) funds.” | |
| [42] Throughout, figures in parentheses following the chosen option
indicate how many positive responses this option received; not necessarily the
number of individual stakeholders who would choose the option. That is,
respondents were not restricted to choosing a single preferred option for each
question. It is for this reason that the sum of the figures in the graphs
below may equate to a number greater than the total number of responses
received. | |
| [43] For an overview of these measures and their current state of
play, see European Commission (2013), “Towards a stronger financial sector to
support growth” (http://ec.europa.eu/internal_market/publications/docs/financial-reform-for-growth_en.pdf). | |
| [44] Directives 2009/111/EC and 2010/76/EC. | |
| [45] Proposals for a Directive on access to the activity of credit
institutions and the prudential supervision of credit institutions and
investment firms, and a Regulation on prudential requirements for credit
institutions and investment firms, COM(2011)452 and 453 of 20 July 2012 – also
referred to as the CRD IV package. Political agreement between the European
Parliament and the Council was reached in April 2013. | |
| [46] Proposal for a Directive establishing a framework for the
recovery and resolution of credit institutions and investment firms and
amending Council Directives 77/91/EEC and 82/891/EC, Directives 2001/24/EC,
2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC and 2011/35/EC and Regulation
(EU) No 1093/2010, COM/2012/0280 final - 2012/0150 (COD). Political agreement
was reached in July 2013. | |
| [47] The exact rules in some areas, notably liquidity, remain to be
fully specified. | |
| [48] “The ratio of risk-weighted assets to total assets differs
significantly between banks. It is remarkable that the banks with the highest
amount of trading assets, notional derivatives, etc. (i.e. banks that are least
"traditional") tend to have the lowest ratio.” Report of the
HLEG, p. 43. | |
| [49] “[…] for a sample of 16 large EU banks, the capital
requirements for market risks vary between close to 0% to just over 2% of the
total value of trading assets, the average being close to 1%.” Report of
the HLEG, p. 48. | |
| [50] E.g. the use of stressed VaR as part of Basel 2.5’s revisions
to the market risk framework. | |
| [51] European Banking Authority (2013), “Interim results of the
EBA review of the consistency of risk-weighted assets. Top-down assessment of
the banking book”, February 2013; Basel Committee on Banking Supervision
(2013), “Regulatory consistency assessment programme (RCAP) – Analysis of
risk-weighted assets for market risk”, January 2013. | |
| [52] Ibid. | |
| [53] See Annex A5, “Analysis of possible incentives towards trading
activities implied by the structure of banks’ minimum capital requirements. | |
| [54] Schich, S. and S. Lindh (2012), “Implicit Guarantees for Bank
Debt: Where Do We Stand?”, OECD Journal: Financial Market Trends, were on the
basis of empirical work unable to generate strong support for the hypothesis
that the availability or introduction of special bank failure resolution
regimes has been successful in reducing the incidence of implicit guarantees. | |
| [55] G20 (2013), G20 Leaders Declaration, St Petersburg,
September 2013. | |
| [56] See e.g. FSB (2013), Progress and Next Steps Towards Ending
“Too-Big-to-Fail” (TBTF), Report of the Financial Stability Board to the
G-20, 30 August 2013, highlighting the potential of structural reform to put
constraints on excessive risk-taking and contribute to improve resolvability at
jurisdictional level. FSB also stresses the complexities in the legal,
financial and operational structures of banks. | |
| [57] FSA (2011), “Recovery and resolution plans”, CP11/16. | |
| [58] According to the FSB, the extent of CCP clearing varies
according to segment. For example, for interest rate swaps, where CCPs have
existed since quite some time, estimates of activity by the G15 dealers
indicate that, as of end-February 2013 around 50% of these dealers’ gross
notional outstandings where CCPs active had been centrally cleared. For OTC
credit derivative products the corresponding figure for all market participants
was around 30% of the total notional outstandings. Central clearing of OTC
commodity, equity and FX derivatives is yet to be well established at a global
level. FSB (2013), OTC Derivatives Market Reform: Fifth Progress Report,
April 2013. | |
| [59] Belgium, Germany, Estonia, Greece, Spain, France, Italy,
Austria, Portugal, Slovenia and Slovakia | |
| [60] 0.1% for shares and bonds, units of collective investment
funds, money market instruments, repurchase agreements and securities lending
agreements, and 0.01% for derivative products. | |
| [61] The FTT proposal contains two safeguards against relocation of
financial transactions. The first is the "residence principle", where
who is party to the transaction is what counts, not where it takes place. If a
financial institution involved in the transaction is established in the FTT
zone, or is acting on behalf of a party established in this zone, then the
transaction will be taxed, regardless of where it takes place in the world. To
further prevent avoidance of the tax, the Commission has added to this proposal
the "issuance principle". This means that a transaction will also be
taxed, whenever and wherever it takes place, if it involves financial
instruments issued in one of the participating Member States. | |
| [62] A parallel with the leverage ratios of hedge funds vs. banks is
interesting in that respect. Banks typically operate with a higher leverage
than hedge funds, which is only tolerated by investors due to the fact that
the bank has a core of safe, stable deposit funding that is subject to explicit
government guarantees. | |
| [63] As put by the Federal Reserve Bank of New York in a 2010 shadow
banking paper: "Time and again, history shows that activities regulated
out of banks, or financial innovations conducted and embodied by non-bank
financial specialists (such as money-market mutual funds or finance companies)
that pose a threat to the profitability of essential bank functions, are later
acquired by banks – what's "regulated and innovated out" is usually
"acquired back in". ("Shadow Banking", July 2010). | |
| [64] http://ec.europa.eu/internal_market/bank/docs/shadow/green-paper_en.pdf | |
| [65] G20 communiqué following the Cannes summit, November 2011. | |
| [66] One should distinguish the systemic importance of an institution
with its size. While many systemically important financial institutions (SIFIs)
are systemically important by virtue of size, size is neither a sufficient nor
a necessary conditions for a firm to be SIFI. | |
| [67] Bankruptcy costs are very high for banks.
Typically in bankruptcies the liabilities of the company are freezed while it
business is operating in a way to maximize the resources available to
creditors. However, a bank's liabilities are central to the value it creates
and therefore this process is almost impossible for banks (see ICB (2011)). | |
| [68] Such assets valued at fair value are likely to be extremely
volatile in a crisis and can eventually wipe out the capital of the whole
group. Securities business sharing capital with commercial banking creates a
contagion risk as the highly volatile securities business shares capital with
the less volatile commercial bank where cost amortisation accounting applies.
They conclude that removing TBTF problems will not be credible if it is clear
to investors that contagion risk is present. | |
| [69] They also find that there is an increase in the yield spread of
saving banks' bonds after the announcement of the court decision to remove
guarantees (from 45 to 51 basis points) and savings banks adjusted their
liabilities away from risk-sensitive debt instruments, and towards insured
deposits and equity. | |
| [70] See Moody's Investors service (2011) "Status Report on
Systemic Support Incorporated in Moody's Bank Debt Ratings Globally",
Special Comment, page 2 | |
| [71] For example Washington Mutual and Lehman Brothers with more than
USD 300 billion and 600 billion assets respectively were not bailed out. | |
| [72] For example Moody's (2011) explains the methodology underpinning
the assessment of support which is based on the willingness to provide support,
the capacity of a sovereign to do so and the workability of overall resolution
regimes. | |
| [73] They also find that both target and acquiring bank bond returns
record a positive cumulative adjusted return (of 4.3 and 1.2% respectively). | |
| [74] They find that non-bank financial s enjoyed
a much higher benefit of 77 bps for the same period. | |
| [75] The authors would like to thank S. Maes and M. Marchesi for useful
comments and discussion. | |
| [76] One must be cautious in interpreting the results of Schich and Lindh
(2012) as they fit a linear probability model to numerically-translated
ratings. Indeed, handling categorical variables as if they were continuous
leads to the well-known flaws of the linear probability model such as
heteroskedasticity and non-normality of residuals. These flaws may make
inference invalid. | |
| [77] Appendix A provides a list of the banks used | |
| [78] Source: ECB statistics. | |
| [79] For some G-SIBs no stand-alone ratings are available at
group/holding level, thus the focus is on the main bank (e.g. Barclays and
Standard Chartered are included in the sample as Barclays Bank PLC and Standard
Chartered Bank). | |
| [80] BFSR, which is only used to describe the evolution of the UPLIFT is
mapped into 13 classes. | |
| [81] It must be noted that when constructing the UPLIFT* variable the
following simplified assumption is made: An UPLIFT* of 1 notch is
quantitatively the same irrespective of the underlying adjusted BCA and
stand-alone ratings. | |
| [82] A detailed comparison of the obtained results with the existing
literature can be found in Appendix C. | |
| [83] Each observation of the two ratings is weighted according to the
bank’s total assets. | |
| [84] On average 72 and 80 banks per week in 2011 and 2012, respectively,
due to missing values for some banks in some weeks. | |
| [85] The very high yield spreads for the lower ratings might be driven by
the fact that there are few observations of bonds for the low notches (see Appendix
E). Therefore the possibility that our estimates are not accurate is greater
for such observations. However, there is also a small number of banks with low
notches in the sample of the banks used for the computation of the UPLIFT* and
therefore this is unlikely to lead to very significant errors in the monetary
quantification of the implicit subsidies over the whole sample. | |
| [86] Points below the straight line represent banks for which the
estimated yield spreads is lower than the average market yield spreads. Points
above the straight line represent cases for which the estimated yield spreads
are higher than the average market yield spreads. The difference between a
bank’s average market yield spread and its estimated yield spread is the
vertical distance between the point and the straight line. | |
| [87] We have examined in more detail three cases where the market yield
spreads are higher than the estimated yield spreads in Figure 15. Santander UK,
for example, had an average market yield spread of 624 bp in 2012H2, which
corresponds approximately to a Ba2 rating. The estimated yield spread based on
its long-term rating (A2) is 142 bp, a difference of 482 bp compared to the
average market spread. For Dexia Credit Local SA (FR) and Banco Popular Español
SA (ES) the average yield spreads are 532 and 770 bp, respectively, higher than
the estimated yield spreads in 2012H2. There are also cases where the average
market yield spread is lower than the estimated yield spread. See, for example,
National Bank of Greece SA in 2011H2, which had an average market yield spread
of 1527 while the estimated yield spread is 2057. | |
| [88] The
weighted average funding cost advantage (weighted on bank’s total assets) is
171 and 149 basis points for 2011 and 2012 respectively. This corresponds to an
increase in the WACC of 25-35 bps, since the proxies for credit sensitive
liabilities represent 15% to 20% of total liabilities (see Section 4.3). | |
| [89] In SNL, Total Debt is the sum of Total subordinated debt and Senior
debt. | |
| [90] In Bankscope, Total Long-term Funding is the sum of Senior Debts
Maturing after one Year, Subordinated Borrowing and Other Funding. | |
| [91] For each large banking group we have used the highest possible
consolidation level, i.e., the group head if possible. Only if the group head
does not have both the long-term issuer rating and the adjusted BCA, we have
included the main subsidiary in the country where the group's headquarter is
located. We have, for example, included HSBC Bank PLC (UK) and not HSBC
Holdings PLC in the sample because the latter lacks an adjusted BCA. This will
of course influence the amount of rating sensitive liabilities. | |
| [92] For a large bank with relatively large subsidiaries in the country
where it is headquartered we have chosen not to include these subsidiaries
separately when calculating the total countrywide implicit subsidy even though
we have the necessary information (ratings and balance sheets). This was done
in the cases of Crédit Agricole CIB (subsidiary of Crédit Agricole SA),
Hypothekenbank Frankfurt AG (Commerzbank AG), Deutsche Postbank (Deutsche
Bank), Bank of Scotland (Lloyds TSB Bank), and National Westminster (RBS Plc). | |
| [93] The use of consolidated balance sheet data might have a second
caveat for cross-border banking groups. We aim at estimating the implicit
subsidy due to an implicit guarantee from the sovereign where the reporting
entity is headquartered, excluding any potential support from the parent bank.
Consequently, for cross-border banking groups with bank subsidiaries outside
their respective domestic country (i.e. where it is headquartered) the use of
consolidated balance sheet data might lead to an overestimation of the implicit
subsidy from the sovereign where the parent bank is headquartered. | |
| [94] These changes in Portugal are driven by banks stand-alone and
long-term ratings being downgraded, with a larger downgrade of the stand-alone
rating, and, therefore, increasing the UPLIFT* from 0 to 1 notch to 0 to 4
notches. This increase in the UPLIFT*, together with the downgrade of the
adjusted BCA, is translated into higher funding advantage. | |
| [95] The sample used here is slightly smaller than the full sample, since
some banks are not in SNL which implies that we do not have data for the
pre-impairment profit. Most notably we have excluded Barclays Bank PLC and
Standard Chartered Bank in the UK. | |
| [96] Pre-impairment profit equals operating income less operating
expenses. Operating income is the total operating income from banking,
insurance and asset management. It is the sum of net interest income, net fee
and commissions, net insurance income, net trading income and other operating
incomes. Operating expenses is the total operating expenses from banking,
insurance and asset management. It is mainly personnel expenses. | |
| [97] These
variables have been computed using SNL data. Appendix A gives a detailed
description on the employed variables. | |
| [98] The
model prediction is computed as follows. Let us denote Xk the
average of the explanatory variables of all banks for which UPLIFT*=k is
observed and let P(Xk) be the probability that a bank has an UPLIFT*
equal to k. Trivially P(Xk) corresponds to the empirical probability
of the UPLIFT* in Table 4. The model prediction is calculated using the
relationship: | |
| P(UPLIFT* = j) =
Σk=0m P(Xk) P(UPLIFT* = j | Xk) | |
| The model enters through the term
P(UPLIFT* = j | Xk) which is measured as: | |
| P(UPLIFTi*= 0|Xk) =
Φ(μ1 - Xk' β) | |
| P(UPLIFTi*= j|Xk) =
Φ(μj+1- Xi' β) - Φ(μj-
Xi' β) , j = 1,…,m-1 | |
| P(UPLIFTi*= m|Xk) =
1- Φ (μm - Xi' β) | |
| where the β and μ
coefficients are given in Table 5. | |
| [99] These figures are obtained from Table 7 as follows: the probability of
having an UPLIFT* equal to 0 or 1 notch is 0.023 + 0.276 = 0.30 (third and
fourth column). When increasing BCA by one notch, one should add to this
quantity the marginal effect of BCA (third and fourth column): 0.30 + 0.021 +
0.112 = 0.43. | |
| [100] Some country dummies were found to be significant at the 10% level,
i.e. for AT, IE, NL, SI and UK. They leave unaltered the sign, the order of
magnitude, and the significance of the coefficient estimates. More country
dummies appear to be significant when the sovereign rating is excluded from the
regression, but the coefficients of the other variables remain stable. Given
the high correlation between country dummies and sovereign rating, we do not
consider it worth adding them. | |
| [101] The all-in rating, we remind, is
determined together with the UPLIFT*. | |
| [102] The source of data for the debt to GDP ratio is DG ECFIN AMECO
database. | |
| [103] In parentheses the respective number of banks | |
| [104] The source
of the Bank Watch data is Bloomberg. | |
| [105] We have
used yield spreads to isolate the credit risk component of each bank bond and
to facilitate a comparison between bonds. | |
| [106] A mixture
of bonds is used to estimate the yields, mainly senior unsecured and covered
bonds. | |
| [107] Including both hedging and non-hedging derivatives. | |
| [108] Item includes loans from banks; debts securities in issue, the
liability component of convertible bonds, and other borrowed funds. | |
| [109] Subordinated loans and debt including any dated hybrid instruments. | |
| [110] Including both trading and hedging derivatives. | |
| [111] Short positions, repos; short-term notes and other financial
liabilities classified as held for trading. | |
| [112] The ratio of Total Funding to Total Financial Liabilities is around
100% for all the banks. | |
| LIST OF ANNEXES | |
| ANNEX A5. Analysis of possible incentives
towards trading activities implied by the structure of banks’ minimum capital
requirements - PAGE 3 | |
| ANNEX A6. Qualitative assessment of
benefits and costs of separating banking activities from deposit-taking
entities - PAGE 53 | |
| ANNEX A7. Strength of separation - PAGE 88 | |
| ANNEX A8. Trading activities and bank structural
separation: possible definitions and calibration of screening - PAGE 119 | |
| ANNEX A9. Summary of the main findings
in literature on economies of scale and scope in the banking sector - PAGE 175 | |
| ANNEX A10. Quantitative estimation of a
part of the costs and benefits of bank structural separation - PAGE 203 | |
| ANNEX A11. Impact on private costs –
bank responses - PAGE 245 | |
| ANNEX A12. Economy-wide impact of
structural separation - PAGE 249 | |
| ANNEX A13. Shadow banking – Securities
finance transactions and transparency - PAGE 254 | |
| ANNEX A14. Glossary - PAGE 287 | |
| Annex A5 : Analysis of Possible Incentives towards Trading Activities implied by the Structure of Banks’s Minimum Capital Requirements | |
| Forename(s) Surname(s) | |
| M. Petracco-Giudici, M. Marchesi, A. Rossi, N. Ndacyayisenga, J. Cariboni | |
| 2013 | |
| European Commission | |
| Joint Research
Centre | |
| Institute for the
Protection and Security of the Citizen | |
| Contact information | |
| Marco Petracco Giudici | |
| Address: Joint Research Centre, Via
Enrico Fermi 2749, TP 361, 21027 Ispra (VA), Italy | |
| E-mail:
marco.petracco@jrc.ec.europa.eu | |
| Tel.: +39 0332 78 3511 | |
| Fax: +39 0332 78 5733 | |
| http://ipsc.jrc.ec.europa.eu/ | |
| http://www.jrc.ec.europa.eu/ | |
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| JRC88529 | |
| © European Union,
2013 | |
| Executive Summary | |
| This report focuses on the analysis of
structure of banks’ Minimum Capital Requirements (MCRs) within the EU. In
particular, the aim is to investigate the possibility of the current regulatory
framework making trading activities more attractive than traditional deposit
taking bank activities (e.g. loans and credits), and more generally its
implications for the adequacy of MCRs on the two activities. | |
| Possible incentive toward trading
activities and the effectiveness of MCRs are assessed by looking at a measure
of returns per unit of MCR in each line of activity. | |
| As publicly available data in the annual
reports and in commercial databases only report the overall amount of MCRs but
do not report their attribution to different activities, the estimate of the
MCRs referring to each activity line are obtained via an econometric panel
analysis. | |
| The MCRs and income attributable to each of
the two activity lines are estimated under various regulatory scenarios and the
net income per unit of regulatory capital generated by the two activities over
the period 2006-2011 are analysed. | |
| Based on available data, and subject to the
caveat that the division of assets and of risk weighted assets between trading
and deposit taking activities is subject to a degree of uncertainty, results of
this analysis show: | |
| ü Possible existence of an incentive towards trading activities | |
| Current regulation
appears to provide incentives to banks to prefer trading activities to
deposit taking activities due to differences in returns on minimum capital
requirements on the two activities.
Results indicate
that even moving to Basel III MCRs could still not eliminate this effect. | |
| ü MCR adequacy | |
| Based on the
definition of trading activities adopted, estimated MCRs for trading
activities under current rules do not seem to allow absorbing net losses
stemming from trading in crisis periods (2008), while estimated MCRs for
deposit taking activities appear to allow covering net losses stemming
from them more fully
The analysis
confirms that the introduction of Basel 2.5[1] rules
in 2011 at least partially achieved the goal of substantially increasing
the MCRs for some activities. | |
| Table
of Contents | |
| Executive Summary.. 5 | |
| 1..... Introduction
and background.. 7 | |
| 2..... The datasets for the panel regression and for
the presentation of results.. 9 | |
| 3..... Investigating the relationship between
balance sheet composition
and MCRs: estimation of risk weights via panel data analysis.. 11 | |
| 4..... Determining the assets and income items to be
assigned to each activity line.. 14 | |
| 4.1.. Balance sheet split between activity lines and
determination of the MCRs.. 14 | |
| 4.2.. Income statement split between activity lines.. 17 | |
| 5. Results.. 19 | |
| 5.1 Total Assets, RWAs, RWA
densities and Returns on Assets per line of activity.. 19 | |
| 5.3 Income per unit of MCRs or
Regulatory Capital per line of activity 26 | |
| 6. Conclusions.. 31 | |
| APPENDIX A: Panel analysis to
estimate risk weighted assets for deposit taking and trading activities.. 32 | |
| APPENDIX B: Estimation of the
returns for the two business lines 34 | |
| APPENDIX C: Candidates sample.. 40 | |
| APPENDIX D: Analysis of the MCR
structure for the full sample of banks 45 | |
| APPENDIX E: Correction of RWAs.. 50 | |
| APPENDIX F: ROA by line of
activity and relationship with ROMCR.. 52 | |
| 1.
Introduction and background | |
| The European Commission is putting forward
a proposal to reform the structure of the EU banking sector which could result
in separation of trading activities from deposit taking activities.[2] This analysis is being
developed as part of the background material of the Impact Assessment for this
legislative initiative. | |
| In particular, the present note aims at
assessing the presence of an implicit incentive toward trading activities
embedded in current regulations[3]
by estimating the difference in the returns per unit of Minimum Capital
Requirements (MCR) or of Regulatory Capital for trading and deposit taking
activities. | |
| Since banks are not obliged to publish the
allocation of their MCRs between these activities,[4] the estimation of the
average amount of MCRs associated to categories of assets and liabilities in
the balance sheet of banks is obtained via a three step procedure: first, an
estimation of the average risk weights associated to different categories of
assets and liabilities is performed via a panel data analysis.[5] Second, assets and
liabilities in the balance sheet are allocated to the two activities; finally,
the MCRs and Regulatory Capitals for each line of activity are obtained based
on the allocation of assets and liabilities and the estimated average risk
weights, under the current regulatory framework and a set of counterfactual
scenarios (e.g. Basel III …). | |
| Income for each line of activity is
estimated by allocating income statement items to each of the two activities
and by using, where necessary, a set of proportionality assumptions. | |
| Finally, returns on capital requirements
are obtained as the ratio of income to MCRs for each line of activity under
each regulatory scenario in order to assess the possible presence of an
incentive towards trading activities.[6] | |
| As one the objectives of the analysis is to
provide background material for the structural reform, results are presented
separately for a sub-sample of 29 banks which might be candidates for
structural separation (see next section and Annex A8 for details) and for the
rest of the sample used for the analysis of risk weights and MCRs. | |
| The remaining of the report is structured
as follows: Section 2 describes the dataset used in the analysis; Section 3
illustrates the results of the panel analysis used to estimate the average risk
weight of different balance sheet items; Section 4 describes the assumptions
used to split the balance sheet and the income statement between trading and
deposit taking activities and the regulatory scenarios used to calculate the
MCRs referred to each activity; Section 5 presents the results of the analysis
of the relationship between income and MCRs for the two lines for banks in the
sample of banks potentially subject to structural reform and Section 6
concludes. Several technical annexes provide details on: the panel regression
specification (Appendix A); the way income is assigned to trading and deposit
taking activities (Appendix B) and the dataset (Appendix C). Appendix D
presents the returns per unit of MCRs for the full sample of banks. Appendix E
reports the assumptions made for the Basel 3 scenario and in particular details
the corrections applied to RWAs and Regulatory Capital. Appendix F presents a
comparison of estimated returns per unit of capital with balance sheet figures
as well as a decomposition of the differences. | |
| 2.
The datasets for the panel regression and for
the presentation of results | |
| The dataset for the panel analysis used to
allocate RWAs between trading and deposit taking activities includes 255[7] banks located in the
EU27 area having total assets available for 2011.[8] Their total assets as
of end 2011 are 34’645 bn EUR for EU27[9]
(77% of the EU27 banking sector[10]). | |
| Results in the main text are presented for
an “candidates sample” formed of 29 banks which are possible candidates for
separation.[11],[12] The “candidates
sample” also includes Norwegian DNB bank, with 274 bn EUR of total assets. All
results are calculated for the “candidates sample” and for the rest of the EU27
sample used for the regression.[13] | |
| Table 1: Distribution of the banks of the whole
sample based on their average total assets over the 2006-2011 period. 500 bn
EUR roughly corresponds to the 75th percentile of the total assets
in the sample of banks considered by the European Banking Authority in its
capital exercise.[14]
30 bn EUR is the size above which banks will be supervised directly by the SSM. | |
| Banks’ Buckets || Banks’ size (Total Assets) || Average size of a bank in the bucket (average over years) – bn Eur || Number of banks in the sample || Percentage of banks in the sample || Total Assets in the sample (average over years) – bn Eur || Share of total assets in the sample (average over years) || | |
| Small || Up to 30 bn EUR || 9.8 || 152 || 59% || 1'477 || 4% || | |
| Medium || 30 to 500 bn EUR || 128.9 || 85 || 33% || 10'959 || 32% || | |
| Large || Over 500 bn EUR || 1'233.8 || 18 || 7% || 22'209 || 64% || | |
| Total || 135.8 || 255 || 100% || 34'645 || 100% || | |
| Source: SNL database and JRC estimates | |
| NOTE: Large-size
banks are located in seven countries: DE, FR, GB, IT, NL ES and SE. | |
| 3.
Investigating the relationship between balance
sheet composition and MCRs: estimation of risk weights via panel data analysis | |
| Data on the allocation of MCRs by types of
activities are not published by banks in the majority of cases.[15] We therefore need to
establish a relationship between the nominal values of asset and liabilities
attributable to different activities and the corresponding MCRs in order to
proceed. | |
| Since data on MCRs are not publicly
available, while data on Risk Weighted Assets (RWAs) are, and since MCRs are
mandated in regulation to be a fixed percentage of RWAs, we concentrate our
attention on the latter quantity. Given (i) an allocation of nominal assets and
liabilities to different activities, (ii) an average ratio of RWAs to nominal
values for different balance sheet items and (iii) a fixed ratio of MCRs to
RWAs; we will then be able to estimate MCRs for each line of activity. | |
| In order to obtain the average ratio of
RWAs to nominal amounts (i.e. the average risk weights or “RWA density” as
termed in related literature[16])
for different balance sheet items a regression panel analysis is performed.
Technical details of the analysis are illustrated in Appendix A, while only
results which are used in the rest of this report are presented here. | |
| Table 2 shows the results of
the preferred regression model to predict RWAs based on nominal balance sheet
data.[17]
The values of the coefficients correspond to the equivalent weights of the
various classes of assets to be used for the purposes of calculating total
RWAs.[18] | |
| The following classes of assets and
liabilities available in SNL are included in the preferred model:[19] | |
| 1. Net loans to banks (LB) | |
| 2. Net loans to customers (NCL) | |
| 3. Activities held at amortized cost excluding loans (AMZ) | |
| 4. Securities held to maturity (HTM) | |
| 5. Available for sale assets excluding loans (AFS) | |
| 6. Assets held at fair value excluding loans (FV) | |
| 7. Securities held for trading excluding derivatives (volume in asset
and liability sides) (TSA+TSL)/2 | |
| 8. Derivatives held for trading (volume in asset and liability sides)
(DA+DL)/2 | |
| 9. Derivatives held for hedging purposes (volume in asset and liability
sides) (DH). | |
| Results show that net loans to customers
(1), activities at amortized cost (3) and assets held at fair value (6) explain
most of the RWAs (and hence of the MCRs). | |
| Results are controlled for time effects and
for individual bank effects, making use of robust estimation methods. The
effects of the introduction of Basel 2.5 regulation were also tested by
introducing time dummies for the period before 2011. The only significant
change which can be detected based on available data is an increase in the
coefficient for available for sale assets. | |
| Table 2: Resulting coefficients as estimated under current regulation (Basel 2
till 2010, Basel 2.5 in 2011) for the panel analysis linking RWAs to balance
sheet composition. All EU27 countries. [20] | |
| || LB || NCL || AMZ || HTM || AFS | |
| || Net loans to banks || Net loans to customers || Assets held at amortized cost || Sec. held to maturity || AFS assets[21] | |
| || (1) || (2) || (3) || (4) || (5) | |
| RWA coefficient || .18 || .52 || .31 || .25[22] || .39 | |
| t-statistic[23] || 1.44 || 8.04*** || 2.98*** || 0.28 || 2.75*** | |
| Source:
SNL database and JRC estimates | |
| || FV || (TSA+TSL) / 2 || (DA+DL) / 2 || DHV | |
| continue || Assets held at fair value || Sec. held for trading || Derivatives held for trading || Derivatives held for hedging purposes | |
| || (6) || (7) || (8) || (9) | |
| RWA coefficient || .23 || .198 || .048 || -1.95 | |
| t-statistic || 1.06 || 1.86** || 2.75*** || -3.64*** | |
| Note: 183 units[24], 923 observations. St.
Errors adjusted for 183 clusters. | |
| 4. Determining the assets and income items to be assigned to each
activity line
4.1
Balance sheet split between activity lines and
determination of the MCRs | |
| Having obtained the average weight or
density of each balance sheet item, in order to obtain the MCRs corresponding
to deposit taking and trading activities, it is necessary to (i) attribute each
element of the balance sheet to one of the two lines of activity, (ii) predict
the RWAs of each activity based on the weights above and then (iii) estimate
the MCRs based on a regulatory scenario.[25] | |
| The first step to estimate the MCRs is
therefore to classify balance sheet items as belonging to one activity line or
the other. As there is no clear-cut definition for these two lines of
activities either in literature or in current regulatory practice, we propose
the following methodology: | |
| 1) securities held for trading and derivatives held for trading, (i.e.
classes (7) and (8) in Table 2) are classified as trading
activities; | |
| 2) classes (1) to (6) are classified as commercial activities[26] | |
| 3) class (4) coefficient is not significant so this class is not
considered (i.e. the coefficient is set to zero); | |
| 4) derivatives held for hedging purposes (class (9)) are allocated
between the two lines of activities proportionally to total RWAs computed based
on classes (1) to (8). | |
| Based on this allocation, predicted RWAs
are calculated for each year and for each bank according to the coefficients
obtained in the econometric model. | |
| Predicted RWAs are not however directly
used in the rest of the analyses. Instead, predicted RWAs for each of the
activities are re-normalized to sum to the RWAs as reported in the balance
sheet.[27] | |
| These predicted and re-normalized RWAs
reflect an allocation of RWAs between activities under Basel 2 and Basel 2.5
rules. The ratio of predicted RWAs for Deposit Taking Banking activities to
total predicted RWAs is hereafter termed βBasel II. The value
(1- βBasel II) instead represents the ratio of predicted RWAs
for the trading activity. | |
| In addition to this re-normalization, RWAs
can also be corrected to obtain counterfactual scenarios reproducing the
impacts of introducing Basel III rules, which allows to better understand
whether Basel III could contribute to shift any incentive towards trading activities
which might be found under current regulation. These correction factors are
obtained from the Basel III Quantitative Impact Study exercise conducted by EBA
(see Appendix E for details).[28] | |
| MCRs are obtained based on these normalized
RWAs by multiplying them by the Capital Adequacy Ratio appropriate for each
regulatory scenario (e.g. 8% for Basel II and 10.5% for Basel III). | |
| Finally, as the definition of eligible
capital will also be changing under Basel III, also MCRs can be corrected under
some regulatory scenarios, to reflect that current rules admit as capital a set
of instruments which will not be recognized as eligible capital under future
regulation. In this way a uniform baseline is assured to compare incentives and
capital adequacy across regulatory regimes. Also these correction factors are
obtained from the EBA Basel III Quantitative Impact Study (see Appendix E for
details).[29] | |
| An overview of the regulatory scenario used
in the rest of the analysis are presented in the following tables: | |
| Table 3: Scenarios for assessing the effectiveness of minimum capital
requirement allocating the minimum capital requirement to deposit taking or
trading activity. α, βbasel II and βbasel III
represent receptively the share of assets or RWA computed under Basel2 or Basel
3 scenario. | |
| || || MCR | |
| Basel 2 scenario || Deposit taking (DTB) || | |
| Trading (TE) || | |
| Basel 3 scenario || Deposit taking (DTB) || | |
| Trading (TE) || | |
| Basel 3 scenario || Deposit taking (DTB) || | |
| Trading (TE) || | |
| Table 4: Scenarios for
assessing the effectiveness of equity allocating the minimum capital
requirement to deposit taking or trading activity. α, βbasel II
and βbasel III represent receptively the share of assets or RWA
computed under Basel2 or Basel 3 scenario. | |
| || || Equity (approximated by actual total regulatory capital, B3 def) | |
| Basel 2 scenario || Deposit taking (DTB) || | |
| Trading (TE) || | |
| Basel 3 scenario || Deposit taking (DTB) || | |
| Trading (TE) || | |
| Basel 3 scenario || Deposit taking (DTB) || | |
| Trading (TE) || | |
| Table 5: Total assets in the various regulatory scenarios. | |
| Activity || Regulatory scenario || Total Assets (TA) | |
| Deposit taking (DTB) || Basel 2 || α TA | |
| Deposit taking (DTB) || Basel 3 || α TA | |
| Trading (TE) || Basel 2 || (1-α) TA | |
| Trading (TE) || Basel 3 || (1-α) TA | |
| Note: α represents the share of assets
that are attributed to deposit taking activities. See details in Appendix B. | |
| Source: SNL and JRC
estimates. | |
| 4.2
Income statement split between activity lines | |
| SNL income statement data are used to
estimate the net income per line of activity. Based on the definitions of
trading activities introduced in the previous section, each income statement
item is allocated to each activity either fully or according to a set of
proportionality rules, as fully detailed in Appendix B. | |
| The following rules are used in the income
allocation procedure:[30] | |
| The revenue from
all loans, securities Held To Maturity, Assets held at Fair Value, securities
Available For Sale are allocated to deposit taking activities;
Commissions on
Loans and credit cards are allocated to deposit taking activities;
The revenue
attributed to securities and derivatives Held For Trading are completely
allocated to trading activities;
Taxes are not
considered (i.e. pre-tax income is considered), as well as non-recurring
expenses, non-recurring revenues and insurance incomes
Some comprehensive
income elements are included,[31] especially unrealized variations of value of Available For
Sale securities (which are allocated to deposit taking activities together
with realized gains, as detailed above)
The part of the
revenues or the expenses that are not linked to any of these two
activities is split proportionally to the respective shares of assets or
funding (see Appendix B for details on how funding costs are allocated).[32] | |
| This set of
rules allows us to completely allocate all gross recurring income excluding
insurance income, as well as some comprehensive income elements, to the two
lines of activity. | |
| Missing data on
sub-items of the income statement hierarchy were considered as zeros. | |
| Appendix B
offers a decomposition of the differences between the sum of the incomes
allocated to the two activities and the net profit presented in the balance
sheets. | |
| Due to the
impossibility of precisely allocating operational expenses and funding costs,
this methodology could underestimate net incomes from deposit taking activities
in favour of income from trading activities. The robustness of the core results
has therefore been tested by repeating the analysis without considering
operational expenses: this leads to a limited convergence of the two series.[33] | |
| 5. Results | |
| 5.1 Total Assets, RWAs, RWA densities and Returns on Assets per line
of activity | |
| Based on the definitions presented in the
previous section and on the results of the panel analysis, Total Assets, Risk
Weighted Assets and MCRs for trading and deposit taking activities can now be
computed under each regulatory scenario. | |
| Estimates of Total Assets, RWA densities
(i.e. the ratio RWA/TA) and MCRs for the two lines of activities are obtained
for each bank and each year between 2006 and 2011 and for each scenario. | |
| Results in this section refer to both the
“candidates sample” (termed the “Output sample” in the first parts of this
section) for the part illustrating the allocation of assets and Risk Weighted
Assets, and only to the “candidates sample” for the part looking at Returns on
Minimum Capital Requirements. | |
| Figures 1 and 2 provide a graphical
representation on how the shares on total assets of the trading and deposit
taking activities and of their associated RWAs change when moving from the
Candidates sample (right plots) to Rest of the sample (left plots).[34]
In the plots, the central line of the boxes are the median value, the edges are
the 25th and 75th percentiles, the whiskers extend to the most extreme data
points not considered outliers.[35] | |
| Figure 1 shows that banks that are selected
as candidate for structural separation in the calibration exercise tend to have
a lower amount of deposit taking activities assets and/or RWAs. This figure
also underlines the fact that the shares of RWAs (red boxplots) which are
assigned to the deposit taking activity are always higher than the share of
underlying assets which can be classified as “deposit taking activities” by the
corresponding definition (blue boxplots). | |
| Figure 1: Variation of the shares of assets or
risk-weighted-assets for the deposit taking activity | |
| Source: SNL database and JRC estimates | |
| Figure 2: Variation of
the shares of assets or risk-weighted-assets for the trading activity | |
| Source: SNL database and JRC estimates | |
| Figures 3 and 4 show how the dispersion of
RWA densities differs for deposit taking and trading activities, and how it
varies across years and how the implementation of Basel 3 should allow to lower
this difference. These graphs again illustrate how the risk weighted assets
allocated to trading per unit of assets are consistently lower than the risk
weighted assets allocated to deposit taking activities’ per unit of assets. | |
| We observe a decrease in the overall RWA
density starting in 2006 for banks which get selected as candidates for
separation in both deposit taking and trading activities. For banks that are
candidate for separation the median RWA density of deposit taking activities
lies between 40 and 50% for all years. For trading activities, the level of RWA
on total assets remains low, under 20%, for almost all banks selected for
structural separation and for all years.[36] | |
| Figure 3: share of RWA on TA for trading activities, deposit taking activities
and for the whole bank, RWA is computed based on Basel II definition | |
| | |
| Source: SNL database and JRC estimates | |
| Figure 4: share of RWA on
TA for trading activities, deposit taking activities and for the whole bank,
RWA is computed based on Basel 3 definition | |
| Source: SNL database and JRC estimates | |
| Figure 5 shows how Basel 3 regulation,
represented by our scenario Basel 3, has allowed increasing the RWAs associated
to trading activities relative to underlying assets. It is possible to observe
the shift of scatterplot towards the x=y line, going from the Basel 2 scenario
(left plot) to the Basel 3 scenario (right plot), which shows that RWA density
of trading activities increased more than the RWA density of deposit taking
activities: the cloud of dots (either black from the Candidates sample or blue
dots from the rest of the sample) shifts to the right on the right figure. | |
| Figure 5: Plot of the
share of RWA over TA when changing the definition of RWA, which can be computed
based on Basel II (left) or Basel III definition (right) | |
| Source: SNL
database and JRC estimates | |
| Figure 6 presents the evolution of the ROA
for trading and for deposit taking activities for the 29 banks of the
“candidates sample”. [37] By observing the figure it seems possible to conclude that: | |
| Deposit taking
activities seem less profitable per unit of nominal value compared to
trading,
In 2008, when
extreme losses were incurred, deposit taking activities performed
similarly to trading activities for banks proposed for structural reform,
However ROA on
trading appears to be both much larger on average and much more volatile. | |
| It should be kept in mind that, as the
income split between trading and deposit taking activity doesn’t include
non-recurring expenses, non-recurring revenues and insurance, the item ‘ROA for
the whole bank’ and ‘ROA from Balance Sheet’ are different as the difference
between the orange line (representing the whole bank, as the sum of both
trading and deposit taking activity) and light blue line (ROA from Balance
Sheet) show. A decomposition of the differences due to the definitions used to
calculate the balance sheet income and the income used in this analysis is
presented in Appendix B. | |
| Figure 6: Average income / total assets for
trading activity, deposit taking activity, for the whole bank (summing trading
and deposit taking activity as estimated according to the methodology used for
this report) and based on public data information for the 29 banks of
Candidates sample. The average is weighted on banks' total assets. | |
| Source: SNL
database and JRC estimates | |
| 5.3 Income per unit of MCRs or Regulatory
Capital per line of activity | |
| To assess if existing regulation on MCRs
encourages banks to prefer trading activities to credit activities, the Return
On Minimum Capital Requirement (ROMCR) of the two classes are compared: | |
| vs | |
| , | |
| where t labels the various years. | |
| Income for the two classes is estimated
using data from the financial statements of banks reclassified according to the
SNL template, as detailed in Appendix B. MCRs are estimated as detailed in
sections 2 to 4. The comparison is performed under each regulatory scenario
introduced in Table 3.[38]
Results are always expressed as a weighted average, weighted over the total
assets of the banks. Figure 7 and Figure 8 show the evolution over time of the
average ROMCR for each activity under each scenario for the banks in the
candidates sample. | |
| From the figure it seems possible to
observe that: | |
| The recent and
current regulatory framework seems to provide incentives to banks to
prefer trading with respect to deposit taking activities, as the ratio of
income per unit of MCR in trading seems always much higher than in deposit
taking activities (the exception is 2008 which could be considered as a
very critical year given the economic outlook).
Under Basel 3 the
difference would be reduced but it could still on average be not
negligible.
It can also be
observed that, especially under the Basel II scenario, the average ratios
for trading activities exhibit a much higher volatility than deposit
taking activities. | |
| For comparison purposes, a proxy of a
Return on Equity measure is also calculated in Figure 9 and Figure 10. This
measure is calculated by using actual balance sheet regulatory capital
(eventually including a correction for changes in the definitions of capital
when moving from Basel II to Basel III) as a proxy for equity, and allocating
it to the two lines of business proportionally to estimated RWAs.[39] | |
| Figure 7: Average income /MCR by type of activity and by regulatory scenario for
the candidates sample of 29 banks. MCR refer to estimated minimum capital
requirements. The average is weighted on banks' total assets. , while RegCap is
a proxy for return on equity based on total balance sheet regulatory capital
(corrected for changes in capital definition) | |
| Source: SNL
database and JRC estimates | |
| Figure 8: Zoom on Figure 7: average income / MCR
by type of activity and by regulatory scenario based on balance sheet
information) for the Candidates sample. The average is weighted on banks' EU
total assets. | |
| Figure 9: Average income / Equity by type of activity and by regulatory scenario
for the candidates sample of 29 banks. RegCap is a proxy for return on equity
based on total balance sheet regulatory capital (corrected for changes in
capital definition). . The average is weighted on banks' EU total assets. | |
| Source:
SNL database and JRC estimates | |
| Figure 10: Zoom on figure 9: average income / Equity by type of activity and by
0regulatory scenario for the Candidates sample which corresponds to the 29
banks proposed for further investigation for structural reform. The average is
weighted on banks' EU total assets. | |
| 6. Conclusions | |
| Based on the available data, and subject to
the caveat that the division of activities and of risk weighted assets between
trading and deposit taking activities is subject to a degree of uncertainty,
results of JRC preliminary analyses show for the banks that are part of the EBA
list for capital exercise: | |
| ü Possible existence of an incentive towards trading activities | |
| Current regulation
appears to provide incentives to banks to prefer trading activities to
deposit taking activities due to differences in returns on minimum capital
requirements on the two activities.
Results indicate
that even moving to Basel III MCRs could still not eliminate this effect. | |
| ü MCR adequacy | |
| Based on the
definition of trading activities adopted, estimated MCRs for trading
activities under current rules do not seem to allow absorbing net losses
stemming from trading in crisis periods (2008), while estimated MCRs for
deposit taking activities appear to allow covering net losses stemming
from them more fully
The analysis
confirms that the introduction of Basel 2.5[40] rules
in 2011 at least partially achieved the goal of substantially increasing
the MCRs for some activities. | |
| Appendix A:
Panel analysis to estimate risk weighted assets for deposit taking and trading
activities | |
| Given both the cross-sectional and temporal
dimensions of the problem we implement a set a panel regressions with the aim
of identifying the model that best and parsimoniously describes the data. | |
| Given both the cross-sectional and temporal
dimensions of the problem we implement a set a panel regressions with the aim
of identifying the determinants of Risk Weighted Asset (RWA). | |
| RWA for a generic bank i at given time t is
explained by the following set of covariates: Total Loans to Banks (LB), Net
Customer Loans (NCL), Securities (excluding loans) held at amortized value
(AMZ), Securities Held to Maturity (HTM), Available For Sale securities
(excluding loans) (AFS), Securities held at Fair Value (FV), Securities
(excluding loans and derivatives) Held For Trading as Assets or Liabilities
(TSA+TSV)/2, Derivatives Held For Trading as Assets or Liabilities (TDV),
Derivatives held for Hedging purposes as Assets or Liabilities (DHV) and an
interaction dummy for the period before 2011 (B2dum) representing the use of
Basel 2 rules, as opposed to Basel 2.5 rules from 2011. The sample covers a
total of 215 European banks of various size and typology from 2006 to 2011. The
panel is balanced. The type of regressions we use is panel data model of the
form: | |
| (1) | |
| where the represents
the unobserved effect that is peculiar of the i-th bank, and are
the error terms that we assume to be independent and identically distributed
Gaussian random variables uncorrelated with the regressors at any lead and lag
and across units. Model parameters are estimated by the fixed-effect estimator
assuming that all regressors are uncorrelated with the errors and the fixed effects,
i.e. .
As there is some evidence of heteroskedasticity, we employ robust standard
errors (cluster method) in the estimation. | |
| Alternative regressions have been tested to
check for the presence of effects of the introduction of Basel 2.5 rules on
other coefficients, and to test for alternative variable definitions. The only
coefficient that seems significant and shows the correct (i.e. expected on the
basis of economic theory) is the coefficient for AFS, which is retained. In
some of these models, we could note the presence of barely significant
coefficients with positive sign on assets held at fair value and with negative
sign on derivatives held for hedging, representing an indication that weights
assigned to these categories in the risk management process could have been
lowered (i.e. more negative for hedging) after the crisis, either due to asset
reorganization or due to risk weights optimization. These results point in an
interesting direction but the effects would need to be confirmed with further,
more sophisticated analyses. It should also be noted that in some versions of
the model also the coefficients for trading securities excluding loans and
derivatives appears to increase after 2011, however in order to keep that
coefficient as significant, it would be necessary to allow the post-2011
coefficients for derivatives to drop considerably and the coefficients on FVA
to become not significant. We therefore repute these models not fully supported
by both theory and data and discard them. | |
| Alternative designs included considering
the breakdown of loans by asset holding classification (i.e. at amortized cost,
at fair value, for trading …), the use of net exposures in trading activities,
with or without sign, and the inclusion of additional elements from the
liability side. None of the models which could be justified based on economic
grounds proved to be satisfactory in statistical terms. | |
| All regressions include year dummies to
control for fixed time effects. Models with interactions of single year time
effects and the regressors were tested and rejected. | |
| Results for the preferred model are
reported in Table 6. The
t-statistic is defined as the ratio between the coefficient and its standard error,
the p-value is the probability of observing by chance a test statistic which is
at least as extreme as the one observed, under the null-hypothesis that the
coefficient is equal to zero. | |
| Table 6: Estimates for the unrestricted fixed-effect
model (1) - 50 parameters | |
| || || || || || || || || || || | |
| Coeff. || .18 || .52 || .31 || .25 || .39 || .-19 || .23 || 0.198 || 0.048 || -1.95 | |
| t-stat || 1.44 || 8.04 || 2.96 || 0.28 || 2.75 || -2.52 || 1.06 || 1.86 || 2.75 || -3.64 | |
| Number of observations: 923 in 183 groups Std. Error adjusted for 183 clusters | |
| R-squared: within = 0.72 Between = 0.96 Overall = 0.95 || Corr(ui, Xb) = 0.76 | |
| Rho (fraction of variance due to ui) = .91 | |
| Notice that the effect of HTM is completely
not significant according to the t-statistic. | |
| The magnitude of fixed time effects is
extremely small compared to fitted values. Individual fixed effects are very
small to small in the vast majority of cases. | |
| The model has an extremely high R-squared,
this is in part to be expected due to the fact that we know that the dependent
variable is obtained based on calculations including the regressors or some of
their combinations. | |
| It should also be noted that the model is
not intended to check the relationship between the risk weights and underlying
risk factors, but has the more limited aim of predicting (in-sample) the value
of RWA based on the composition of the balance sheet. | |
| Appendix B: Estimation of the returns for
the two business lines | |
| This appendix reports the criteria used to
allocate the revenue between deposit taking and trading activities. | |
| The allocation of the revenue is based on
income statement public data as reported in the commercial database SNL[41],
based on template data. | |
| The definition of income used in this
report differs from net profits as reported in the SNL balance sheet template
in the following ways:[42] | |
| 1.
Income is based on pre-tax income definition | |
| 2.
non-recurring expenses and nor non-recurring
revenues are excluded | |
| 3.
insurance incomes are excluded | |
| 4.
unrealized gains and losses (an element of
comprehensive income) are included | |
| The main criteria used in the allocation
are that: | |
| 1.
the revenues from loans and HTM securities are
always attributed to the deposit taking activity. | |
| 2.
Securities held at fair value and securities
available for sale are always counted to the deposit taking activities income
as well.[43] | |
| 3.
Trading revenue of the bank mainly comes from
securities and derivatives held for trading. | |
| 4.
The part of the revenue or expense that is not
directly attributed to one of these activities is proportionally attributed
based on the allocation of assets (for income) or of liabilities (for expenses)
of each type of activity (trading or deposit taking). Applying this
proportionality to net-interest income and to the fees and commissions, we
implicitly assume that the interest rate expense and revenue on deposit taking
or trading activities’ assets are equivalent. [44] | |
| Table 7 below
illustrates the procedure in more detail | |
| Table 7: Split of net income between trading
and deposit taking activities based on SNL classification for definition 1 and
2. Income not directly assigned to one type of activity is split based on the
share of assets (α) or liabilities (Φ) assigned to each activity. | |
| Level || Income Statement || Rule for repartition between activity | |
| 1 Operating income | |
| 1.1 || Net interest income || | |
| 1.1.a || Interest income || | |
| 1.1.a1 || Interest Earned on Customer Loans || Comm. Bk | |
| 1.1.a2 || Interest Earned on Trading Assets || Trading | |
| 1.1.a3 || Rest of Interest Income[45] = 1.1.a – 1.1.a1 – 1.1.a2 || α | |
| 1.1.b || Interest Expenses || | |
| 1.1.b1 || Interest Expenses on Customer Deposits || Comm. Bk | |
| 1.1.b2 || Interest Expenses on Trading Assets || Trading | |
| 1.1.b3 || Rest of Interest Exp. = 1.1.b – 1.1.b1 – 1.1.b2 || Φ | |
| 1.2 || Net fee & commission income || | |
| 1.2.a || Deposits and Loans fees || Comm. Bk | |
| 1.2.b || Credit card income || Comm. Bk | |
| 1.2.c || Investment banking fee || Trading | |
| 1.2.d || Rest of Net fee & Com.= 1.2 – 1.2.a – 1.2.b – 1.2.c || α | |
| 1.3 || Net trading income || | |
| 1.3.a || Net gain on securities held for trading || Trading | |
| 1.3.b || Net gain on securities held at fair value || Comm. Bk | |
| 1.3.c || Realised gain on securities || Comm. Bk | |
| 1.3.d || Other net gain on securities || α | |
| 1.4 || Other operating income[46] || α | |
| 2 Operating expense || α | |
| 3 || Assets write-downs || | |
| 3.1 || Loans and credit commitment impairments || Comm. Bk | |
| Level || Income Statement || Rule for repartition between activity | |
| 3.2 || Impairment on securities || | |
| 3.2.a || AFS financial assets impairment || Comm. Bk | |
| 3.2.b || Held to maturity financial assets imp. || Comm. Bk | |
| 3.2.c || Other financial assets impairment || α | |
| 3.3 || Impairment on non-financial assets || α | |
| 4 || Total other comprehensive income || | |
| 4.1 || Change in Unrealised Gain || Comm. Bk | |
| 4.2 || Change in FV of Effective Hedge || α | |
| 4.3 || Change in Foreign currecny ex || α | |
| 4.4 || Other comprehensive income || α | |
| The revenue of deposit taking activities
has thus been estimated as: | |
| Interest Earned on Customer Loans (1) | |
| - Interest Expenses on Customer Deposits | |
| +Deposits and Loans fees | |
| +Credit card income | |
| + Net gain on securities held at fair value | |
| +Realised gain on securities | |
| - Loans
and credit commitment impairments | |
| - AFS financial
assets impairment - held-to-maturity financial assets imp. | |
| + change in unrealized gain | |
| -Φ *Sum of expenses to be split along phi as
defined in eq. (3) | |
| +α *Sum of income to be split along alpha as
defined in eq. (6) | |
| where | |
| α is the
proportion of the retail assets over total assets as detailed in equation (4) , | |
| Φ is the
proportion of the retail funding over total liabilities as detailed in equation
(7) | |
| Income issued from AFS and held to maturity
securities are always completely in the income of deposit taking activities. | |
| The revenue of trading activities has been estimated as: | |
| Interest Earned on
Trading Assets (2) | |
| - Interest Expenses on Trading Assets | |
| + Net gain on securities held for trading | |
| - (1-Φ) *Sum of expenses to be split along phi as
defined in eq. (3) | |
| + (1-α) *Sum of income to be split along alpha as
defined in eq. (6) | |
| where | |
| (1-α) is the
proportion of the trading assets over total assets as detailed in equation (4), | |
| (1-Φ) is the proportion
of the trading funding over total liabilities as detailed in equation (7) | |
| The net gain issued from securities held
for trading is completely included as trading income. | |
| All remaining voices correspond to income
that shall be distributed between trading and deposit taking activities based
on the repartition of the underlying assets, RWA or liabilities. | |
| The remaining voice linked to expenses will
be split between trading and deposit taking activities based on the repartition
of the related funding Φ. It includes only | |
| Interest
Expenses excluding the part already computed in eq(1) and (2). (3) | |
| These expenses are split between deposit
taking (Φ) or trading activities (1- Φ) based
on the share of funding / liabilities repartition between these two activities
as followed. | |
| γ corresponds to the part of
liabilities assigned to deposit taking activities and equals to | |
| a * total assets
– customer deposits . | |
| total debt + banks
deposits + non-financial liabilities+ derivitatives id. as +hedges+ equity (4) | |
| We can compute the share of funding Φ
for deposit taking activities | |
| Φ = (cust deposits + γ (debt + bank deposits + derivatives
id. as negative hedges) | |
| financial
liabilities (5) | |
| The remaining voices not linked to expenses will be split between trading and
deposit taking activities based on the repartition of the related assetsa. They include: | |
| Interest Income excluding Interest Earned on Customer
Loans or on Trading Assets (6) | |
| + Net fee &
commission income not yet considered in (1) or (2) | |
| - Operating
expense | |
| -Other financial assets impairment -
Impairment on non-financial assets | |
| +Change in FV of Effective Hedge | |
| +Change in Foreign
currency ex | |
| +Other
comprehensive income | |
| where | |
| a = net loans
to customers/banks + sec. held at maturity or at fair value+ amortized cost
sec. | |
| financial assets- cash at central bank – derivatives
identified as positive hedges (7) | |
| It should be noted that the implementation
of some of the formulas that use more detail from balance sheet present
problems due to data missigness even for some large banks. Missing data are
imputed as zeros for the purposes of the calculations presented here. | |
| In order to make comparison with
performance indicators from the balance sheet such as ROAE or ROAA, figure 11
presents a decomposition of the differences between Net profit as presented in
the balance sheet and the sum of the incomes allocated to trading and deposit
taking activities used for the purposes of this study. In this decomposition,
items which are are not included in net profit (as defined in the SNL template)
but are included in our custom definition are termed “extra income items”;
items which are included in the calculation of net profit, but are ignored for
the purposes of our definition are termed “missing income items”. | |
| Also they have been no imputation of
missing values, the respective amount of income is not considered if the value
is missing. The voices of income that we have used are sometimes deep in the
income hierarchy detail and thus for some bank some missing values can be
observed. In this case, we assume missing values are 0. | |
| Figure 11: Representation
of the difference between the sum of net profit summing TE and CBT income and
net profit for 2011 only from the income statement based on the 29 banks of our
sample. Incomes are profited in Bio €. Area in Blue represent positive value
and in orange are provided negative values. | |
| In absolute value over the sample, the net
income diminished from 3’477 Bio EUR which correspond to 8% of the summed
income from TE and CBT. This is an overall figure and some individual banks can
present larger differences. | |
| Appendix C: Candidates sample[47] | |
| This appendix describes the Candidates
sample: the 29 banks have been selected as potential candidates for structural
reform as presented in the Commission Staff paper “Trading activities and
functional structural separation: possible definitions and calibration of a de
minimis exemption rule”[48]
| |
| The list of banks is presented in the
following table. | |
| Table 8: List of banks considered in the Output Sample sample used
for this section. | |
| Deutsche Bank || Groupe BPCE || LB Baden-Württemberg || Swedbank | |
| HSBC Holdings || ING Bank || Bayerische LB || Portigon | |
| BNP Paribas || UniCredit || KBC Group || HELABA | |
| Crédit Agricole Group || Nordea || Handelsbanken || DekaBank | |
| Barclays || Commerzbank || DNB || Mediobanca | |
| RBS Group || Danske Bank || SEB || | |
| Santander || Standard Chartered || Monte dei Paschi Siena || | |
| Société Générale || DZ-bank || Belfius || | |
| Table 9:
Summary by bank of the allocation of assets between trading (TE) and
commercial banking (DTB) activities under Basel II or Basel III scenario for
2011 | |
| Institution Name || || Share Business in EU || Total EU Assets (€000) || RWA / TA || a = TADTB/ TA || GrpQIS[49] || RWADTB / RWA (B2) || RWADTB/ RWA(B3) || RWADTB(B2) / TADTB || RWATE(B2)/ TATE || RWADTB/ TADTB (B3) || RWATE/ TATE (B3) | |
| Deutsche Bank || DE || 79.31% || 1,716,350 || 18% || 45% || 1 || 83% || 73% || 33% || 5% || 35% || 10% | |
| HSBC Holdings || GB || 41.05% || 807,780 || 47% || 77% || 1 || 92% || 83% || 57% || 16% || 62% || 42% | |
| BNP Paribas || FR || 87.57% || 1,720,998 || 31% || 56% || 1 || 85% || 75% || 47% || 11% || 51% || 21% | |
| Crédit Agricole Group || FR || 97.74% || 1,837,058 || 28% || 73% || 1 || 94% || 84% || 36% || 6% || 39% || 20% | |
| Barclays || GB || 56.34% || 1,053,412 || 25% || 52% || 1 || 88% || 78% || 42% || 6% || 45% || 14% | |
| RBS Group || GB || 77.96% || 1,406,125 || 29% || 53% || 1 || 86% || 76% || 47% || 9% || 50% || 18% | |
| Santander || ES || 77.81% || 973,410 || 45% || 85% || 1 || 97% || 87% || 52% || 10% || 56% || 46% | |
| Société Générale || FR || 90.11% || 1,064,534 || 30% || 62% || 1 || 87% || 78% || 42% || 10% || 45% || 21% | |
| Groupe BPCE || FR || 97.10% || 1,105,382 || 34% || 85% || 1 || 97% || 87% || 39% || 7% || 42% || 36% | |
| ING Bank || NL || 85.38% || 820,643 || 34% || 90% || 1 || 97% || 88% || 37% || 9% || 41% || 50% | |
| UniCredit || IT || 93.54% || 854,551 || 50% || 86% || 1 || 97% || 88% || 57% || 9% || 62% || 54% | |
| Nordea || SE || 87.70% || 628,111 || 26% || 67% || 1 || 92% || 82% || 36% || 6% || 39% || 17% | |
| Commerzbank || DE || 97% || 642,506 || 36% || 75% || 1 || 95% || 85% || 45% || 7% || 49% || 26% | |
| Danske Bank || DK || 99% || 458,252 || 26% || 71% || 1 || 93% || 83% || 35% || 6% || 38% || 19% | |
| Standard Chartered || GB || 100% || 456,368 || 46% || 86% || 1 || 97% || 88% || 52% || 9% || 57% || 47% | |
| DZ-bank || DE || 100% || 405,926 || 25% || 84% || 1 || NA || NA || NA || NA || NA || NA | |
| LB Baden-Württemb. || DE || 100% || 373,069 || 29% || 71% || 1 || 90% || 81% || 37% || 10% || 40% || 23% | |
| Bayerische LB || DE || 100% || 309,172 || 38% || 84% || 1 || 97% || 88% || 45% || 6% || 49% || 35% | |
| Institution Name || || Share Business in EU || Total EU Assets (€000) || RWA / TA || a = TADTB/ TA || GrpQIS[50] || RWADTB / RWA (B2) || RWADTB/ RWA(B3) || RWADTB(B2) / TADTB || RWATE(B2)/ TATE || RWADTB/ TADTB (B3) || RWATE/ TATE (B3) | |
| KBC Group || BE || 100% || 285,382 || 44% || 91% || 1 || 98% || 89% || 48% || 10% || 52% || 67% | |
| Handelsbanken || SE || 100% || 275,514 || 21% || 92% || 1 || 98% || 89% || 22% || 4% || 24% || 34% | |
| DNB || NO || 100% || 274,216 || 50% || 93% || 1 || 93% || 85% || 50% || 48% || 55% || 128% | |
| SEB || SE || 100% || 264,852 || 29% || 80% || 1 || 95% || 85% || 34% || 7% || 37% || 26% | |
| Monte Paschi di Siena || IT || 100% || 240,794 || 44% || 89% || 1 || 97% || 88% || 48% || 11% || 52% || 57% | |
| Belfius || BE || 100% || 232,509 || 23% || 84% || 1 || 98% || 88% || 26% || 3% || 29% || 21% | |
| Swedbank || SE || 100% || 208,464 || 27% || 86% || 1 || 96% || 87% || 30% || 7% || 33% || 30% | |
| Portigon || DE || 100% || 167,910 || 29% || 65% || 1 || 94% || 83% || 42% || 5% || 45% || 16% | |
| HELABA || DE || 100% || 163,985 || 35% || 75% || 1 || 90% || 81% || 42% || 15% || 45% || 33% | |
| DekaBank || DE || 100% || 133,738 || 19% || 70% || 2 || 89% || 87% || 24% || 7% || 25% || 8% | |
| Mediobanca || IT || 100% || 72,934 || 75% || 79% || 1 || 95% || 86% || 91% || 17% || 99% || 63% | |
| Source
: SNL and JRC estimates | |
| Table 10: Summary by bank of the return
on assets (ROA) or return on MCR (ROMCR) obtained after the split between
trading (TE) and commercial banking (DTB) entities for 2011 | |
| || Income || ROA || ROMCR | |
| Institution Name || Trading Income || Banking Income || DTB || TE || DTB + TE || ROAA (BalSht) || TE, B2 || TE, B3 || DTB, B2 || DTB, B3 | |
| Deutsche Bank || 7,432 || -275 || 0.62% || -0.03% || 0.33% || 0.21% || 218.2% || 57.2% || -1.7% || -0.8% | |
| HSBC Holdings || 10,672 || 5,686 || 2.33% || 0.38% || 0.83% || 0.65% || 286.6% || 53.3% || 12.6% || 5.8% | |
| BNP Paribas || -138 || 7,364 || -0.02% || 0.67% || 0.37% || 0.35% || -2.8% || -0.7% || 26.9% || 12.5% | |
| Crédit Agricole Group || 1,119 || -1,827 || 0.22% || -0.13% || -0.04% || 0.06% || 66.3% || 10.6% || -7.1% || -3.3% | |
| Barclays || 2,878 || -9,811 || 0.32% || -1.01% || -0.37% || 0.25% || 95.9% || 21.6% || -45.5% || -21.2% | |
| RBS Group || 5,038 || -4,099 || 0.60% || -0.43% || 0.05% || -0.13% || 129.1% || 31.6% || -17.3% || -8.0% | |
| Santander || 4,037 || 546 || 2.13% || 0.05% || 0.37% || 0.50% || 408.6% || 43.7% || 1.9% || 0.9% | |
| Société Générale || 3,878 || 597 || 0.87% || 0.08% || 0.38% || 0.24% || 168.8% || 39.8% || 3.7% || 1.7% | |
| Groupe BPCE || 2,532 || 1,286 || 1.51% || 0.13% || 0.34% || 0.28% || 388.2% || 40.4% || 6.5% || 3.0% | |
| ING Bank || -23,789 || 27,652 || -24.74% || 3.20% || 0.40% || 0.43% || -5014.3% || -471.8% || 163.8% || 74.7% | |
| UniCredit || 148 || -10,026 || 0.12% || -1.27% || -1.08% || -0.96% || 24.5% || 2.1% || -42.5% || -19.5% | |
| Nordea || -1,254 || 3,541 || -0.53% || 0.74% || 0.32% || 0.43% || -166.4% || -30.1% || 39.5% || 18.2% | |
| Commerzbank || 2,304 || -2,546 || 1.42% || -0.51% || -0.04% || 0.11% || 380.2% || 52.0% || -21.5% || -9.9% | |
| Danske Bank || 1,120 || -888 || 0.84% || -0.27% || 0.05% || 0.05% || 252.1% || 43.2% || -14.9% || -6.9% | |
| Standard Chartered || 1,740 || 1,903 || 2.66% || 0.49% || 0.80% || 0.87% || 574.7% || 53.3% || 17.9% || 8.2% | |
| DZ-bank || -237 || -308 || -0.36% || -0.09% || -0.13% || 0.15% || -4.5% || -2.0% || || -33.0% | |
| LB Baden-Württemb. || 1,308 || -1,514 || 1.21% || -0.57% || -0.06% || 0.02% || 225.1% || 49.0% || -29.8% || -13.7% | |
| Bayerische LB || 563 || 4 || 1.10% || 0.00% || 0.18% || 0.03% || 334.5% || 30.1% || 0.1% || 0.0% | |
| KBC Group || 53 || 2 || 0.20% || 0.00% || 0.02% || 0.02% || 37.2% || 2.9% || 0.0% || 0.0% | |
| Handelsbanken || -226 || 1,904 || -1.02% || 0.75% || 0.61% || 0.53% || -502.4% || -28.7% || 64.5% || 29.4% | |
| || Income || ROA || ROMCR | |
| Institution Name || Trading Income || Banking Income || DTB || TE || DTB + TE || ROAA (BalSht) || TE, B2 || TE, B3 || DTB, B2 || DTB, B3 | |
| DNB || 505 || 1,799 || 2.55% || 0.71% || 0.84% || 0.60% || 100.8% || 18.9% || 26.9% || 12.2% | |
| SEB || 498 || 970 || 0.95% || 0.46% || 0.55% || 0.49% || 240.9% || 35.1% || 25.6% || 11.7% | |
| Monte Paschi di Siena || 764 || 746 || 2.82% || 0.35% || 0.63% || -1.95% || 483.1% || 47.0% || 13.9% || 6.4% | |
| Belfius || 126 || -1,108 || 0.35% || -0.56% || -0.42% || -0.57% || 193.5% || 15.5% || -40.8% || -18.7% | |
| Swedbank || 403 || 1,194 || 1.34% || 0.67% || 0.77% || 0.66% || 351.2% || 43.2% || 42.8% || 19.6% | |
| Portigon || 958 || -350 || 1.62% || -0.32% || 0.36% || -0.03% || 591.2% || 93.5% || -14.8% || -6.8% | |
| HELABA || 498 || 13 || 1.24% || 0.01% || 0.31% || 0.24% || 162.1% || 35.7% || 0.5% || 0.2% | |
| DekaBank || 587 || -177 || 1.46% || -0.19% || 0.31% || 0.20% || 351.2% || 164.3% || -13.4% || -7.2% | |
| Mediobanca || 121 || 386 || 0.81% || 0.67% || 0.70% || 0.49% || 90.1% || 12.1% || 14.0% || 6.4% | |
| Source : SNL and
JRC estimates - extreme values obtained for ROMCR on
trading ING for 2006-2011 and Belfius for 2006-2010 made these banks dropped
from the figures of this document. | |
| Appendix D: Analysis of the MCR structure for the full sample of
banks | |
| The complete sample used for panel
regression contains 215 banks. The number of banks for which data are available
for the computation of the ROMCR is much lower and varies across the years, as
detailed in Table 11. | |
| Table 11: Evolution of the sample
size depending on data availability | |
| Year || 2006 || 2007 || 2008 || 2009 || 2010 || 2011 | |
| Number of banks used in the figures || 144 || 183 || 187 || 196 || 204 || 209 | |
| The below figures are using the whole
sample of banks and confirm the conclusions discussed in the main text that
focusing only on the EBA sample. | |
| Figure 12: Average income / Total Assets by type of activity: trading, deposit
taking or whole bank as computed and based on balance sheet information) for
the complete sample[51].
The average is weighted on banks' total assets. | |
| Source : SNL and
JRC computation | |
| Figure 13: Average income /MCR by type of activity and by regulatory scenario for
the candidates sample of 29 banks. MCR refer to estimated minimum capital
requirements. The average is weighted on banks' total assets. , while RegCap is
a proxy for return on equity based on total balance sheet regulatory capital
(corrected for changes in capital definition) | |
| Source : SNL
database and JRC estimates | |
| Figure 14: Zoom on Figure 7 : average income /
MCR by type of activity and by regulatory scenario based on balance sheet
information) for the Candidates sample. The average is weighted on banks' EU
total assets. | |
| Figure 15: Average
income / Equity by type of activity and by regulatory scenario for the
candidates sample of 29 banks. RegCap is a proxy for return on equity based on
total balance sheet regulatory capital (corrected for changes in capital
definition). . The average is weighted on banks' EU total assets. | |
| Source
: SNL database and JRC estimates | |
| Figure 16: Zoom on figure 9 : average income / Equity by type of activity and by
0regulatory scenario for the Candidates sample which corresponds to the 29
banks proposed for further investigation for structural reform. The average is
weighted on banks' total assets. | |
| Appendix E: Correction of RWAs | |
| To reflect the change in RWA following the
introduction of Basel III, QIS correction factors as of June 2011 are employed[52]. These changes are
taking into account the strengthening of regulatory capital both in quantity
and in quality imposed by Basel III. | |
| Adjustments to take into account the impact
due to the introduction of Basel 3 (CRDIV) on RWA, regulatory capital and
minimum capital requirements are implemented. These adjustments imply increased
RWA, a more strict definition of regulatory capital, and the introduction of
the Capital Conservation Buffer. Average EU results of the 2011 Quantitative
Impact Study (QIS) are employed for the adjustments, as detailed in the table
below. The changes are allocated between the DTB and the TE as described in the
next section. | |
| Table 10 - Average EU (weighted on
total assets) corrections for RWA and regulatory capital from EBA as of
30/06/2011 | |
| || G1 Banks || G2 Banks | |
| Relative Change in RWA for the whole bank (%) || 21.20 || 6.90 | |
| Relative Change in Regulatory capital for the whole bank (%) || -34.35 || -7.76 | |
| Source: EBA | |
| Note: In this exercise G1 - Tier 1 Capital > 3 bn€, G2 - Tier 1
Capital <3 bn€ | |
| The split Basel 2 RWAs are adjusted to take
into account future changes introduced by Basel 3 to RWA definitions and
requirements. The Basel 3 increase in the RWA is allocated based on a breakdown
of the changes in RWA published by EBA[53],
reported here in Table 10. In particular, the Table shows the part of the total
percentage increase in RWA due to: | |
| a) the change in
the ‘definition of capital’[54],
which is split proportionally to the share of total assets allocated to the TE
and the DTB. | |
| b) counterparty
credit risk, which is allocated to TE for the share due to Credit Valuation
adjustment (CVA) and to the DTB for the part due to the higher asset
correlation parameter included in the IRB formula. | |
| c)
securitization in the banking book, which is fully allocated to the DTB. | |
| d) to market
risk (including securitisation in the trading book) is fully allocated to the
TE. | |
| Table
11: EBA split of the increase in RWA due to Basel 3 (average
%-increase) | |
| Type || Total relative increase in RWA || Part due to definition of capital || CCR banking book || CCR trading book || Securitisation banking book || Trading book | |
| G1 || 21.2 || 7.9 || 1.2 || 6.9 || 1.0 || 4.2 | |
| G2 || 6.9 || 3.4 || 2.9 || 0.2 || 0.4 | |
| Source: EBA | |
| Results are presented in Table 12 both for Basel 2 and
for Basel 3. | |
| Table 12: Allocation of
total RWA between the TEs and the DTBs under Basel 2 and Basel 3 | |
| || Basel 2 || Basel 3 | |
| DTB || 91% || 79% | |
| TE || 9% || 21% | |
| The new Basel 3 definition of the quality
of capital affect both entities, thus the decrease in the regulatory capital is
split proportionally to the capital allocated to the two entities. For banks
with adjusted regulatory capital below 10.5% of RWA, the capital is topped up
to meet the Basel 3 minimum required capital including the capital conservation
buffer (10.5% RWA). | |
| Appendix F: ROA by line of activity and
relationship with ROMCR | |
| This appendix includes some further
formulas illustrating the relationships between ROA, ROE, ROMCR, RWA density,
leverage and the capital adequacy ratio. | |
| ROA and ROE are related as follows: | |
| | |
| Where: | |
| ROE – Return on Equity; | |
| E – Equity | |
| TA – Total assets | |
| - Leverage. | |
| ROA and ROMCR are tied by the following
relationship: [55] | |
| Where: | |
| –
Return on Assets | |
| –
Income as defined for the purposes of this report (see Appendix B) | |
| –
Total Assets | |
| –
RWA density | |
| –
Capital Adequacy Ratio (i.e. 8% currently or 10.5% under Basel III regulatory
scenarios) | |
| From the two relationships above, ROE is tied to ROMCR as follows: | |
| | |
| Where all symbols have the same meaning as above. | |
| | |
| Annex A6: Qualitative assessment of benefits and costs of separating
banking activities from deposit taking entities | |
| 1.
Introduction | |
| Separating banking
activities from deposit taking entities should address the problems highlighted
in Chapter 2 and should deliver the following social benefits: | |
| ·
Facilitate bank resolution and recovery; | |
| ·
Facilitate management, monitoring and
supervision; | |
| ·
Reduce moral hazard; | |
| ·
Reduce conflicts of interest; | |
| ·
Reduce capital and resource misallocation; and | |
| ·
Improve competition. | |
| At the same time,
separating banking activities from deposit taking banks may give rise to social
costs: | |
| ·
Foregone economies of scale and scope; and | |
| ·
Operational costs. | |
| This annex analyses in
more detail the social benefits and costs of separating specific banking
activities from a deposit entity. The assessment is largely qualitative, as
deciding which activities need to be separated will ultimately be a social and
economic issue that cannot be justified on the basis of calibrated and stylised
models. | |
| In determining the specific set of activities
that should be examined with a view to assess whether they should be subject to
separation, the Commission services have considered (i) the extent to which
losses related to an activity would impact a bank’s balance sheet; (ii) the
extent to which an activity gives rise to market or counterparty risk; (iii)
the importance and potential impact of the activity on systemic risk; (iv) the
customer-oriented nature and usefulness of an activity for financing the real
economy, and (v) the extent to which the banking activity resolves a market
failure (such as asymmetric information) in the economy. The application of
these criteria suggests a relatively narrow range of corporate and investment
banking activities that require further analysis: proprietary trading including
bank-owned hedge funds (PT/HF), market making (MM), underwriting (UW),
securitisation related activities (SEC), derivatives transactions, exposure to
private equity or venture capital funds (PE/VC), and lending to large
corporates (LLC). | |
| 2.
Proprietary trading | |
| Proprietary trading is
the purchase and sale of financial instruments for own account with the intent
to profit from subsequent price changes. Banks submitted evidence following the Commission public consultation confirming that (dedicated
desk) proprietary trading is currently a banking activity of minor importance
for many large EU banking groups (see Annex A11). This is consistent with
evidence reported for a number of EU Member States.[56] | |
| 2.1.
Social benefits of separating proprietary
trading | |
| Would separating
proprietary trading facilitate recovery and resolution? Proprietary trading potentially gives rise to large open positions
and counterparty risk (risk that the counterparty to the investment will fail
to pay), as well as interconnectedness between institutions. Correspondingly,
separating proprietary trading from the deposit entity will facilitate the
recovery and resolution of the separate entities. The potential opaqueness,
complexity, and interconnectivity of proprietary trading represent important
impediments to orderly and swift resolution. | |
| Would separating
proprietary trading reduce moral hazard? Proprietary
trading is an inherently risky banking activity that is by definition not
customer-oriented. It has the ability to produce “tail risk” or systemic risk
and is easily scalable (in comparison to more relationship-based activities
such as lending). Traders have the ability and incentive to take significant
risks, even without having access to liquidity (through short-selling positions).
Separating proprietary trading from the deposit entity allows shielding
depositors from this type of risk-taking. Reducing the cross-subsidies would
also help to re-align private and social interests. The increased funding cost
would reflect the inherent riskiness of the activity (although systemic risk
may still not be adequately reflected in the institution-specific funding
cost). As a result, moral hazard on behalf of the trading entity will be
reduced. | |
| Would separating
proprietary trading facilitate monitoring, management, and supervision? Increased market discipline on the trading entity will help the
supervision of the trading entity, even without factoring in the likely
reduction in proprietary trading that would result from its safety net alienation
and the enhanced market monitoring that should result from it. The nature of
proprietary trading hinders the ability of regulators, supervisors and bank
managers to properly understand and thereby calibrate the risks taken, in
particular tail risks. It is equally complex to apply the correct capital
treatment so that banks have sufficient resources to absorb losses if these
occur. Proprietary trading can also be a high-frequency activity that may
result in thousands of daily transactions. As a result, snapshots of the
positions of these activities may have limited predictive value for future
positions. Understanding and monitoring the risks is difficult, in particular
when management itself has difficulties in understanding and monitoring the
risks. Some of the “rogue trader” losses only became apparent at a late stage,
when they eventually could no longer keep accumulated losses hidden from their
internal control mechanisms.[57] | |
| Would separating
proprietary trading reduce conflicts of interest? Proprietary
trading is particularly prone to conflicts of interests because the bank in its
role of proprietary trader no longer is a service provider to its client, but
becomes a potential competitor and hence faces interests that are no longer
aligned with those of its clients. The bank can make improper use of
client-related information to increase its own profits. The commercial bank
department may have private information about the likely bankruptcy of a firm
it has granted a loan and may buy credit protection against the default of the
firm from the unsuspecting public, thereby reducing its own credit risk. | |
| Would separating
proprietary trading reduce capital and resources misallocation? The traditional raison d’être of deposit-taking banks is to be a
financial intermediary between savers and investors (and thereby competing with
capital markets that play a similar role). In comparison to capital markets,
who intermediate more directly between savers and investors, deposit-taking
banks are relatively good at (i) monitoring and knowing their customers, i.e.
resolving information asymmetries, (ii) providing insurance against
idiosyncratic liquidity risks faced by households and firms, (iii) pooling
risks efficiently, and (iv) performing risk-return tranching services to
customers. None of these roles is fulfilled by proprietary trading. Therefore,
as proprietary trading activities benefit from the implicit subsidy even though
they do not fit in the traditional role of banks, capital and human resources
are being misallocated to the extent that they are put at work in proprietary
trading rather than in engaging in loan making and other core banking services
(or even other activities beyond the banking sector). Banks would no
longer have an incentive to over- expand their proprietary trading activities. | |
| Would separating
proprietary trading impact on competition? Given
that implicit subsidies to proprietary trading activities would be reduced with
separation, there would be a beneficial impact on competition amongst banks.
However, the impact will be proportional to the relatively limited importance
of proprietary trading. | |
| 2.2.
Social costs of separating proprietary trading | |
| Would separating
proprietary trading lead to a loss of efficiencies? Separating proprietary trading is unlikely to lead to significant
social costs. In fact, as argued above, proprietary trading can be characterised
by diseconomies of scope such as excessive complexity, conflicts of
interest, excessive risk taking and interconnectedness which can lead to higher
systemic risk. Genuine economies of scope related to risk diversification
cannot be excluded but are likely to be small, given the limited importance of
the activity. Also there may be some cost economies of scope if proprietary
trading is subsidiarised as a stand-alone activity, as proprietary trading
employs the trading infrastructure used in other activities such as market
making. Those would not be lost if trading activities are subsidiarised
altogether or if proprietary trading is prohibited from the banking group. In
sum, significant economies of scope are unlikely to be foregone following a
separation of proprietary trading. | |
| The impact of
separating proprietary trading on economic growth is likely to be small. The
funding cost related to the activity is likely to go up when the inherent
riskiness of the activity needs to be reflected, but the costs cannot be passed
on to households and SMEs, given that proprietary trading is an own account
activity. Costs are likely to be borne by traders (lower wages) or shareholders
(lower net worth). Aggregate consumption may go down as a result, but again not
to a material extent. In any case, the increased financial stability and
elimination of diseconomies of scope will dwarf any quite hypothetical social
cost. | |
| Industry claims that
prohibiting proprietary trading would negatively and significantly influence
market liquidity and price-discovery relate more to market making. Also, as
banks claim that they do no longer engage in proprietary trading activities to
a material extent, such negative consequences appear overstated.[58] | |
| What is the impact
on stakeholder groups of separating proprietary trading? Depending on the strength of separation, the reduced scope for
conflicts of interest should have a positive effect on most bank clients
(households and corporates). The impact on the banking industry should also be
limited, given claims that banks no longer engage in this activity to a
material extent. Traders will face increased competition from the hedge fund
industry. | |
| Are there doubts
about the effectiveness of separating proprietary trading in achieving its
objectives? It is difficult for people not involved
in the actual transactions to distinguish proprietary trading (say, buying and
holding a highly illiquid asset to benefit from the expected price dynamics)
from customer-driven trading (say, buying and holding a highly illiquid asset
because you expect a customer demand to arise for the asset in the near
future). Indeed, a market maker might legitimately choose to take a long
position in an asset either in anticipation of client demand to allow the order
to be fulfilled quickly or to facilitate a quick sale by a client of an
illiquid asset. | |
| Moreover, proprietary
trading can be conducted in other divisions of the banking group alongside the permitted
activity. Proprietary trading is for example difficult to distinguish from
Treasury management operations.[59] | |
| For both these reasons,
it will be challenging to avoid that proprietary trading takes place within a
deposit taking entity after merely having formally separated proprietary
trading into a separated trading entity. | |
| 3.
Market making | |
| Market making makes up
for a significant part of large banking group’s trading revenues.[60] | |
| In general terms,
market making is the purchase and sale of financial instruments (government
bonds, corporate bonds, equities, derivatives, etc.) for own account at prices
defined by the market maker, on the basis of a commitment to provide market
liquidity on a regular and on-going basis.[61]
Consequently, market makers provide "immediacy" to clients and
investors by facilitating their requests to buy and sell quickly and, arguably,
in a cost-effective way for them. For example, an investor anxious to sell an
asset relies on a market maker's standing ability to buy the asset for itself,
immediately. Likewise, an investor who wishes to buy an asset often can call on
a market maker to sell the asset out of its inventory. By doing so, market
makers can instil greater investor confidence in the functioning of financial
markets and encourage investors to trade confidently. Without market makers,
customers would face higher transaction costs and security prices would be more
volatile. A market
maker acquires a position at one price and then lays off the position over time
at an uncertain average price by providing liquidity to customers. The ultimate
goal is to "buy low, sell high". In order to accomplish this goal on
average over many trades, with an acceptable level of risk for the expected
profit, a market maker relies on its expectation of the investors’ needs and
the future path of market prices. In general, market makers provide liquidity
and produce positive externalities. | |
| Although traders
involved in the actual trade are able to identify any given transaction as
being of a market making or proprietary trading nature, such a distinction no
longer is simple from the perspective of an outsider such as a manager,
regulator, supervisor, creditor, or judge. From a legal and economic point of
view, market making (and the securities inventory used to facilitate customer
trading) is difficult to distinguish from proprietary trading, in particular
for “outsiders”. Indeed, a market maker might legitimately choose to take a
long position in an asset either in anticipation of client demand to allow the
order to be fulfilled quickly or to facilitate a quick sale by a client of an
illiquid asset. | |
| While it is possible
for institutions other than banks (such as funds) to take on a similar role to
market makers, banks do have a natural advantage in acting as market makers
because of the fact that banks have a variety of other relationships with the
clients who want to make trades and the fact that acting as a market-maker for
a security is often a natural follow-on activity for securities underwritten by
the banking group. | |
| The most active market
makers in financial markets today are High Frequency Traders (HFT), many of
whom trade as voluntary market makers with no obligations to maintain markets.
According to several academic studies, high frequency market making is a
profitable enterprise and, more importantly, market quality has improved
alongside the growth in algorithmic trading. These results are frequently
interpreted as support for a structure where participants supply liquidity
because it is a profitable and viable activity on its own (see Anand and
Vankatamaran (2013) for a more in-depth analysis). Several important market
makers are not taking any deposits, also suggesting that market making is a
viable activity on its own. | |
| Market-making is
entwined with underwriting. In every initial public offering (IPO), the lead
underwriter always acts as a market maker. Market makers build up significant
inventories following underwriting transactions. Ellis et al. (2000) report for
Nasdaq IPOs that the lead underwriter has accumulated as market maker approximately
8% as inventory position after 20 trading days. Inventory accumulation by the
underwriter gives a direct measure of price stabilisation activities. While
simply buying and selling securities over the course of a trading day is not
unusual for any market maker on any stock, accumulation of a significant
inventory position is. | |
| Many IPOs experience
large price gains however, negating any need for market maker purposes. The
inventory position of the lead underwriter will depend on the subsequent return
of the IPO. The lead manager may assume approximately 60% of the trading volume
on the first day. The lead manager’s share of the trading volume slowly
declines, but it typically still remains greater than 40% even three months
after the IPO has begun trading. Of course, the trading volume in numbers of
shares decreases dramatically over time. Most co-managers make a market in the
issue as well, but to a fairly limited extent. | |
| The market making
profits of the underwriter include both the trading profits due to buying and
selling at his quotes, and the profits and losses of his inventory position. In
general, market making is profitable, particularly on the offer day. Ellis et
al. (2000) find that there is no significant difference between the inventory
profits of underwriters of successful and unsuccessful IPOs. This suggests that
the overallotment option (see section 4 on underwriting below) is successful in
reducing inventory risks for underwriters. The trading profits seem to relate
to the IPO being successful or not. | |
| Overall, it is found
that market making is not a cost to underwriters, that total market making
profits are positive on the first day, and that they remain positive throughout
the first month of trading (Ellis et al. (2000)). | |
| 3.1.
Social benefits of separating market making | |
| Would separating
market making facilitate recovery and resolution? Would separating market
making facilitate monitoring, management, and supervision? A separation of market making activities would have social benefits
in terms of facilitating resolvability. The resolvability of a bank is impeded
by the presence of trading and inventory within a large banking group (again,
in particular due to market making as follow-on activity of securities
underwriting or proprietary trading, but possibly also when significant
customer orders are expected to arise in the future). Individual trading
positions are treated the same way in resolution whether they result from
client activity driven market making or speculation, and market making affects
the quantity of positions needing to be resolved. Impediments to orderly and
swift resolution, monitoring, regulation, supervisability of the activity are
the opaqueness, complexity, and interconnectivity of market making. Market
makers are interconnected with other large banking groups. | |
| Would separating
market making reduce moral hazard? When facilitating
client business, a bank is likely to try and hedge most of its risks. Hence,
genuine market making should entail limited market risk. However, the actual
exposure to risk may vary across time depending on the liquidity of the
instruments, on changes in market volatility and on significant variation in
the sizes of positions that market making clients may wish to acquire or
liquidate. Moreover, there may be a mismatch between the position and the hedge
(basis risk) and the hedge will need to be rebalanced over time as market moves
alter risk profiles. Furthermore, market makers are still exposed to high
counterparty risk and the concrete functioning of market making can vary in
relation to different financial instruments and market models. | |
| Market making as a
follow-on activity of underwriting does imply that significant securities and
derivatives inventories are being built up (see above), and hence that risks are
potentially significant, although hedging instruments exist. | |
| Given its importance as
a share of trading revenues, market making entails significant risk and separating
it from the deposit entity will significantly reduce moral hazard, excessive
risk taking, and artificial balance sheet expansion. | |
| Making a distinction
between genuine market making and proprietary trading is inherently difficult
for outsiders, however. Banks remain highly leveraged and highly expert
organisations that aim to make profits from managing their balance sheet. To
the extent that banks conceal proprietary trades as market making transactions,
the arguments raised above for proprietary trading continue to hold. Traders have the ability and the incentive
to take significant risks, and interests are not always aligned with those of
its customers. | |
| Would separating
market making reduce conflicts of interest? In
theory, genuine market making is aiming to facilitate client business and hence
the bank interests are supposed to be aligned with customer interests. However,
principal agent problems need not to be confined to proprietary trading given
that market making and proprietary trading activity are difficult to
disentangle for outsiders to the actual transactions. | |
| In general, if markets
are opaque, such as is the case in over-the-counter markets, and if market
makers have superior access to information, collusion and exploitation of
conflicts of interests may occur. The origin of the problem is an inherent
conflict of interest. Banks possess (asymmetric) information in the form of
customer trade details, including the number and size of trades to be executed.
And they have knowledge that their own proprietary positions could be harmed
without or could benefit with trader intervention. The banks allegedly act on
that knowledge, against their customer’s best interests and in favour of their
own, as evidenced in recent banking scandals, related to front running, FX bid
rigging, Libor benchmark rate setting, etc.[62] | |
| Would separating market
making reduce capital and resources misallocation? The
inherent riskiness of trading attracts and requires people who are good at
taking short-term risks rather than lenders with a long-term perspective.
Absent separation, a short-term returns culture may arise within the entire
banking group, given the high profitability associated with trading. | |
| Academics have argued
that market makers hamper the development of securities markets.[63] Large universal banks
are currently accused of having protected their indispensable position in the
global CDS market through control of a trading body and information provider,
which vetted whether new exchanges should be licensed. The alleged harm
consists of exchanges being blocked from bringing part of the over-the-counter
CDS transactions onto public exchanges, which would have resulted in lower
transaction costs for their investor-customers, as well as in less financial
instability as OTC markets are more opaque and involve more counterparty risk. | |
| As market making
activities would no longer benefit from the same level of implicit subsidies,
banks would not have an incentive to over-expand their activities in the field.
The level of market marking activities would reflect the market pricing and
therefore would not attract resources from other banking activities (or
activities beyond banking). | |
| Would separating
market making impact on competition? The competition
benefits relate to the removal of the implicit subsidy, post separation, as it
would allow banks to compete on a level playing field. Given that market
making is a significant part of banks' trading activities, the impact on
competition would be relatively important. Also market makers that do not
currently benefit from implicit subsidies (non-bank broker dealers) would be in
a position to compete on a level playing field with the separated entities
undertaking market making activities. | |
| 3.2.
Social costs of separating market making | |
| Would separating
market making lead to a loss of efficiencies? Given
that market making comprises significant segment of trading activities, there
would be some economies of scale, and cost and diversification economies of
scope lost. However, the former would only apply to small banks, while the
latter would be limited and are likely to be dominated by diseconomies of scope
such as increased systemic risk, excessive risk taking, increased complexity
and conflicts of interests. For example, while diversification may make
individual bank default less likely it actually may increase the likelihood of
systemic risk (as they become more similar and they have increased
interconnectedness). | |
| As explained in chapter
4, integrated banks do have a natural advantage in acting as market makers
because of the fact that banks have a variety of other relationships with the
clients who want to make trades and the fact that acting as a market maker for
a security is often a natural follow-on activity for securities underwritten by
the banking group. This may allow integrated banks to perform this activity
more efficiently than other market players, thus better serving clients and/or
contributing to enhancing market liquidity. Such effects should be weighed
against potential benefits that could flow from structural separation, in
particular for market making, as discussed elsewhere in this Impact Assessment. | |
| It is frequently argued
that separating market making will harm market liquidity and hence will be
socially costly. Bid-ask spreads may increase, increasing the costs to
trade at any scale. Likewise, the set of options to investors will be reduced,
as they can no longer trade as much and as easily as before. Price discovery is
made more difficult. And price volatility may be reduced, if professional
position takers spot price divergences from rational levels and correct them
through speculation and trading. | |
| This argument (i) neglects the fact that
structural separation aims to reduce the implicit subsidies that distort the
proper market functioning and bank activities, (ii) builds on the presumption
that more liquidity is inherently positive, which may not always be the case[64], and (iii) should be
put into perspective. Indeed, market prices are distorted when contaminated
with implicit public subsidies and may in fact produce excess liquidity. One
could argue that it is preferable to allow the discipline of the market to
choose the pricing of these securities and the amount of liquidity. If
liquidity cannot be reached then it may suggest more about the underlying
securities' viability (see Richardson, 2013). | |
| Richardson (2013) notes that the issue of
liquidity is more relevant in times of crisis than in normal times when
liquidity is typically not a pressing concern. Private banks, however, have not
performed a significant liquidity role during crisis period and central banks
have stepped in to assume the role of Market Maker of Last Resort (in covered
bond markets, government bond markets, etc.). Charts 3.11 and 3.2 plot the
yields and corresponding bid-ask spreads of 10 year Spanish government bonds.
Chart 3 shows that yields have more than doubled and increased from less than
3.5% in June 2006 to more than 7.5% in July 2012. Chart 4 plots bid-ask
spreads. Whereas their pattern is equally volatile, it is clear that they
matter much less in comparison to the changes in the interest rate level.
Bid-ask spreads in the period June 2006 to August 2013 on average are 2bp (0.02%)
and spiked at 12bp (0.12%) in June 2012. This suggests that the ability of
(private sector) market makers to influence the interest rate level is
relatively limited. | |
| Chart 3.1: Yield to maturity of 10 year Spanish government bonds || Chart 3.2: Bid-Ask spreads of 10 year Spanish government bonds | |
| || | |
| Source: Commission Services - Bloomberg || Source: Commission Services - Bloomberg | |
| To function properly
markets need a large number of independent traders. A separation between
deposit entities and trading entities deprives the latter of access to cheap
funds (in the form of deposits), forcing them to limit their size and the size
of their bets. These limitations may increase the number of market
participants, making markets more liquid.[65] | |
| The increased funding cost for the trading
entity that acts as market maker is unlikely to be passed on to the real
economy and therefore harm economic growth. | |
| –
First, households and SMEs that are clients of a
banking group that needs to separate certain capital market activities are
typically and mainly clients of the deposit entity. Hence, the increased
funding cost for the entity not taking deposits would not necessarily affect
borrowing conditions for households and SMEs. In fact, market making entails
significant risk.[66]
These risks are important, given the size and importance of market making as a
share of large banks’ trading activities. Separating market making from the
deposit entity will reduce excessive risk taking and artificial balance sheet
expansion and hence may lower the funding cost for the deposit entity. | |
| –
Second, medium-sized competitors or new entrants
that are not subject to mandatory separation may gain market share from large
banking groups if artificial competition distortions in favour of too-big-to fail
banking groups are being reduced. Hence, whereas some banking groups may face
increased costs and may no longer serve certain customers, those activities may
be picked up by smaller competitors that do not face structural separation
requirements. Customers are accordingly not likely to be left unserved. | |
| –
Third, under a subsidiarisation model, market
making is not prohibited within a banking group. It just needs to be performed
by a legally separate trading entity. Estimates for UK banks (that are amongst
the most important players in the targeted trading activities) suggest that
funding costs may go up for the trading entity in a range between [0bp and
75bp] (HM Treasury, 2012). As said before, the increased funding cost for the
trading entity is part of the desired effects of the separation. | |
| –
Finally, market making is a financially viable
activity on its own, as shown by Anand and Vankataraman (2012) and as
illustrated by the fact that several important market makers are not taking any
deposits. | |
| What is the impact on stakeholder groups
of separating market making? Again, the ultimate
impact will also depend on the strength of the separation. Distortionary
implicit subsidies are being eliminated. The scope for excessive risk-taking
should decrease and conflicts of interest should be reduced. The impact on bank
creditors would differ between the trading entity (more exposed to risk, hence
requiring higher returns) and the deposit entity (required returns may
decrease). | |
| 4.
Underwriting | |
| Securities
underwriting is a typical investment banking activity in which banks raise
investment capital from investors on behalf of corporations and governments
that are issuing securities (both equity and debt securities) in
return for a fee. It is a way of selling newly issued securities, such as
stocks or bonds, to investors. | |
| There are two types of
underwriting. "Firm commitment" underwriting is one in which the
underwriter guarantees the sale of the issued stock at the agreed-upon price.
Hence the underwriter takes the risk of an unsuccessful sale. In practice, a syndicate of banks
underwrites the transaction, which means they take on the risk of distributing
the securities. Should they not be able to find enough investors, they will
have to hold unsold securities themselves. Alternatively, in a "best
efforts" contract, the underwriter agrees to sell as many shares as
possible at the agreed-upon price. Such a contract generates more limited risk
for the underwriter, in comparison. Typically, the process is led by a lead
underwriter or book manager, sometimes one or more co-managers and a large
syndicate of investment banks that aid in the distribution of shares. | |
| Underwriters make their
income from the difference between the price they pay to the issuer and what
they collect from investors or from broker-dealers who buy portions of the
offering ("underwriting
or gross spread" or “underwriting fees”). While underwriters
are typically involved in immediate IPO aftermarket trading and this market
making is a stand-alone profit centre, underwriters generate most of their
profits by the fees they demand for their services in issuing securities.[67] | |
| In most cases, the
managing underwriter “overallots” the issue, creating a short position by
accepting more orders than there are shares to be sold. The overallotment
option grants an option to the underwriter to purchase from the company an
additional portion of the shares sold in the IPO at the offer price. With this
option, an underwriter can and virtually always does sell more than 100% of the
offered shares. The motivation for this option is to provide buying support for
the shares without exposing the underwriter to excessive risk. The underwriter
buys back the extra portion of shares in the market at the offer price, they
can do this without the market risk of being "long" this extra portion
in their own account, as they are simply "covering" (closing out)
their short position. | |
| Put differently, if the
offering is strong and the price goes up, the underwriter covers his short
position by exercising the overallotment option at the offering price. The
underwriter is able to close its short position by purchasing shares at the
same price for which they sold-short the shares, so the underwriter does not
lose money. If the offering is weak and the price goes down, the underwriter
does not exercise the option, and instead buys back all or part of the extra portion
of the shares in the market at the price below which it can sell it to its
customers, thereby supporting the stock price. The overallotment option
provides the underwriter with buying power in the aftermarket, enabling him to
support the price of the newly traded security. The underwriter typically has
30 days to decide to exercise all or part of his option. | |
| Underwriting and
advisory services require relationship-building with clients. It is closely
connected to corporate banking. From the corporate client’s perspective,
issuing a bond is an alternative way of financing to taking a bank loan. | |
| Deutsche Bank, HSBC,
BNP Paribas, Barclays and Unicredit make up the top 5 of the league tables for
Eurobonds (2012), whereas Goldman Sachs, Deutsche Bank, Morgan Stanley, Credit
Suisse, and Bank of America Merrill Lynch make up the top 5 in the league table
on stocks (2011, Europe, Middle-East, and Africa). The top 10 debt underwriters
account for 43% of Euromarket corporate debt issuance, and even for 51% of the
government debt market. Each of the top 5 debt underwriters has underwritten in
excess of 100 billion EUR in 2012. See Chart 4.1. | |
| Chart 4.1 Euromarket
debt underwriting (2012) | |
| 4.1.
Social benefits of separating underwriting | |
| Would separating
underwriting facilitate recovery and resolution? Given
that underwriters typically retain a significant fraction in their inventories
and play an active market making role after the issuance, resolution may be
improved by separating underwriting from deposit taking, as the inventory of
relatively illiquid assets will be smaller. Otherwise, the underwriting as such
does not give rise to similar interconnectedness across financial
institutions. | |
| Would separating
underwriting reduce moral hazard? Firm-commitment
underwriting is an inherently risky banking activity, although underwriters
can hedge themselves to reduce the corresponding risks (Ellis et al. (2000)).
Separating the activity from the deposit entity will shield depositors from
such risks. Allowing it to be performed by a legal entity that enjoys an
explicit safety net will encourage the activity, as the safety net presence
will reduce the risk-sensitivity of its funding sources. Given that underwriting
is not as easily scalable as pure market making, the scope for moral hazard
reduction is significant, but smaller than for market making. | |
| Would separating
underwriting facilitate monitoring, management, and supervision? Given that underwriting is prone to conflicts of interests, the
management of a group would be facilitated if performed in a more structured
way in which underwriting is being separated from lending and other commercial
banking activities. It does not create challenges as high as for market making,
given that the activity is not short term and easily scalable. | |
| Would separating
underwriting reduce conflicts of interest? Separating
underwriting will reduce the scope for conflicts of interests, as the interests
of the bank as underwriter and as loan provider are typically not aligned.[68] Within a large and
diversified banking group, the commercial bank department may have private
information about the likely bankruptcy of the firm it has granted a loan and
may hence encourage the underwriting department to sell bonds or issue shares
to the unsuspecting public, thereby reducing its own credit risk whilst earning
a fee. Banks have an incentive to hedge their risk as underwriters,
guaranteeing the proceeds of the share issue, but this may potentially have an
adverse impact on their clients’ share price. Alternatively, a bank’s lending
division may feel pressured to provide bank loans to a firm whose shares have
been issued by the bank’s underwriting division, even though such loans would
not be granted absent any such in-house pressure. According to certain studies,
earnings forecasts and stock recommendations provided by an analyst working
with the lead-underwriter are on average inaccurate and positively biased, and
unaffiliated analysts perform better and provide higher long-run value to their
customers. The main concern is that the bank uses the informational advantage
it gains from conducting different activities to its own advantage, thereby
misleading customers and investors. | |
| Having said that, the
evidence does not suggest that conflicts of interests are obvious between
underwriting and loan making.[69]
In fact, it suggests that bonds underwritten by commercial banks default less
often than bonds underwritten by investment banks. However, the conflicts of
interest seem more severe and more likely to exist in a universal bank that has
an underwriting division together with an asset management division. These
studies seem to support the view that asset management divisions may feel
pressured by the bank’s underwriting division to buy and hold poorly performing
issues to make a customer satisfied, even though this may be unwise. | |
| Next to internal
monitoring and controlling procedures, there is outside regulation (for example
with respect to insider trading) and the rule of law to contain the
exploitation of possible conflicts of interests. In principle, the market can
also respond to apparent conflicts of interests, thereby constraining their
scope. The market can penalize the service provider if they exploit conflicts
of interest, in the form of a higher funding cost or lower demand for its
services even to the point of forcing the firm into bankruptcy. The market can
also promote new institutional means to contain conflicts of interest, by
generating a demand for information from non-conflicted specialized
organizations. | |
| However, the market is
likely to be unable to contain the incentives to exploit the conflicts of
interests. For the market to be able to do this, it needs to have information
on whether exploitation might take place. Sometimes, such information is simply
not available or would require the revealing of proprietary information that
would benefit a firm's competitors, thus reducing the incentives to reveal this
information. Sometimes, when corporate governance is poor, even the top
management of the firm is not aware of the conflicts of interest and mala fide
opportunistic individuals are able to capture the firm's reputational rents. | |
| Would separating
underwriting reduce capital and resources misallocation? Conflicts of interest can substantially reduce the quality of
information in financial markets, thereby increasing asymmetric information
problems. In turn, asymmetric information prevents financial markets from
channeling funds into the most productive investment opportunities and causes
financial markets and the economy to become less efficient. Conflicts of
interest become a problem for the financial system when they lead to a decrease
in the flow of reliable information, either because information is concealed or
because misleading information is spread. The decline in the flow of reliable
information makes it harder for the financial system to solve adverse selection
and moral hazard problems, which can slow the flow of credit to parties with
productive investment opportunities. | |
| On the other hand,
being a client-driven and core relationship-oriented investment banking
activity that was not at the root of the financial crisis, it is not obvious
that banks have misdirected significant amounts of human resources and capital
to underwriting activities. Moreover, underwriters fulfil a certification role
to monitor public firms and their governance structures.[70] | |
| Would separating
underwriting impact on competition? To the extent
that underwriting activities benefit from an implicit public subsidy, there
would be benefits in terms of competition. However, given that underwriting is
less scalable than market making or proprietary trading, it is not able to
rapidly exploit significant implicit subsidies. | |
| 4.2.
Social costs of separating underwriting | |
| Would separating
underwriting lead to a loss of efficiencies? The
literature suggests that the processing of information about making loans to
clients facilitates the efficient provision of other financial services,
including securities underwriting. This positive information-sharing process
can also work in the opposite direction, whereby underwriting and other
activities may improve loan-making procedures, but this relationship remains
underexplored in the literature. [71]
Hence, a strong separation of underwriting from deposit issuing activities
would reduce efficiencies (genuine cost and revenue economies of scope) because
of the social costs associated with losing knowledge and information advantages
associated with combining lending and underwriting.[72] | |
| These efficiency gains
and linked savings could be particularly pronounced for the issuers who are
noninvestment grade-rated (Drucker and Puri (2005)). There may be economies of
scope to be enjoyed from spreading fixed costs of acquiring information over
multiple outputs; more specifically, concurrent lending and underwriting could
be beneficial. Furthermore, the primary market activity of underwriting is
connected to the secondary market activity of market making. In addition, underwriting
is naturally followed by market making of the security that has been
underwritten by the underwriting bank and therefore significant economies of
scope arise between these two activities. | |
| Hence, some economies
of scope may arise, in particular if the separation goes beyond a
subsidiarisation. | |
| What is the impact on stakeholder groups
of separating underwriting? Again, the ultimate
impact will also depend on the strength of the separation. SMEs and large
corporates may benefit from the reduced scope of conflicts of interests, but
they may face a higher cost following the separation of underwriting from the
DE. | |
| 5.
Securitisation | |
| Securitisation as an
activity refers to the investing, sponsoring and structuring activities related
to certain securitisation instruments. | |
| Asset backed securities
(ABS) are securities backed by a pool of receivables. Investors only bear the
risk arising from these receivables and are generally insulated from the credit
risk of the respective (former) owner of the assets (originator/seller). The
receivables of the underlying portfolio that is securitised generate interest
and principal payments. These payments as well as potential losses that may
occur in case the underlying obligors of the securitised assets do not serve
their obligations, are distributed to investors according to certain rules
(“the structure”). Hence, the investors in ABS have to focus on both the
underlying risk of the securitised portfolio and the rules that determine which
consequences investors have to face in case a certain event occurs. Typically,
the securitised assets are referenced by various notes with different risk
profiles, and hence, ratings. The fact that different notes have different risk
profiles, though they all reference the same underlying portfolio, is based on
the respective aforementioned transaction structure. This in principle can
enable investors to satisfy their individual risk appetite and needs. ABS
allows for a broad band of flexibility in terms of asset classes being
securitised and structures being applied. | |
| Chart 5.1: Stylised
illustration of the transfer of cash flows and risks in a securitisation deal | |
| Chart 5.1 is a simple
illustration of a securitisation deal with the main three parties involved:
originator, the Special Purpose Vehicle («SPV») and investors. The seller
or originator is the original owner of the assets. The Special Purpose
Vehicle («SPV») is an independent entity, created for the purpose of the one
specific securitisation transaction. It is typically bankruptcy remote and
often located off-shore for tax reasons. Investors are typically asset
managers. They are allowed to buy and sell assets during the time period
subject to rules (in case of managed, i.e. non-static, pools of underlying securities).
However, in practice, there are more parties involved in the transaction. The arranger
determines the underlying pool of assets and sets up the transaction structure
on behalf of the originator. The servicer collects and distributes the
cash flows that arise from the assets (interest and/or principal), arrears
management, collateral management. The provider of external credit
enhancement/liquidity provides subordinated loans, guarantees, insurances
(as protection for investors against credit risk) as well as liquidity
facilities (“sponsor”). The rating agencies assess both the credit risk
of the underlying pool of assets and the structural features of the
transaction, and consequently determine the size of the required credit
enhancement to achieve a certain rating level. The trustee is the
“agent” of the investors that controls and checks cash flows, loss allocations,
adherence to provisions, etc. The swap counterparty provides the
interest rate swap to hedge market risk, as the SPV must not bear any interest
rate risk due to the bankruptcy remoteness requirement, and as the securitised
assets very often generate fixed-rate interest income, while the notes are
mostly floaters (possibly also currency swaps). | |
| The rationale of
securitisation from the viewpoint of the originator/seller-perspective is that
it allows for (i) balance sheet management, (ii) portfolio and risk management,
(iii) funding management, (iv) price discovery by selling and “liquifying”
illiquid assets and, (v) most importantly, lower capital requirements. The
rationale of securitisation from the investor-perspective is that investors
benefit from (i) the diversifications’ effects due to investments in alternative
asset classes (risk diversification across geographies and asset types), (ii)
the flexibility of securitisation (instruments tailored to the needs,
preferences and profile with the opportunity to invest in high quality asset
classes or earn a high rate of return), and (iii) being insulated from the
originator’s/seller’s credit risk. In an increasingly fragmented European
banking market where interbank markets gradually evaporate. Securitisation
allows to channel savings from parts of Europe that have a surplus to those
parts of Europe with the greatest needs and growth prospects, which is
especially beneficial in an increasingly fragmented European banking market
where interbank markets gradually evaporate. Whereas the funding can come from
investors and depositors across Europe, the loan origination can remain with
the existing local providers. | |
| Different types of
securitisations are classified, depending on the nature of assets underlying
the pool. The underlying assets can be credit cards, consumer or auto credits
as well leases. However, the majority of securitisation transactions in Europe,
as Chart 5.2 illustrates, are Residential Mortgage-backed Securities (RMBS)[73], followed by Collateralized Debt Obligations[74] (CDO), Collateralized Loan Obligations[75] (CLO) and Commercial Mortgage-backed Securities (CMBS). After the
peak of securitisation issuance in 2008, securitisation in Europe shows a steep
downwards trend, with a significant reduction in the issuance of CDO/CLO and
RMBS, as displayed in chart 5.3. | |
| Chart 5.2. Source:
JP Morgan research June 2013 | |
| | |
| Chart 5.3. Source:
JP Morgan research June 2013 | |
| Prior to the crisis,
securitisation was regarded as contributing to financial stability, as it
disperses credit risk to those that are best suited to bear it and as long
intermediation chains may promote more efficient maturity transformation.
However, the financial crisis has led to a rethink. Ex post, the boom of
securitisation allowed to build up risks quickly, it enabled significant growth
in short-term debt between financial intermediaries and led to financial
intermediaries becoming more intertwined. | |
| The valuation losses
and difficulties with securitisation that have materialised since 2007 can be
linked to excessive (i) originate-to-distribute activity, (ii) leverage, (iii)
embedded maturity transformation, and (iv) lack of transparency. | |
| Accordingly, for the
purposes of this impact assessment, “complex” securitisation is defined as all
securitisation activity that is characterised by any of the following four
undesirable features: | |
| (1)
Securitisation with risk transfer - having
insufficient “skin in the game”. | |
| (2)
Re-securitisation – Securitisation of a
synthetic nature and/or containing mixed and complex pools of underlying
assets. Repackaging or leveraging of existing securitisation instruments
becomes increasingly complex, requires sophisticated modelling approach and is prone
to model risk and valuation uncertainty. | |
| (3)
Securitisation with maturity transformation:
vehicles such as SIVs and ABCPs perform maturity transformation, on top of the
liquidity risk and credit risk transformation and can be classified as unsafe
types of securitisation. | |
| (4)
Intransparent securitisation: due to the
inherent complexity of the underlying pool of assets or due to available data
to assess the riskiness of the instrument. | |
| Alternatively, “simple
and transparent” securitisation is characterised by the following joint
characteristics: | |
| (1)
Retention of sufficient “skin in the game”
requirements (absence of full risk transfer), ideally of a vertical slice, as
allowed by CRDIV-CRR rules. | |
| (2)
Primary securitisation: structures other than of
a synthetic nature; no repackaging or leveraging of existing securitisation
instruments, as they become increasingly complex and prone to modelling risk; no
mixed pools of underlying assets.. | |
| (3)
Securitisation without maturity transformation,
the so called “pass-through” securitisation, links the rights of investors to
receive interest and principal to the securitised assets’ generation of cash,
subject only to hedging instruments or the availability of a liquidity facility
designed to smooth out irregularities in payments. Vehicles such as SIVs and
ABCPs perform maturity transformation and are considered “unsafe”
securitisation. | |
| Separation of securitisation activities would allow deposit entities
to conduct and invest only in “simple and transparent” and not in “complex”
securitisation.[76] In the following sections the social benefits and costs of this
separation are discussed. | |
| 5.1.
Social benefits of separating securitisation and
debt origination | |
| Would separating
securitisation facilitate recovery and resolution? Would separating
securitisation facilitate monitoring, management, and supervision? Separating “complex” securitisation will facilitate resolvability of
large banking groups and facilitate management and supervision, as it concerns
complex, opaque and illiquid securitised instruments. If the securitised assets
become complex, they become hard to value and sell off without incurring large
losses. Likewise, investing in securitised products may give rise to
interconnectedness of financial institutions which impedes orderly and swift
resolution. The ability to adequately supervise, regulate, and manage ABS
structures is likely to be inversely related to its complexity and degree of
transparency | |
| Would separating
securitisation reduce moral hazard? “Complex”
securitization has allowed banks to grow their bank balance sheet aggressively,
build up risks quickly, concentrate risks within the leveraged sector,
grow notably short-term debt reliance between financial intermediaries,
and make financial intermediaries significantly more intertwined. Without
sufficient skin in the game, securitisation becomes a transaction-oriented and
fee-driven activity, which can be scaled up easily, as clearly demonstrated in
the financial crisis. If loans are packaged and sold off to investors against a
fee, banks have less incentive to monitor borrowers and the interests of the
bank and its borrowers are no longer aligned. Likewise, unless maturity
transformation is limited, banks still run significant liquidity risk. Both,
opaque securitisation structures and maturity transformation have fuelled the
originate-to-distribute model, followed-up from excessive build-up of risks in
the financial system. In that sense, separating “complex” securitisation from
the public safety net would reduce moral hazard significantly and would stop
the artificial and socially undesirable promotion of these activities. | |
| Would separating
securitisation reduce conflicts of interest?
Conflicts of interests clearly arise when banks are allowed to sell ABS to
investors against a fee without retaining sufficient skin in the game. This was
the case during the crisis with the originate-to distribute business model. | |
| Would separating
securitisation reduce capital and resources misallocation? In retrospect, the securitisation process and transactions has led
to a misallocation of capital and has given rise to real estate bubbles (in the
US, Ireland, Spain, etc.) and to credit bubble in debt capital markets. They
have fuelled the credit default spread (CDS) markets (used to hedge the credit
risk of the underlying) and complex and synthetic fixed income products, such
as collateralised debt obligation (CDOs) and CDO². | |
| Would separating
securitisation impact on competition? Separating
“complex” securitisation from the public safety net would reduce the implicit
subsidy that these activities benefit from and would lead to enhanced
competition on the merits among banks. | |
| 5.2.
Social costs of separating securitisation and
debt origination | |
| Would separating
securitisation lead to a loss of efficiencies? “Simple
and transparent” securitisation potentially generates genuine economies of
scope related to risk diversification, regulatory capital release, revenue
increases, and cost reductions. Such securitisation facilitates banks’ ability
to perform their risk pooling and asymmetric information resolving role. In
general, securitisation is a funding source that is not tied to the credit of
the bank. Hence, in a time of doubt about a bank’s financial strength, it may be
relatively resilient, compared to unsecured or short term secured borrowing. It
allows capital market investors (such as insurance companies, pension funds,
etc.) to fund EU banks. It also breaks the link between the financing needs of
the economy and the banks’ capacity to raise capital. However, “complex”
securitisation is characterised by potential diseconomies of scope such
as excessive complexity, conflicts of interest, excessive risk taking and
increased systemic risk. There has been a sudden stop in “complex”
securitisation following the eruption of the financial crisis, and it is not
clear to what extent it will re-emerge. Hence, the cost of separating this
activity is likely to be low, based on current activity levels. Subsidiarising “complex”
securitisation in a separate trading entity would still allow for
market-constrained, limited and genuine innovation to take place within the
regulated banking group, whilst not promoting it artificially by linking it to
the deposit entity that enjoys public safety net support. | |
| In addition,
securitisation has allowed for a rapid expansion of the financial sector
through greater interconnectedness. The enlargement of the financial system,
beyond a certain size, is associated with reductions in real productivity
growth. This, in part, is due to the financial sector competing with the rest
of the economy for scarce resources. Excessively large financial systems may
reduce economic growth because of the increased probability of a misallocation
of resources, the increased probability of large economic crashes[77], or the endogenous feeding of speculative bubbles. | |
| 6.
Derivative transactions | |
| Trading in derivatives
is mostly performed over-the-counter (OTC) and is dominated by a handful of large
US and European banking groups. Derivatives are contracts between two
counterparties. Their notional value has increased significantly and has
reached extremely high levels. Chart 6.1 compares the notional value of
derivatives and the volume of primary securities, consisting of all issued
domestic and international securities, bank intermediated credit and equity
market capitalisation, as a percent of world GDP. The Chart illustrates that
the notional value of derivatives has increased from 3.5 times world GDP in
1998 to 12 times world GDP when the crisis materialised. The volume of primary
securities, in contrast, has remained stable at around 3 times world GDP. | |
| Chart 6.1: Derivative
notional values versus primary securities (% of world GDP) | |
| Source: BIS, OECD, World Federation of Stock
Exchanges, as reported in Blundell-Wignall, Atkinson, and Roulet (2012) | |
| Variation margins
reflect changes in prices and volatility and imply transfers from losing or
out-of-the-money counterparties to winning counterparties (zero sum game). The
margins are mostly collateralised with cash and sometimes government
securities. | |
| The notional value may
not be informative about the riskiness of the derivative positions. First, the
Gross Market Value (GMV) measures what it would cost to replace all trades at
current market prices. It is typically significantly smaller than the notional
value. While the notional value of global derivatives was 586 trillion USD in
December 2007, the GMV at the same time was only 16 trillion USD. Even when
valued at GMV, derivatives can still be very important in terms of balance
sheet of the biggest systemically important banks. Second, financial firms have
offsetting positions that can be netted and banks expressly hedge most of their
positions. The GMV minus netting is the Gross Credit Exposure (GCE). It is
against the GCE that collateral is held. It amounted to 3.3 trillion USD in
December 2007, against which 2.1 trillion USD was held. The final global open
exposure amounted to 1.2 trillion USD. | |
| However, it would be a
mistake to conclude from relatively small open positions that systemic risks
are equally small. Changes in volatility may shift the GMV quickly and netting
provides no protection against such shifts in market risks, because netting is
about settlement amounts using prices at the point of close out. When the
crisis hit in 2008, the GMV more than doubled from 15.8 trillion USD to 35.3
trillion USD, the GCE increased from 3.3 trillion USD to 5 trillion USD and the
estimated collateral had to rise from 2,1 trillion USD to 4 trillion USD.
Significant margin calls needed to be met in a highly risky environment. | |
| Charts 6.2 and 6.3
illustrate the size if derivatives for EU banks. | |
| Chart 6.2 – Total
liabilities for the EU average bank (2007 versus 2012) | |
| Source: ECB | |
| Chart 6.3 –
Derivatives as a share of total liabilities for EU Member States | |
| Source: ECB | |
| 6.1.
Social benefits of separating derivatives
activity | |
| Would separating derivatives
activity facilitate recovery and resolution? Would separating derivatives
activity facilitate monitoring, management, and supervision? ISDA surveys suggest that roughly three quarters of trades comingle
these margins in non-segregated accounts and over 90 per cent of the cash is
used in rehypothecation. The amount of leverage that can be achieved through
this process is high and its nature gives rise to interconnectedness between
financial firms. | |
| Would separating derivatives
activity reduce moral hazard? Derivative activity allows
banks to grow their bank balance sheet aggressively, build up risks quickly, concentrate
risks within the leveraged sector, grow notably short-term debt reliance
between financial intermediaries, and make financial intermediaries
significantly more intertwined. Derivatives may imply high leverage. By making
a small down-payment (or initial margin), banks can take large speculative
positions in the market and can transform the riskiness of their assets and
income flows, while booking revenues from fees and OTC derivative spreads.
Through re-hypothecation, the leverage can be multiplied throughout the
financial system. | |
| Would separating derivatives
activity reduce conflicts of interest? Derivatives
play a critical role in regulatory arbitrage under the Basel capital requirement
framework, essentially permitting banks to have a wide discretion in
risk-weighting their assets for regulatory capital purposes. Likewise,
derivatives were used as a tool to profit from tax arbitrage. | |
| Would separating derivatives
activity reduce capital and resources misallocation? Derivatives play a critical role in regulatory arbitrage under the
Basel capital requirement framework. The structuring of products via
securitisation, swaps, use of seniority tranches and CDS insurance was an
integral part of the growth of derivatives transactions. | |
| Would separating derivatives
activity impact on competition? If a bank is unable
to post the necessary collateral, the risk of transacting with the bank is
perceived to go up and other banks will begin to take defensive actions which
exacerbate the bank’s weak cash position. Ultimately, without state support,
the bank will need to sell assets and unwind trades at fire-sale prices, which
will amplify its distress. The moment a bank does not have a sufficient cash
buffer, short term securities of sufficient quality, or the ability to borrow
to meet collateral calls, it essentially becomes reliant on direct official
support. For systemically important banks such public support is always there,
and the support itself becomes part of the problem (distortionary implicit
subsidies). Asset managers and hedge funds prefer to deal with systemically
important banks precisely because the public support can be relied upon. In the
absence of such cross-subsidisation support, the cost of capital would have to
be much higher. Counterparties to the bank would demand segregated accounts and
no re-hypothecation. Securities used for collateral would require higher
haircuts. Risk premia for lending collateral would rise. | |
| 6.2.
Social costs of separating securitisation and
debt origination | |
| Would separating derivatives
activity lead to a loss of efficiencies?
Derivatives activity has grown aggressively and is characterised by potential diseconomies
of scope such as excessive complexity, conflicts of interest, excessive risk
taking and increased systemic risk. Subsidiarising derivative activity in a
separate trading entity would still allow for market-constrained, limited and
genuine innovation to take place within the regulated banking group, whilst not
promoting it artificially by linking it to the deposit entity that enjoys
public safety net support. Derivative activity has allowed for a rapid expansion
of the financial sector through greater interconnectedness. The enlargement of
the financial system, beyond a certain size, is associated with reductions in
real productivity growth. This, in part, is due to the financial sector
competing with the rest of the economy for scarce resources. Excessively large
financial systems may reduce economic growth because of the increased
probability of a misallocation of resources, the increased probability of large
economic crashes, or the endogenous feeding of speculative bubbles. | |
| 7.
Private equity/Venture capital | |
| Private equity (PE) is an asset class consisting of equity
instruments provided to firms that are not publicly traded on an exchange.
Private equity is about buying stakes in businesses, transforming business and
then realising the value created by selling or floating the business. Because
it is equity, it is risk capital allocated to firms for the purpose of funding
early stage ventures, growth and diversification opportunities, restructuring
and management buy-outs and buy-ins in established companies. Private equity is
inherently an illiquid and long-term oriented investment traded only on
acquisition and exit. This differs from trading on public markets, trading
liquid asset classes such as currencies, stocks, bonds and other derivatives.
It typically involves the acquisition of a major stake in a targeted company
and comprises also of active management of business operations therein. It can
be distinguished from hedge funds which apply various trading strategies to
accomplish supra-competitive returns. | |
| One of the parties to a
private equity transaction is the fund manager (private equity firm) who is in
charge of managing the pooled money in the fund coming from investors and who
makes investment decisions. The fund manager can be either a single person or
an investment firm. He is responsible for raising funds, sourcing investments
and managing them as well as realising capital gains. Another party is the
private equity fund which is the investment vehicle pooling money from
investors. The target company with its shareholders and management is a third
party. In case of leveraged buy-outs, the bank providing debt instruments is a
fourth player. | |
| Private equity can
generally be seen as a term encompassing the three subgroups venture capital,
growth capital as well as management buy-outs and buy-ins. | |
| Venture capital (VC) is
that part of private equity that entails finance provided to early-stage,
high-potential and possibly, high-growth start-up companies. This commonly
covers the seed to expansion stages of investment. The venture capital funds
follow an active investment model and provide funding in exchange for
management influence and equity in the company invested in. Most often,
expertise and experience of the venture capital funds' personnel is one of the
main contributing factors. Venture capital firms earn money by owning equity in
companies that they invested in which possess novel technologies and/or
business models. In the history, most of the venture capital-backed companies
have been active in biotechnology, IT, software and such. These firms are too
small and their credit history is too limited to acquire debt financing from
banks, but their capital need is usually too large to be satisfied by own
means. In exchange for the high risk venture capital funds embrace with their
investment in young companies, they are rewarded with considerable managerial
control and ownership. | |
| Growth capital is the
subset of private equity investments aimed at relatively mature companies that
need external financing for expanding or restructuring their operations,
business diversification, market expansions or for acquisitions. This often
involves a minority investment by a private equity firm to companies which are
yet unable to generate sufficient funds through debt offerings. Most commonly,
growth capital is common or preferred equity and lies at the intersection of
mature private equity and venture capital. | |
| The most mature private
equity investments are buy-outs and buy-ins where private equity firms target
companies to be acquired with equity instruments from current shareholders and
restructured in order to be sold off at a later stage for a profit. These
companies are usually considered to be fundamentally undervalued because of
their unrealized organisational, product or management capacities. Because the
targeted companies are rather large, most often these private equity deals are
leveraged buy-outs (LBO) where a bank additionally provides debt financing so
that the private equity firm can acquire the majority control over the mature
company. This varies from venture capital and growth funds which typically do
not acquire a majority stake. A special case of these activities are management
buy-outs (MBO) or buy-ins (MBI) where the incumbent or an external management
team raises funds to acquire a significant share in the company. | |
| The European Private
Equity and Venture Capital Association (EVCA) estimated that European private
equity funds raised approximately EUR 265 billion in 2007-2012. In Europe over
the period 2007-2012, banks made up 11% of all investors in private equity
funds, with pension funds having the largest exposure to private equity (21%). | |
| Banks may be involved
in two different ways in private equity: as the equity investors
(bank-affiliated deals) or as both the equity investor and the debt financier
(parent-financed deals). Fang et al. (2012) estimate that bank-affiliated
private equity groups account for 30% of all private equity investments in the
US. | |
| Private equity is also
dealt with in the "Volcker Rule" provision of the Dodd-Frank Act
which limits banks' exposure to private equity and hedge funds to no more than
3% of Tier 1 capital. | |
| 7.1.
Social benefits of separating private equity and
venture capital | |
| Would separating
private equity facilitate monitoring, management, and supervision? Would
separating private equity facilitate recovery and resolution? Hoenig and Morris (2013) argue that several non-traditional
activities, including private equity, are less transparent than traditional
banking activities as the success of the underlying investments depends on the opaqueness
of the bank's position and on the speed at which their exposures can be
changed. Transparency concerns are relevant for private equity. For example,
they have led to the adoption of the non-voluntary code of conduct in the UK (Walker
guidelines), which require companies to provide the same kind of information to
the public that is required for publicly traded companies. The main difficulty
with private equity is that valuing private equity investments is inherently
difficult for the market. Therefore market monitoring will be less effective, although
the relatively long-term nature of private equity mitigates some of the
uncertainty. Supervision cannot address all shortcomings as supervisors only
have snapshots of various operations while the underlying activities can become
very risky in a short time span changing a bank's risk profile. However, as
Hoenig and Morris (2012) point out, there is a risk that such activities
following separation would migrate into shadow banking leading to even less
transparency and monitoring. | |
| The resolvability of
banks may be affected as it is difficult to determine reliably the true value
of the private equity activities, which raises obstacles to the resale of the
bank during resolution. Also, almost all bank-affiliated and parent-financed private
equity deals run through special purpose vehicles (SPV) which may complicate
these procedures. | |
| Would separating
private equity reduce moral hazard? Gilligan and
Wright (2012) argue that private equity tries to address the principal agent
problem between managers and shareholders, as private equity backed companies
do not pay material cash bonuses to senior managers and get a return if the
business is sold or floated. On the other hand, despite the long-term nature of
private equity investments (compared to proprietary trading) and the
informational advantages enjoyed by private equity firms specializing in
investing in certain industry sectors, equity investments made by private
equity funds remain inherently risky. Private equity firms managing the funds
can assess the true valuation of the targeted company only with significant
uncertainty, given the start-up nature and/or restructuring required for the
target companies. This may lead to significant discrepancy between the price
paid for gaining managerial control over a targeted company and the true fair
value of the company once taken over. Fang et al. (2012) argue that banks still
run serious risks when investing in private equity funds, and have experienced
substantial losses. As the potential downside when investing in private equity
is high, the potential to reduce moral hazard when separating risky private
equity activities from commercial banking is also significant. There is also
evidence that private equity performance is highly pro-cyclical. Fang et al
(2012) also explain that bank-affiliated deals, even though have similar
characteristics and financing compared to stand-alone deals, perform worse if
they are made during peaks of the credit market. | |
| Would separating
private equity reduce conflicts of interest? Private
equity may lead to conflicts of interest between banks and other stakeholders.
A bank may take advantage of its superior information about firms as private
equity provider to make decisions that benefit the banks at the expense of the
target firm (similarly as in underwriting). Furthermore, banks may have
stronger incentives to finance in-house deals compared to outside investors as
these deals may lead to more cross-selling opportunities to the banks. It can bring
additional revenues to banks as the private equity target can be a potential
customer for the bank. On the other hand, Fang et al. (2012) explain that banks
become exposed to both the equity and debt of the target through private equity
and commercial lending and hence that there is a better alignment of
stakeholder versus debt-holder's incentives. | |
| Would separating
private equity reduce capital and resources misallocation? The removal of the safety net from private equity can restore the
level of these activities to the level dictated by the market. Given, however,
the significant asymmetric information and other market failures relevant to
the financing of companies, and in particular start-ups, it is not obvious that
separation would lead to an improvement in capital and resources. | |
| Would separating
private equity impact on competition? The reduction
in the implicit subsidy in private equity activities would have a positive
effect on competition among banks, but relatively limited given the relative
size of these activities for banks. Furthermore, it would lead to a level
playing field between banks and non-bank-affiliated private equity firms
(depending on the extent that the implicit subsidy is removed). | |
| 7.2.
Social costs of separating private equity and
venture capital | |
| Would separating private equity lead to a loss of
efficiencies? Economies of scope would be lost when
separating private equity activities from the deposit issuing entity that is
also active in lending to SMEs. Firstly, as Gilligan and Wright (2012) point
out, banks' involvement in private equity activities provides scope for
diversification of risk. The Frontier Economics report (2013), commissioned by
EVCA, argues that the advantages of private equity include the possibility to
diversify portfolios, while earning returns, and having access to otherwise
unavailable investment opportunities. Private equity provides institutions
(including pension funds, banks and insurance companies) with investment
opportunities that they may not be able to pursue otherwise, improving the
diversification of their portfolio. Given the attractiveness of diversifying
the portfolio and the possibility of earning greater returns from this
diversification, the preservation of private equity activities within the
deposit-taking bank may provide the potential for advantageous returns and
portfolio characteristics for the bank, as well as the bank's customers. A
second efficiency relates to the informational advantages that can be exploited
by banks' involvement in private equity which stem from relationship banking. Fang
et al (2012) claim that through the screening of loans and monitoring banks
obtain private information about their clients which they can reuse (and
similarly they could use information gathered during past banking relationships
to make private equity investment decisions). Thirdly, the banks' engagement as
a private equity investor could carry a positive signal about the quality of
the investment. This would be credible if the bank has past relationships with
the firm and if the bank has a good reputation. Popov and Roosenboom (2012) estimate
that while the ratio of venture capital to R&D has averaged around 6%
between 1991 and 2005, venture capital has accounted for 9.7% of industrial
innovation during that period. | |
| What is the impact
on stakeholder groups of separating private equity?
Private equity is often argued to be an important source of funding for SMEs.
The channelling of fund to SMEs via private equity may make also bring benefits
to SMEs through external expertise provided by private equity firms in regards
to investments into specific industry sectors. Hence, a separation of private
equity activities and the increased funding costs for private equity may have an
adverse impact on SMEs. Furthermore, several studies suggest that private
equity has an important impact on growth, though innovation and increased
productivity.[78] | |
| 8.
Lending to SMEs and households | |
| Relationship-oriented
banking refers to the traditional originate-and-hold model of banking; Banks
build up and maintain long relationships with their clients, have an alignment
of interests with their clients (they fare well if their customers fare well),
have limited scope for trading, and are encouraged to monitor and serve their
clients.[79] | |
| Lending to SMEs (as
well as syndicated lending and lending to less advanced economies) is
relatively intensive in “soft information” that cannot be easily exchanged and
sold. | |
| 8.1.
Social benefits of separating lending to SMEs
and households | |
| Would separating
lending to SMEs and households reduce moral hazard? Lending to households and SMEs is risky and hence separating the
activity would allow shielding deposits from potentially large losses. On the
other hand, in normal times the risk is primarily of a non-systemic nature.
Loan portfolios are typically relatively granular and obey the law of large
numbers and proper risk management. Also, the ability to build up tail risk is
not present, to the extent that it is for trading activities. The scalability
of lending to SMEs and households is not as prominent as for certain other
banking activities. | |
| Would separating
lending to SMEs and households facilitate recovery and resolution? Separating lending to SMEs and households would not facilitate
resolvability to a significant extent, nor would it facilitate the management,
monitoring and supervision of the banking group, given that retail lending does
not give rise to complex interconnectedness and intra-financial sector
contagion. | |
| Would separating
lending to SMEs and households reduce conflicts of interest? Separating lending does not reduce conflicts of interest, because it
is a typical example of relationship-oriented banking in which the interests of
the lender and the borrower are aligned. The lender does well if the borrower
does well, and vice versa. | |
| Would separating
lending to SMEs and households reduce capital and resources misallocation? Would
separating lending to SMEs and households impact on competition? Separating lending would not result in reduced resource
misallocation, given that monitoring small and medium sized borrowers is a core
activity of deposit taking banks. Linking savers and borrowers implies that
asymmetric information get resolved. If lending and intermediation is left to
the market, this is likely to lead to under-provision of credit for SMEs and
households. | |
| 8.2.
Social costs of separating lending to SMEs and
households | |
| Individuals are
typically risk averse and this characteristic is reflected in their
preferences. Those with an excess of funds typically have a preference to lend
short, while those with a shortage of funds have a preference to borrow long.
Still, in the presence of perfect financial markets (Arrow and Debreu (1954)),
there would be no need for maturity-mismatching intermediating banks, since
savers and borrowers would execute their transactions directly with
sufficiently rewarded and willing counterparties in the financial markets (see
also Modigliani and Miller (1958)). So, the true raisons d'être of banks are
market imperfections such as information asymmetries, transaction costs, tax
distortions and market incompleteness. | |
| Given the existence of
market imperfections, there is a role for banks in bringing risk-averse savers
and borrowers together. However, banks create a mismatch between the maturity
of their assets and liabilities by issuing demandable and other short-term debt
and granting long-term loans. Among many others Diamond (1984) and Gorton and
Pennacchi (1990) try to understand the exact circumstances under which each of
these two separate activities might require the existence of an intermediary,
as opposed to being implemented directly through arm's-length financial
markets. Although this literature yields many insights, only a few papers address
the more fundamental question of why it would make economic sense for a single
institution to carry out both functions under the same roof. Real synergies
have to exist between the two activities, since if there exist none, there
would be no rationale for the existence of loan making and deposit taking
banks. | |
| Kashyap et al. (2002)
show that, indeed, as long as markets are imperfect, synergies exist between
deposit-taking and loan-making activities. They argue that banks offer credit
lines or loan commitments to their borrowers, such that the latter hold the
option to draw down the loan on demand over a specified period of time. Once
the decision to extend a credit has been made, the borrower can show up at any
time and withdraw funds, just as with a demand deposit. In that sense, banks
provide their customers with liquidity on both the liability and asset side to
accommodate their unpredictable needs, extending the original Diamond and
Dybvig (1983) argument[80]. Now, given that financial markets are imperfect,
a bank cannot accommodate liquidity shocks instantaneously by raising new
external finance, so that a buffer stock of liquid assets needs to be held.
Holding this buffer is costly for several reasons: opportunity costs, tax
distortions, increased agency costs, etc. So, if demand withdrawals and loan
draw downs are not perfectly correlated, a real synergy arises and a bank would
be able to hold a smaller total liquid asset stock than two separate
institutions would have to hold jointly. | |
| Other arguments have
also been raised. Dermine (2003a,b) lists several synergies between loan making
and deposit taking that lead to real cost reductions. For example, there could
be joint operating expenses in delivering deposits and loans, or the terms of
mortgage loans could simply require the opening of deposit accounts. Diamond
and Rajan (2001) argue instead that banks commit themselves to bearing
withdrawal risk by issuing demandable deposits. Hence, the bank will be
committed to do the utmost to collect from borrowers to repay depositors. If
not, a run might be precipitated and the bank would fail. Similarly, Calomiris
and Kahn (1991) argue that deposits may discipline bankers and hence, by
submitting themselves to demandable deposits, bankers may attain a lower cost
of capital. Finally, Mester et al. (2001) argue that deposits may help banks in
monitoring borrowers, thereby becoming superior lenders. | |
| Would separating
lending to SMEs and households lead to a loss of efficiencies? Lending and deposit taking naturally belong to each other and
separating one from the other would give rise to important efficiency losses.
As argued above, Kashyap et al. (2002) show that, indeed, so long as markets
are imperfect, synergies exist between deposit-taking and loan-making activities.
Dermine (2003a,b) list other synergies between loan making and deposit taking
that lead to real cost reductions. For example, there could be joint operating
expenses in delivering deposits and loans, or the terms of mortgage loans could
simply require the opening of deposit accounts. Diamond and Rajan (2001) argue
that banks commit themselves to bearing withdrawal risk by issuing demandable
deposits. Hence the bank will be committed to do the utmost to collect from
borrowers to repay depositors. If not, a run might be precipitated and the bank
would fail. Also, deposits might help banks in monitoring borrowers, thereby
becoming superior lenders (Mester et al., 2007). | |
| Given the existence of
market imperfections, there is a role for banks in bringing risk-averse savers
and borrowers together. | |
| Given its impact on
household consumption and SME investment, increasing the private funding costs
would give rise to social costs and reduced GDP and economic growth. | |
| 9.
Lending to large corporates | |
| The assessment and
analysis of lending to large corporates is similar to lending to households and
SMEs elaborated in section 8, except for the fact that large corporates depend
much less on banks for their funding, as they have easier access to debt
issuance and capital markets in general. The information asymmetry (and hence
market imperfection) is also less prominent, given that more analysts
scrutinise large corporates. | |
| As a result, lending to
large companies need not be linked to a deposit-issuing entity, but it can be
performed by a deposit entity. | |
| 10. References | |
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(1954), "Existence of an equilibrium for a competitive economy", Econometrica,
22, 3, pp. 265–290. | |
| Benston, G. (1990), The
separation of commercial and investment banking: the Glass-Steagall Act
revisited and reconsidered, Oxford University Press. | |
| Blundell-Wignall, A.,
P. Atkinson, and C. Roulet (2012), “The business models of large interconnected
banks and the lessons of the financial crisis”, National Institute Economic
Review, 221: R31. | |
| Calomiris, C. and C. Kahn
(1991), “The Role of Demandable Debt in Structuring Optimal Banking
Arrangements”, American Economic Review, 81, 3, pp. 497-513. | |
| Dermine (2003a),
“European Banking, Past, Present, and Future”, pp. 31-95 in The
Transformation of the European Financial System (Second ECB Central Banking
Conference), eds. V. Gaspar, P. Hartmann and O. Sleijpen, Frankfurt, ECB. | |
| Dermine, J. (2003b), "ALM in
Banking", Working Paper, INSEAD. | |
| Diamond (1984),
“Financial intermediation and delegated monitoring”, Review of Economic Studies,
51, pp. 393-414. | |
| Diamond (1991), "Monitoring
and Reputation: The Choice between Bank Loans and Directly Placed Debt", Journal
of Political Economy, 99, 4, pp. 689-721. | |
| Diamond and Dybvig
(1983), “Bank runs, Deposit Insurance, and Liquidity”, Journal of Political
Economy, 91, pp. 401-419. | |
| Diamond, D. and R. Rajan
(2001), “Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory
of Banking", Journal of Political Economy, 109, 2, pp.
287-327. | |
| Diamond, D. and R. Rajan
(2001), “Banks and liquidity", American Economic Review, 91, 2,
pp. 422-425. | |
| Drucker, S. and M. Puri
(2005), „On the benefits of concurrent lending and underwriting“, Journal of
Finance, 60, pp. 2763-2799. | |
| Ellis, K., R. Michaely,
M. O’Hara (2000), “When the underwriter is the market
maker: An examination of trading in the IPO aftermarket”, Journal of Finance,
55, 3, pp. 1039-1074. | |
| Fang, L., V. Ivashina and J. Lerner (2012),
“Combining banking with Private Equity investing”, Harvard Business School Finance
Working Paper No. 10-106. | |
| Frontier Economics
report (2013), “Exploring the impact of private equity on economic growth in
Europe”, report prepared for the EVCA, May. | |
| Gambacorta, L. and A.
van Rixtel (2013), “Structural bank regulation initiatives: approaches and
implications”, Bank for International Settlements, WP No. 412. | |
| Gilligan, J. and M. Wright
(2012), “Private equity demystified: 2012 update”, ICAEW. | |
| Gorton, G. and G. Pennacchi
(1990), “Financial intermediaries and liquidity creation”, Journal of
Finance, 45, 1, pp. 49-71. | |
| Hartzell, J., J.
Kallberg, and C. Liu (2008), ”The role of corporate governance in initial
public offerings: Evidence from real estate investment trusts’, Journal of
Law and Economics, 51, 3, pp. 539-562. | |
| Hebb, G. and D. Fraser
(2002), “Conflict of interest in commercial bank security underwritings:
Canadian evidence”, Journal of Banking and Finance, 26, 10, pp.
1935-1949. | |
| Hebb, G. and D. Fraser
(2003), “Conflict of interest in commercial bank security underwritings: United
Kingdom evidence”, Quarterly Journal of Business & Economics, 42,
pp. 79-95. | |
| Hoenig, T. and C.
Morris (2011), “Restructuring the banking system to improve safety and
soundness”, Federal Reserve Bank of Kansas City, May. | |
| Holmstrom, B. and J. Tirole
(1998), “Private and public supply of liquidity”, Journal of Political
Economy, 106, 1, pp. 1-40. | |
| HM Treasury (2012),
“Banking reform: Delivering stability and supporting a sustainable economy”,
June, London. | |
| HM Treasury
(2013),“Banking reform: a new structure for stability and growth”, February,
London. | |
| JP Morgan research June
2013 | |
| Richardson, M. (2013),
“Why the Volcker rule is a useful tool for managing systemic risk”, NYU Stern
School of Business working paper. | |
| Kanatas, G. and J. Qi
(2002), “Underwriting by commercial banks: Incentive conflicts, scope
economies, and project quality”, Journal of Money, Credit and Banking,
30, 1, pp. 119-133. | |
| Kang, J-K. and W-L. Liu
(2007), “Is universal banking justified? Evidence from bank underwriting of
corporate bonds in Japan”, Journal of Financial Economics, 84, 1, pp.
142-186. | |
| Kashyap, A., R. Rajan,
and J. Stein (2002), ”Banks as liquidity providers: an explanation of lending
and deposit-taking”, Journal of Finance, 57, 1, 33-73. | |
| Kovner, A. (2010), “Do
underwriters matter? The impact of the near loss of an equity underwriter”, FRB
New York Staff report No. 459. | |
| Kroszner, R. (1998),
“Rethinking banking regulation: a review of historical evidence”, Journal of
Applied Corporate Finance, 11, 2. | |
| Kroszner, R. and R.
Rajan (1994), “Is the Glass-Steagall Act justified? A study of te U.S.
experience with universal banking before 1933”, American Economic Review,
84, 4, pp. 810-832. | |
| Mester, L., L.
Nakamura, and M. Renault (2007), “Transactions accounts and loan monitoring”, Review of
Financial Studies,
20,pp. 529-556. | |
| Modigliani, F. and M.
Miller (1958), “The cost of capital, corporate finance, and the theory of
investment”, American Economic Review, 48, pp. 261-297. | |
| Mollica, M. and L. Zingales
(2007), "The Impact of Venture Capital on Innovation and the Creation of
New Businesses," October. | |
| Popov, A., and P.
Roosenboom (2012), “Venture Capital
and Patented Innovation: Evidence from Europe”, Economic Policy, 28, 71, pp. 447-482. | |
| Popov, A. and F. Smets
(2013), “Financial markets: Productivity, procyclicality, and policy”, in Financial Innovation: Too Much or Too
Little?, M. Haliassos (ed.), The MIT Press: Cambridge, MA. | |
| Puri, M. (1994), “The
long-term default performance of bank underwritten securities issues”, Journal
of Banking and Finance, 18, pp. 397-418. | |
| Rajan, R. (1992),
“Insiders and outsiders: The choice between informed and arm’s length debt”, Journal
of Finance, 47, 4, pp. 1367-1400. | |
| Richardson, M. (2013),
“Why the Volcker rule is a useful tool for managing systemic risk”, NYU Stern
School of Business Working Paper. | |
| Saunders, A. and I. Walter
(1994), Universal banking in the United States, Oxford University Press,
New York. | |
| Stein, J. (2002),
“Information production and capital allocation: Decentralized versus
hierarchical firms”, Journal of Finance, 57, 5, pp. 1891-1921. | |
| Stiglitz, J. (2010), The
financial crisis of 2007-2008 and its macroeconomic consequences, time for a
visible hand: Lessons from the 2008 world financial crisis, Oxford
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| Zingales (2012), “Why I was won over by Glass-Steagall”, Financial Times, June 10. | |
| Annex A7 – Strength
of Separation | |
| 1.
Introduction | |
| Building on chapters 4 and 5 of the impact
assessment, this Annex will continue the discussion on what forms of separation
could be envisaged as well as the strength of the fence, i.e., the combination
of measures of a legal, operational, economic, and governance nature that could
be adopted to ensure the independence, robustness and effectiveness of the
ring-fenced entity. To decide the optimal strength of the fence, different
proposed solutions will be evaluated to see how they would address the specific
objectives associated with structural reform. This is done by evaluating the
various proposals against the social benefits and social costs of implementing
them. | |
| The Annex is structured as follows: section
2 outlines the main forms of separation that are considered in this Impact
Assessment (accounting separation, functional separation and ownership
separation) and assesses each of these in light of the specific objectives of
structural reform (reduce moral hazard, improve resolvability, facilitate
monitoring, management and supervision, reduce conflicts of interests, reduce a
misallocation of capital, reduce losses of efficiency and impact on
competition) and identifies ownership separation and
"subsidiarisation"[81] as the options going forward. Section 3 proceeds to a more
in-depth analysis of what subsidiarisation actually means in terms of what
existing legislation requires, what changes to current legislation would be
required to maintain the integrity of subsidiarisation, and what additional rules can be used, and in what combinations, to reinforce
the independence of the separated entity from the rest
of the wider corporate group. Finally, section 4 aims
at specifically evaluate different “ring-fences” in that respect against the social benefits and social costs of implementing them which will
provide an answer as to how suitable they may be for addressing the specific
objectives of structural reform. Given the large permutation of possible
combinations of additional restrictions on economic, legal, governance and
operational links that may exist, this Annex elaborates and assesses a wider
range of ring-fencing approaches than the ones compared in the main body of the
Impact Assessment. | |
| 2.
Different forms of structural separation | |
| This Annex presents three broad forms of
separation: (1) accounting separation; (2) functional separation through subsidiarisation;
and (3) ownership separation (i.e., a prohibition of certain business lines). These
forms of separation display an increasing level of severity and intrusiveness
in a financial institution’s structure. | |
| More specifically: | |
| 1.
Accounting separation means that a financial
institution that provides integrated financial services would have to provide
separate accounts for each of its different business segments and make these
reports publicly available. This would constitute the lightest degree of
structural separation compared to the current status quo. | |
| 2.
Functional separation through subsidiarisation
is a requirement for a financial institution to transfer certain activities of
different business units into a separate, legal subsidiary. | |
| 3.
Ownership separation implies a prohibition on a
financial institution to engage in certain activities. This is the most
intrusive degree of structural intervention as it would involve winding down or
selling off assets connected to certain activities to an independent third
party. | |
| These three forms of separation are not
necessarily mutually exclusive; functional separation, for example, presupposes
a degree of accounting separation. The following sections will discuss each of
these forms of separation and evaluate them against the operational objectives
of structural reform. | |
| 2.1.
Accounting separation | |
| Accounting separation would require
financial institutions to provide separate accounts for the main activities
they are engaged in (whether through business divisions or subsidiaries). As a
result, the costs and ultimately revenues of each business division or
subsidiary (and transfers between them) would in principle be separately
identified. Accounting separation therefore increases transparency and makes
it easier to understand different parts of a financial institution and easier to
monitor and control potential financial transfers between divisions and
subsidiaries. | |
| Accounting separation has typically been
used in the utilities sector (e.g., in gas and water companies) to enable the
development of competition in contestable parts of the value chain and to
prevent cross-subsidies between the various activities of the operator. Accounting
separation is also obligatory for firms that provide services of general
economic interest next to any commercial activity. | |
| Currently there are two accounting
frameworks applicable for financial institutions in the EU: (1) the
International Financial Reporting Standards (the “IFRS”);[82] and (2) the Directive on the annual financial statements,
consolidated financial statements and related reports of certain types of
undertakings (the “Accounting Directive”).[83] | |
| The IFRS is mandatory for the consolidated
accounts of listed companies but EU Member States have the option to apply IFRS
also to the consolidated accounts of non-listed companies. The Accounting
Directive applies by default to individual accounts. IFRS is optional for
individual accounts in general. | |
| The introduction of the IFRS in EU has led
an increase in disclosures as IFRS requires more disclosure than the Accounting
Directive. For example, the IFRS requires detailed information on
consolidation and fair value measurement but also on different risks borne by
the financial institution (e.g., credit risk, liquidity risk or market risk).[84] More importantly, IFRS standards have led to improvements in the level of quality of disclosures which means that
it is now easier to assess a bank's risks. | |
| The IFRS asks for specific information per
business segment (e.g., investment banking, retail, corporate banking, and
assets management).[85] However, companies have leeway to define their segments which
means that the definition and the scope of the segments can differ from one
bank to another. Moreover, the information provided is in aggregate form. Therefore,
there is not always enough detail in the financial statements to identify the
financial flows either between business segments (e.g., "do retail
deposits fund investment banking activities?") or between business
divisions and subsidiaries. It is furthermore not possible to identify where
the profit, the cash or the own funds come from within a wider corporate group. | |
| Because the Accounting Directive leaves
Member States some flexibility in the way they transpose the requirements of
the Directives into national law (for example with regard to measurement of
financial instruments, re-evaluation of tangible or intangible assets), there are
now different national, general accepted accounting principles. As a
consequence, it is difficult to compare the financial statements of EU
financial institutions when they are based on the Accounting Directive. The
disclosure requirements in the Accounting Directive are also less stringent
than those of the IFRS. For example, disclosure requirements regarding risk or
business segments are different. | |
| In addition, in accordance with the Directive
on the access to the activity of credit institutions and the prudential
supervision of credit institutions and investments firms (the
"CRDIV")[86] all financial institutions must report to prudential supervisors on
own funds/capital requirements – “COREP.” Prudential supervisors also demand
additional quarterly reports (“FINREP”) on a consolidated level from “IFRS
financial institutions.” This is optional for non-IFRS banks. Finally,
financial institutions are also required to publically disclose information
regarding their prudential calculation (so-called “Pillar 3 disclosures”).[87] | |
| 2.1.1.
Social benefits and social costs | |
| As explained below, the net social benefits
of using accounting separation appear modest. | |
| Would accounting separation facilitate
recovery and resolution? The simplification of and
more transparency in a financial institution’s accounts could be one
contributing factor for facilitating the drawing up of a resolution plan. However,
accounting separation in itself is highly unlikely to significantly increase
resolvability because it does not address the issues that impact on
resolvability: for example, nature of activities (e.g., risky and easily
scalable), the level of complexity of the legal structure, size and intra-group
connectedness. | |
| Would accounting separation reduce moral
hazard? To the extent accounting separation
provides more transparency and to the extent information is publicly available
this could contribute to more informed choices and monitoring by investors
(depositors, creditors, and shareholders). However, accounting separation does
nothing to reduce or remove the incentives to take risk that arise because of
the perception of the implicit public safety net; it would most likely have an
insignificant impact on the incentives of investors to monitor and control bank
risk taking and therefore on the incentives for managers to take excessive risk
from the beginning. The impact on moral hazard would therefore be limited. | |
| Would accounting separation facilitate
monitoring, management and supervision? Accounting
separation leads to more information in the public domain which could make it
easier for relevant supervisory authorities to understand a financial
institution's balancing sheet. Similarly, it could make it easier for
investors to monitor balance sheet activities. However, given that this degree
of separation would not affect incentives to act on information, it is doubtful
that accounting would facilitate monitoring, management and supervision to such
an extent that incentives for excessive risk taking would change. | |
| Would accounting separation reduce
conflicts of interest? As accounting separation
does nothing to actually put a wall between the types of activities which may
give rise to conflict of interests it is highly unlikely that it would have any
significant impact on reducing conflicts of interests. | |
| Would accounting separation reduce
resource and capital misallocation? No. Accounting
separation is more a transparency measure. It will most likely have no impact
on incentives to allocate capital and human resources to trading and
intra-financial activity and away from lending activity. | |
| Would accounting separation lead to a
loss of efficiencies? No. This is because
accounting separation has no impact on diversification benefits and synergies
arising from universal banking. | |
| Would accounting separation impact on
competition? Accounting separation in itself is
unlikely to address the competition concerns that may follow from an implicit
public safety net; bank creditors' perception that the government will
intervene to protect them from the risk of bank failure will remain and any
distortions of competition arising from those banks who benefit from the
implicit subsidy (i.e., lower funding costs) and therefore have the ability to
expand at the expense of those banks that do not benefit from the implicit
subsidy will remain. | |
| To conclude, accounting separation appears
to be ineffective in addressing the operational objectives of structural reform
and this form of separation is therefore discarded from further evaluation. | |
| 2.2.
Functional separation through subsidiarisation | |
| Under functional separation through
subsidiarisation financial institutions would have to transfer certain
activities to a new legal entity (the "trading entity") or at least
ensure that certain activities are carried out in a separate legal entity to
insured deposit taking.[88] This trading entity would have to be authorized as an investment
firm[89] or, to the extent it would intend to take uninsured deposits as a
credit institution.[90] When part of a wider corporate group it would have to be ensured
that the trading entity could be swiftly isolated from the entity taking
insured deposits (the "deposit entity") should the financial health
of the trading entity be at risk. | |
| Subsidiarisation would require the trading
entity and the deposit entity to maintain self-standing reserves of capital and
of loss-absorbing debt, as well as to comply with other prudential requirements
on an individual, sub-consolidated or consolidated basis. Subsidiarisation
provides a degree of independence and to some extent also insulates the deposit
entity from shocks and losses. For more on subsidiarisation as a stand-alone
fence, see section 4 below. Moreover, and importantly, subsidiarisation
can be coupled with additional rules of a legal, operational, economic, and
governance nature to further regulate the relationship between the ring-fenced
entity and the wider corporate group. | |
| This form of separation has been followed
in different ways in a number of instances in other countries. For example, in
the United States bank holding companies are allowed to provide non-banking
financial services (e.g., securities dealing and insurance) under the condition
that these services are located in separate subsidiaries. In a similar manner,
the UK Government has also proposed a ring-fence around certain banking
activities based on functional separation through subsidiarisation, as have the
French and German Governments.[91] | |
| Finally, the act of
separating certain activities could take place through the transfer of relevant
assets and related liabilities to an existing legal entity (wholly-owned or
not) or through the creation of a new legal entity (wholly-owned or not) to
which assets and liabilities are then transferred. Separation would affect
shareholder and creditor rights to the extent that current rules provide for
their consent for the increase/decrease of capital,
and/or for mergers (including cross-border mergers) and divisions.[92] It cannot be excluded that relevant legislation would therefore
have to be amended to ensure that shareholders and creditors could not oppose
separation. | |
| 2.2.1.
Social benefits and
social costs | |
| As will be explained below, functional
separation through subsidiarisation has high potential for scoring well on
addressing the operational objectives associated with structural reform. This
is because subsidiarisation provides a degree of independence and to some
extent also insulates the deposit entity from shocks and losses, but also
because it can be further strengthened by the addition of various restrictions
of legal, operational, economic, and governance nature. These restrictions can
be added in various combinations to further regulate the relationship between
the ring-fenced entity and the wider corporate group and strengthen the wall in
between them. It is important to note that the social benefits and the social
costs increase with the strength of the fence: The better insulated and the
more independent the separated entity is vis-à-vis the wider corporate group
and, in particular, the deposit entity, the better subsidiarisation will
address the specific objectives, which as a result will impact positively on
the social benefits. However, the stronger the fence is the higher the social
costs may also be. For a more developed discussion and analysis of subsidiarisation
and the strength of the fence, see below section 4. | |
| Would subsidiarisation facilitate
recovery and resolution? Functional separation
could facilitate resolvability and resolution as balance sheets would become
smaller and more structured. This could expand the resolution options available
to relevant authorities, e.g., it could be easier to divide groups into
different parts and sell off/close them down. If the effects of a failure can
be functionally insulated, it could also be easier to concentrate supportive
funding to those parts that the society wants to support and therefore reduce
public sector support for other socially less desirable functions (e.g., retail
versus certain trading services). The stronger the fence the more subsidiarisation
would facilitate recovery and resolution. | |
| Would subsidiarisation reduce moral
hazard? Complying with capital requirements on a
stand-alone basis may have the effect of better aligning risk-taking incentives
within a banking group. For example, the cost of increasing trading activities
would partly be reflected in the stand-alone capital requirements. Banks would
not be in a position to expand their trading activities entirely on the basis
of capital from the deposit entity. Depending on the degree of restrictions of
legal, economic and governance nature, functional separation could
significantly curb moral hazard which may have led boards and managers to
encourage excessive risk taking as they knew that big losses would be paid
largely by taxpayers rather than stakeholders. The stronger the fence the larger
the impact would be on reducing moral hazard. | |
| Would subsidiarisation facilitate
monitoring, management and supervision? Functional
separation could increase transparency and clarity, and reduce complexity in
the structure of a group. How much easier market monitoring, management and
supervision of risks in the different subsidiaries become will depend on the
legal, economic and governance links between the separated entity and the wider
group (i.e., the strength of the fence). | |
| Would subsidiarisation reduce conflicts
of interest? Subsidiarisation will provide thicker
walls between various activities in a group. Again, the more legal, economic
and governance links between various group entities are restricted (the higher
the fence) the better conflicts of interest could be resolved. | |
| Would functional separation reduce
resource and capital misallocation? By separating
certain activities from insured deposit taking, the funding of those activities
would become more risk-sensitive. As a result, financial institutions would
have less of an incentive to encourage excessive risk taking. However, the
extent to which funding becomes fully risk sensitive depends on the degree of
separation. If the incentives for excessive risk taking are reduced so would
the incentives to allocate capital and human resources to trading and
intra-financial activity and away from lending activity. | |
| Would functional separation lead to a
loss of efficiencies? Subsidiarisation would not
necessarily affect a financial institution's ability to provide a universal set
of services within a group. Therefore, effects on potential efficiencies
resulting from such diverse services may be limited. However, there is a link
between the strength of the fence and a reduction in efficiency gains. For example,
the requirement to comply with capital requirements on a stand-alone basis
would imply additional capital costs for the two entities due to possible
diversification of capital effects. Also, the stronger the fence is on
requiring subsidiaries to be self-standing and independently funded, the more
functional subsidiarisation could reduce efficiency gains stemming from
economies of scope and scale. | |
| Would subsidiarisation impact on
competition? | |
| Similar to accounting separation,
subsidiarisation in itself and without additional restrictions is unlikely to
address the competition concerns that may follow from an implicit public safety
net. This is because it does not address bank creditors' perception that the
government will intervene to protect the too-big-to-fail banks
("TBTF" banks) from the risk of failure. Therefore creditors have no
incentive to demand banks to pay the right compensation for bearing risks,
which in turn lowers funding costs for the TBTF banks. This enables the latter
to benefit from lower funding costs which in turn enables them to distort
competition by expanding at the expense of those banks that do not benefit (or
benefit less) from the implicit subsidy. Moreover, because different Member
States have a different ability and willingness to intervene to rescue banks, competition
among Member States (and wider, on an international level) also remains
distorted. | |
| 2.3.
Ownership separation | |
| Ownership separation is a prohibition on
those financial institutions that are caught by the relevant thresholds, and
therefore subject to structural reform (the "affected institutions"),
to engage in certain activities, even through legally separated affiliates. This
is the most intrusive form of structural separation as the affected
institutions would accordingly have to wind down or divest any assets
supporting such activities as well as the liabilities related to the assets
that were up for divestiture. If divested, those assets and related
liabilities would have to be sold off/transferred to a completely different
legal and structurally separate entity with which the affected institutions
could have no links of any nature. This would impact on the universal banking
model to the extent that not all activities could be provided by one and the
same financial institution. | |
| Ownership separation could be accomplished
by way of division of assets, transfer of all assets and liabilities through a
merger or an acquisition or through a spin off that would lead to the creation of an independent company through the sale or distribution of
new shares of an existing business/division. | |
| Whichever way, it cannot be excluded that changes
to current EU law would be required to ensure that ownership separation could
not be opposed; For example, current rules that: (i) require shareholders’
approval of any increase or reduction of capital;[93] and (ii) require approval by the General Meeting of
merger/cross-border merger/divisions.[94] Moreover, CRDIV currently provides that Member States can object
to the change of ownership of a bank only on certain prudential grounds. A ban
on the acquisition of a deposit bank by an investment bank – for the reason
that it is an investment bank – could well be held to breach the obligation on
the competent Member State authority to object to an acquisition only on the
limited set of prudential criteria set out in Article 23, which does not
include the criterion that an acquirer of a deposit bank is not an investment
bank. | |
| Imposing ownership separation on financial
institutions could also have an impact on the EU Internal Market. In particular,
ownership separation could limit the freedom to provide services to the extent that
the affected institution would no longer be permitted to carry out certain
activities in combination with insured deposit taking. Finally, the right to property is a fundamental right protected
in the Charter of Fundamental Rights | |
| 2.3.1.
Social benefits and
social costs | |
| As the below description will illustrate,
there are good arguments why ownership separation may lead to high social
benefits. It could, however, also lead to significant losses of economies of
scope and trigger a migration of certain activities toward non-bank credit intermediaries (so-called "shadow banks"),
which could imply high social costs. | |
| Would ownership separation facilitate
recovery and resolution? Ownership separation
would facilitate resolution mainly because certain risks linked to the
prohibited activities would no longer feature on the balance sheets of the
financial institution. Depending on the scale of the relevant activities,
banks may also become less complex and smaller in size as a result of divesting
them or winding them down. | |
| Would ownership separation reduce moral
hazard? The primary advantage of ownership
separation is that, while it may be complex to implement, it is an “unclouded”
solution which after completion could alleviate the need for further regulation
within the context of structural reform. Ownership separation could
effectively remove the implicit state subsidy from those financial institutions
that are TBTF. This would remove the related moral hazard, depending on the
extent of the ownership separation, i.e., the activities to be separated. | |
| However, ownership separation could give
rise to more homogeneous and less diverse entities and business models and
allow for less economies of scope, such as risk diversification. It can
therefore not be excluded that completely separated entities may fail more, and,
if so, more as a herd, which would complicate system-wide resolution. | |
| Would ownership separation facilitate
monitoring, management and supervision? Monitoring,
managing and supervision could be facilitated, as the activities that are most
scalable and complex and consequently difficult to monitor would be located
outside the financial institution. | |
| Would ownership reduce conflicts of
interest? The impact on conflicts of interests
will depend on the range and type of activities that are prohibited from the
group. See Annex A6 for a discussion of the different activities. Depending
on the scope of the activity prohibition, conflicts of interest may be
significantly reduced through ownership separation. | |
| Would ownership separation reduce
resource and capital misallocation? With the most
risky activities no longer part of its balance sheet, a financial institution
could be able to focus on and allocate more resources to lending to the real
economy. | |
| Would ownership separation lead to a
loss of efficiencies? The
primary disadvantage is the loss of potential economies of scope from
integration within the universal banking model. Economies
of scope consist of risk diversification, cost economies of scope, and revenue
economies of scope. Economies of scale would be present to the extent there
are significant fixed costs for some operations, even though diseconomies of
scope can arise. Similarly, economies of scale are found to be exhausted at
relatively low levels of bank assets, and thereafter diseconomies of scale
become also important. | |
| As a result of the loss in economies of scope
(and scale), private funding and capital costs increase with the strength of
separation and hence would be the highest under ownership separation. If some of these activities perform an important role in the
economy these additional costs may have further efficiency effects in other areas
of the economy. | |
| Would ownership separation impact on
competition? | |
| Ownership separation could eliminate
implicit cross-subsidies and introduce effective market discipline on the
trading entity. This would have the effect of evening out the level playing
field among small, medium-sized and large banks not only within a single Member
State but also across Member States (and wider). | |
| Finally, it cannot be excluded that
divested activities will migrate from affected institutions to shadow banks
where there may be less scope for control by supervisors (whether or not
located with the EU). Work done by the Financial
Stability Board (the "FSB") has highlighted that the disorderly
failure of shadow bank entities can carry systemic risk, both directly and
through their interconnectedness with the regular banking system. The FSB has
also suggested that as long as such entities remain subject to a lower level of
regulation and supervision than the rest of the financial sector, reinforced
banking regulation could drive a substantial part of banking activities beyond
the boundaries of traditional banking and towards shadow banking. The European
Commission has recently adopted a Communication setting-out a roadmap for
tackling the risks inherent in shadow banking. The measures foreseen in this
roadmap, including a series of regulatory measures such as a framework for the
interaction between banks and the shadow banking sector, are intended to ensure
that the potential systemic risks to the financial sector are covered and that
the opportunities for regulatory arbitrage are in limited, in order to
strengthen market integrity and increase the confidence of savers and
consumers. This includes tightening the prudential rules applied to banks in
their operations with unregulated financial entities in order to reduce
contagion risks.[95] | |
| 2.4.
Ownership separation and functional separation
through subsidiarisation are the preferred options
going forward | |
| Based on the above evaluation of each of
the different forms of functional separation the following conclusions are
appropriate: | |
| ·
While accounting separation would leave
potentially existing economies of scale and scope intact, it would have no or
only limited impact on any of other criteria used to measure social benefits
and social costs. It will therefore not be subject to any further analysis. | |
| ·
Ownership separation scores very high on social benefits but also come at high social
costs. There is also a risk which is not insignificant that some of the prohibited
activities might migrate to the shadow banking sector. | |
| ·
Conversely, subsidiarisation would come
at a comparably lower social cost than ownership separation. As section 4
illustrates there is also a case that subsidiarisation
can deliver similar social benefits as
ownership separation at a lower social cost (this lower cost
may vary depending on the strength of the fence). The additional costs of
ownership separation as opposed to subsidiarisation would therefore need to be
justified by additional social benefits on
an activity by activity basis. For example, as highlighted in Chapter 5, as
regards ownership separation of proprietary trading, the balance between
benefits in terms of e.g., facilitating resolvability and reducing moral hazard
and conflicts of interest clearly outweigh the costs in terms of foregone
efficiency, as these are very limited. | |
| ·
While individual weightings might differ, the
sum of social costs and benefits of ownership separation and subsidiarisation
may be more or less equal and they are both candidates for the preferred policy
option. Given, however, that subsidiarisation is a wider concept and can exist
in various degrees the remainder of this Annex will focus on subsidiarisation
and the determination of the appropriate degree/strength of subsidiarisation. | |
| 3.
Subsidiarisation | |
| The remainder of
this Annex will discuss functional separation through subsidiarisation in more
depth to see how this form of separation can best address the specific
objectives of structural reform.[96] In particular, the remaining part will discuss various
"degrees" of subsidiarisation that can be achieved by adding rules in various combinations to reinforce the fence between the separated
entity and the rest of the wider corporate group. | |
| To that end, section 3.1 aims at describe
what the simplest form of separation through subsidiarisation actually means in
terms of how current key banking legislation on prudential requirements and
resolution apply to the separated entities. Section 3.2 discusses more normatively
what changes to current legislation could be envisaged to secure the
effectiveness of subsidiarisation and limit that prudential concerns arise. Section
3.3 lists additional rules that can be added in various
combinations on top of current legislation to build on subsidiarisation and
reinforce the independence of the separated entities and the wall in between
them (i.e., to build a stronger fence between the separated entity and the rest
of the group, in particular the deposit entity). Finally, section 4 aims at determine
the appropriate strength of the fence by specifically evaluating the social
benefits and costs of various combinations of rules (different fences) section. | |
| 3.1.
Subsidiarisation under current regulatory
framework | |
| In accordance with existing legislation
regarding prudential requirements and recovery and resolution,[97] the following would apply automatically in case of subsidiarisation: | |
| Separate management bodies: Under subsidiarisation, the trading entity and the deposit entity
will have their own separate management bodies[98] and follow the requirements regarding composition and selection of
members set out in the CRDIV.[99] | |
| Prudential requirements: In accordance with CRDIV and the Regulation on prudential
requirements for credit institutions and investment firms (the "CRR")[100] the general rule is that the basic prudential requirements with
regard to own funds, capital, leverage (as of 2019), liquidity, large exposures[101] and prudential reporting apply on an individual and consolidated
basis.[102] This means that both the trading entity and the deposit entity
would have to abide by these rules on an individual or consolidated basis. The
CRR also provides competent Member State authorities under certain
circumstances with some discretion to impose additional capital requirements in
the form of buffers on so-called global and other systemically important
institutions. This may include both the trading entity and the deposit entity.[103] | |
| Bail-in tools: The BRRD requires that each credit institution and investment firm
maintains a sufficient amount of liabilities in their balance sheet that could
be subject to bail-in powers.[104] | |
| Capital transfers and dividend payments:
According to CRDIV, capital transfers and dividend
payments are allowed only when it can be established that the institution has
sufficient financial resources to do so and when this does not lead to a breach
of any prudential requirements regarding, for example, capital. This means that
capital transfers and dividend payments from the deposit entity to the parent
or the trading entity could only be effectuated under those circumstances.[105] | |
| Corporate governance arrangements: The CRDIV sets out the basic rules regarding the management body and
other governance arrangements. In particular, the CRDIV provides that each
entity within a wider corporate group has to have its own risk management
strategy which must cover measures to manage, monitor and mitigate risks which the
institution is and might be exposed to. This risk management strategy needs to
be approved and implemented by each separate legal entity's management body.[106] The trading entity shall also formulate its
remuneration policies in line with the rules set out in the CRDIV which require
that the remuneration policy is consistent with and promotes effective risk
management, is in line with business strategies and long-term interest of the
institution.[107] | |
| Disclosures: Where the trading entity is part of a wider corporate group and to
the extent it constitutes a “significant subsidiary” of
an EU parent institution,[108] it shall disclose information regarding its own funds, capital
requirements, capital buffers, credit risk and credit risk mitigation
techniques, remuneration policy, leverage on an individual or sub-consolidated
basis.[109] When the trading entity is not part of a wider corporate group all
disclosures and prudential reporting requirements obviously apply on an
individual basis. | |
| Recovery plans: Finally, according to the BRRD, group recovery plans as well as
individual recovery plans for each institution that is part of the group need
to be drawn up which means that each of the trading entity and the deposit
entity will have to draw up its own recovery plan.[110] This includes identifying arrangements for cooperation and
coordination with relevant authorities in third countries where a group
includes entities incorporated abroad.[111] | |
| 3.2.
What amendments to the current regulatory
framework could be envisaged to enhance the effectiveness of subsidiarisation? | |
| As described in the previous section, subsidiarisation
itself already provides a certain degree of separation
in terms of legal, economic and governance links with the rest of the group.
Subsidiarisation therefore insulates the deposit entity
from shocks and losses to a certain extent. To enhance the effectiveness of subsidiarisation and reduce chances
that prudential concerns arise, a number of amendments to existing legislation
could be envisaged. These amendments relate to legislation regarding prudential
requirements and recovery and resolution. | |
| Amendments ensuring adherence to the
prudential requirements on a sub-consolidated basis: The requirement that prudential obligations must be fulfilled on an
individual basis can be waived under current legislation and under certain
conditions, for example for a subsidiary or a parent established in the same
Member State as the group if certain conditions are met.[112] To ensure the effectiveness of the subsidiarisation it could be
envisaged to prescribe that obligations should apply at sub-consolidated level
– i.e., among entities belonging to the same sub-group.[113] It would also have to be clarified that it can only be applied
among similar entities. Doing so will require changing those provisions in the
CRR that provide for derogation to the application of prudential requirements
on an individual basis. With regard to intra-group large exposures in
particular it should also be envisaged to specifically prescribe that the
limits currently set out in Article 395(6) of the CRR will not apply once an EU
law is adopted and that large exposures rules shall apply as between entities
belonging to different sub-groups of similar entities. | |
| Amendments ensuring that disclosures are
made on an individual or sub-consolidated basis among similar entities: In order to ensure the effectiveness of monitoring and supervision
of the separated entity, it could be envisaged to define the trading entity as
a "significant subsidiary" of an EU parent within the meaning of
Article 12 of the CRR because otherwise disclosure requirements regarding own
funds, remuneration policy and leverage ratio apply on a consolidated basis for
the wider corporate group. | |
| Amendments ensuring that the deposit entity is not made liable for costs related to resolution
actions involving the trading entity: In view of
recovery and resolution, the BRRD currently allows entities within a wider
corporate group that are covered by the supervision of the parent undertaking
to enter into agreements with each other to provide financial support to any
party of the agreement that experiences financial difficulties.[114] Moreover, group resolution plans shall
identify how the group resolution actions could be financed and, where
appropriate, set out principles for sharing responsibility for that financing
between sources of funding in different Member States.[115] | |
| In principle, the agreement to provide
financial support may only be concluded if the supervisory authority considers
none of the parties in breach of the CRDIV in relation to the rules on capital
or liquidity, or is at risk of insolvency. However, to avoid that the deposit
entity becomes liable for costs related to resolution actions involving the
trading entity which may put undue stress on the balance sheet of the deposit
entity it could be envisaged to specifically set out in legislation that for
the deposit entity such agreements can by their nature jeopardize the liquidity
or solvency of the deposit entity or create a threat to financial stability and
therefore cannot be concluded. Similarly with regard to the shared financial
responsibility for resolution actions, it should be specified that the deposit
entity should not be liable for any costs related to resolution actions
involving the trading entity. Both these clarifications would require
amendments to the BRRD. | |
| * * * | |
| In addition to the above amendments, to
safeguard the objectives of subsidiarisation, there are a number of additional
rules that could be used in various combinations to further strengthen the
separation between the trading entity and the rest of the group, in particular
the deposit entity. The following section lists a number of such rules. These
rules are not mutually exclusive. | |
| 3.3.
Potential additional rules to further strengthen
separation
3.3.1.
Rules to achieve stronger legal and operation
separation | |
| To further strengthen the insulation of the
trading entity, to avoid an unrestricted mixture of activities, to limit that
liabilities or potential liabilities are shifted around between entities within
the wider corporate group, and to limit conflicts of interests, one or several
of the following additional rules could be added to the subsidiarisation: | |
| Intra-group ownership restrictions: | |
| ·
The trading entity is not allowed to hold shares
or voting power in a deposit entity. The purpose of this rule would be to avoid
the creation of potential conflicts of interests and culture shocks that may
affect banking standards, and to reduce risks related to moral hazard that may
arise from funding and subsidy leakages that can occur between the different
entities; and/or | |
| ·
The deposit entity is not allowed to hold shares
or voting power in a trading entity. The purpose of this rule would be to
avoid that the deposit entity has to bear any losses related to the trading
entity; and/or | |
| ·
The trading entity is not allowed to hold shares
or voting power in critical infrastructure needed for the operation of the
deposit entity. The purpose of this rule would be to ensure the continuity
of vital banking services provided by the deposit entity in case the trading
entity fails. | |
| Operational continuity: | |
| ·
Another option could be that the wider corporate
group, including the parent, would have to ensure the operational continuity of
the deposit entity under all circumstances; irrespective of the financial
health of the trading entity. This would include but not be limited to: access
to critical infrastructure, staff, data and information, and services. | |
| 3.3.2.
Rules to achieve stronger economic separation | |
| To further ensure that subsidiarisation
results in separate and independent entities that can effectively operate as
stand-alone entities and to increase transparency for supervisors and market
participants, the following requirement could be considered in addition to subsidiarisation: | |
| ·
Separate debt issuance: Both the deposit and trading entities could issue their own debt
(i.e., independently from each other and any other entity, including the
parent, in the wider corporate group). The purpose of this rule would be to
avoid any effects of increasing contagion risk within a group in the event of
distress. | |
| ·
Disclosures: The trading entity and the deposit entity could make all financial
and supervisory disclosures on an individual or sub-consolidated basis. The
purpose of this rule would be to facilitate monitoring, management and
supervision by investors, creditors, managers and supervisors. | |
| Specifically on reducing intra-group
interconnectedness: | |
| To further ensure the insulation and
independence of the trading entity when it forms part of a wider corporate
group and to limit contagion risks, the following rules, which in various
combinations contribute to reducing the interconnectedness among group
entities, could be considered with regard to interactions between the trading
entity and the rest of the group – including the parent: | |
| Exposures[116] to an
individual group entity or group of entities: | |
| ·
Intra-group exposures could only be allowed
between "similar" entities. The purpose of this rule would be to
remove any contagion risks between the trading entity and the deposit entity as
it would effectively result in a zero per cent large exposure limit to any
intra-group exposures between trading entities and entities not belonging to
the same sub-group; or | |
| ·
A large exposure limit could apply to the
exposures of all deposit entities to each trading entity or wider to include
also other financial sector entities (the limit is applied on a
sub-consolidated basis and equal to [x]% of the eligible capital of the
sub-group of deposit entities). This limit could apply on a net basis and after
taking account of credit risk mitigation techniques. The purpose of this
rule would be to reduce contagion risks from trading entities to deposit
entities; or | |
| ·
A large exposure limit could apply to the total
amount of exposures of all trading entities to all deposit entities (the limit
is applied to aggregated exposures on a sub-consolidated basis and equal to [x]%
of the eligible capital of the sub-group of trading entities). This limit could
apply on a net basis and after taking account of credit risk mitigation
techniques. The purpose of this rule would be to limit contagion risks from
deposit entities to trading entities. | |
| Treasury Management: | |
| Treasury management plays a pivotal role in
the running of a financial institution as it is responsible for the management
of the institution’s capital, liquidity and funding. However, to ensure an
appropriate relationship between the trading entity and the deposit entity that
is in the spirit of structural reform, the following rule could be considered: | |
| ·
The trading and deposit entities should have
their own separate treasury management. The purpose of this rule would be to
limit the deposit entity’s dealing in investments and to avoid any potential
conflicts of interest that may arise. | |
| Contracts and other transactions: | |
| To ensure that both entities are acting in
their own self-interest and are not subject to any pressure or duress from the
other party, and to increase transparency and facilitate monitoring and
supervision, one or several of the following rules could be considered: | |
| ·
All transactions within the group (including, if
relevant, the parent) could be made at arm’s length commercial basis. The
purpose of this rule is to avoid undue influence by one entity over the other
and to increase transparency;[117]
or | |
| ·
Only transactions between the trading entity and
the deposit entity could be at arm's length commercial basis. The purpose of
this rule would be to avoid undue influence by the trading entity over the
deposit entity and to increase transparency. | |
| ·
Extensions of credit and guarantees to the trading
entity from the deposit entity could be secured by high-quality collateral. The
purpose of this rule is to act as a mitigant to any prudential concerns. | |
| Intra-group financial support: | |
| In view of recovery and resolution, one
option could be that the trading entity is not allowed to enter into agreements
to receive or in any other form, direct or indirect, benefit from financial
support from the deposit entity (or only if it would be absolutely satisfied
that it can do so without putting into question the "integrity" of
the separation).[118]
The purpose of this rule would be to ensure that the deposit entity cannot
be burdened by financial obligations of the trading entity that ultimately may
put at risk its own solvency. | |
| Resolution actions: | |
| With regard to the financing of groups'
resolution actions, one option could be that the deposit entity should not be
liable for any costs related to resolution actions involving the trading
entity.[119]
The purpose of this rule would be to ensure that the deposit entity cannot
be burdened by financial obligations toward the trading entity that ultimately
may put at risk its own solvency. | |
| Specifically on reducing
interconnectedness between banking groups | |
| To reduce the interconnectedness between
banking groups, to mitigate systemic contagion risks and protect the insured
deposits, one or several of the following rules could be considered: | |
| Exposures to an individual counterparty
or groups of connected counterparties: | |
| ·
Exposures of all entities within the wider
corporate group to financial institutions not part of the same wider corporate
group could be limited beyond current rules regarding large exposures. The
purpose of this rule would be to limit the effects of a financial institution’s
failure on the entire financial system ; or | |
| ·
All the exposures of all trading entities within
a wider corporate could be limited. The purpose of this rule would in
particular be to limit the effects of a trading institution’s failure on the
entire financial system. | |
| ·
To the extent that an ownership separation of
certain activities was to be combined with subsidiarisation, one could consider
limits (including aggregate limits) to the large exposure regime for the
deposit entity toward the trading entity or any financial sector entity. This
could be particularly important for the deposit entity to manage risk
especially in cases where an ownership separation of a significant amount of
trading activities that give rise to major risks could cause a migration of
such activities to the shadow banking area where they are more likely to remain
outside the scope of supervision.[120] | |
| 3.3.3.
Rules to achieve stronger corporate governance | |
| As described in the Commission's Staff
Working Document on Corporate Governance in Financial Institutions, the latest
financial crisis revealed serious flaws and shortcomings in board performance
at a number of financial institutions.[121]
Corporate governance requirements are intended to encourage a bank to be well
managed. Good corporate governance may therefore, in an indirect way, help limiting
the probability of failure and also mitigate the impact of a failure. | |
| To strengthen the separation of the trading
entity, to limit conflicts of interest and to ensure that the trading entity
has a relationship with the rest of the group that is in the spirit of
structural reform, to align incentives, while still leaving flexibility for the
parent to deliver group strategies, one or several of the following rules could
be considered: | |
| The composition of the management body:[122] | |
| ·
A sufficient number of management body members should
be non-executive members. The purpose of this rule would be to reduce
conflicts of interests and provide for more independence within a management
body;[123] | |
| ·
Another option could be that
there should be no (or limited to a minority) cross-membership between the
management body of the trading entity and that of the deposit entity. The
purpose of this rule would be to reduce conflicts of interest and culture
between the two entities; and/or | |
| ·
Another option could be that there should be a
limit to the number of management body members from the parent sitting on the
management bodies of the trading entity and the deposit entity. The purpose
of this rule would be to limit undue influence of the parent over the deposit
entity and to reduce conflicts of interest; and | |
| ·
The same parent member is not allowed to sit on
both the trading entity and the deposit entity management body. The purpose
of this rule would be to reduce, if not avoid, parental influence over the
deposit entity and to reduce conflicts of interest. | |
| The duties of the management body: | |
| ·
One option could be to
impose a statutory duty for managers and all management bodies (including the
parent's) to uphold the objectives of the separation. The purpose of this
rule would be to make the duty to uphold the objectives of the separation a
fiduciary duty to ensure that business strategies are aligned with the
objectives of the separation;[124] | |
| ·
Another option could be to
state that the management body of the deposit entity and the parent should have
a statutory duty to protect depositors. The purpose of this rule would be to
make the duty to protect depositors a fiduciary duty to ensure that the deposit
entity’s business strategies are aligned with the objectives of the separation. | |
| Governance structures, Remuneration: | |
| ·
There could be a statutory duty for the trading
entity and the deposit entity to ensure that the internal remuneration policy
is in line with the objectives of the separation. The purpose of this rule would
be to ensure alignment between remuneration policies, risk management and
internal control systems. | |
| 4.
Determining the appropriate strength of separation | |
| The previous section identified a number of
rules that could be used in the context of subsidiarisation and explained what
the purpose of each rule would be when building a fence. This section evaluates
how various groups of rules (legal, economic and governance) would address the specific
objectives associated with structural reform. Although a great variety of
groups could surely be envisaged the subsequent section will be limited to
assessing three different models of fences displaying various degrees of
strength ranging from limited separation (subsidiarisation only) to very strong
separation (subsidiarisation ++). This range constitutes the most
representative picture of how rules could be played around with to establish an
appropriate fence. The assessment will include an evaluation of each of these
models measured against the social benefits and social costs[125] of implementing them
to see how far they go toward addressing the microeconomic objectives of
structural reform. | |
| 4.1.
Social benefits and
social costs linked to legal, economic and governance rules
4.1.1.
Social benefits and social costs of legal rules | |
| The legal rules discussed in 3.3.1 are
basically rules prohibiting certain ownership: (i) the trading entity cannot
hold shares or voting power in a deposit entity; (ii) the deposit entity cannot
hold shares or voting power in a trading entity; and (iii) the trading entity
cannot hold shares or voting power in critical infrastructure needed for the
operation of the deposit entity. | |
| ·
Would the legal rules facilitate recovery and
resolution? Ownership restrictions can have the
effect of further insulating the trading entity from the deposit entity in
terms of funding; more insulation enhances resolvability without taxpayer
support. It may also reduce complexity in resolvability. Moreover, if there
were a sibling structure entirely different resolution tools could be deployed
for the trading entity and the deposit entity. The risk of contagion would also
be reduced as the parent/holding company would act as a firewall between the
two sister companies | |
| ·
Would the legal rules reduce moral hazard? Ownership restrictions are consistent with the principle of
insulating the trading entity from the deposit entity that structural reform
seeks to achieve through functional separation. The more independent the
trading entity is and the more intra-group relationships are assimilated to
relationships with third parties, the more credible it may be to the market
place that the trading entity will not benefit from government support in case
of financial trouble. This can discipline any incentives for excessive risk
taking as well as ensuring better alignment of incentives. Ultimately, however,
the effect on moral hazard will also depend on the extent other parts of the
intra-group relationship are regulated (i.e., see the discussion below
regarding economic and governance links). | |
| ·
Would the legal rules facilitate monitoring,
management and supervision? More insulation of the
trading entity from the deposit entity would mean that the objectives and needs
of each separate entity would be even clearer and therefore easier for
management to implement and supervise. Reducing the intra-group
interconnectedness will make each entity's accounts more clear and likely more
transparent, which will facilitate supervision. | |
| ·
Would the legal rules reduce conflicts of
interest? Different legal entities with separate
management bodies with their own separate objectives can reduce conflicts of
interest. | |
| ·
Would the legal rules reduce resource and
capital misallocation? On its own there is no
guarantee that an ownership restriction would significantly disincentivize the
allocation of capital and human resources to trading and intra-financial
activity and away from lending activity. It will depend on the entire group
structure and what other measures there would be to curb incentives to take
excessive risks. | |
| ·
Would the legal rules lead to a loss of
efficiencies? Not on its own; it would depend on
what additional rules may apply among entities within the wider corporate group
and that may restrict to a varying degree efficiencies of scale and scope to be
shared among group entities. However, the legal rules under consideration would
have a significant effect on legal corporate structures and holding patterns
within the wider corporate group. | |
| Would the legal rules impact on competition? Generally, legal rules complement economic and governance rules
and, taken together, they may credibly remove the implicit subsidy and improve
competition. However, an ownership separation applied across an entire
sector would be the most effective and credible way to eliminate the
implicit public safety net and could therefore improve the level playing
field. | |
| As is illustrated above, an ownership
restriction on its own can be effective with regard to certain issues. Its
effectiveness will, however, increase if it is imposed on both the trading and
the deposit entity and if it is coupled with additional rules that can target
other parts of intra-group relationships. | |
| 4.1.2.
Social benefits and social costs of economic
rules | |
| The economic rules discussed in section 3.3.2
concerned: (i) separate debt issuance; (ii) financial and prudential disclosure
requirements; (iii) large exposure rules (both within a banking group and among
different banking groups); (iv) treasury management; (v) arm's length base
approach in contracts and other transactions; and (vi) intra-group financial
support for resolution purposes. | |
| ·
Would the economic rules facilitate recovery
and resolution? The effect of making in particular
the trading entity more independent of the other entities in the wider
corporate group in the sense that it is not reliant on resources provided by
the wider corporate group is that it enhances resolvability without taxpayer
support. | |
| ·
Would the economic rules reduce moral hazard? The more economically independent in particular the trading entity
is of the other entities in the wider corporate group in the sense that it is
not reliant on resources provided by the wider corporate group, the greater the
incentives of investors (depositors, creditors, and shareholders) to monitor
and control bank risk taking, which in turn decreases incentives for managers
to take excessive risk as they would have to bear the consequences of their own
risk actions. | |
| ·
Would the economic rules facilitate
monitoring, management and supervision? The more
the trading entity's funding has to come from external capital markets the more
shareholders and creditors would be incentivized to monitor risk taking. Moreover,
reducing the intra-group interconnectedness will make each entity's accounts
more clear and self-contained and likely more transparent which will facilitate
supervision. | |
| ·
Would the economic rules reduce conflicts of
interest? On their own, economic rules most likely
have a limited impact on reducing conflicts of interests. | |
| ·
Would the economic rules reduce resource and
capital misallocation? The more economically
independent in particular the trading entity is of the other entities in the
wider corporate group in the sense that it is not reliant on resources provided
by the wider corporate group, the more its funding will be risk sensitive and
also more costly. This may reduce incentives to invest in projects which are
not worthwhile on average, but risky enough to have at least some chance of
making money, which could lead to a better allocation of capital in the
economy. | |
| ·
Would the economic rules lead to a loss of
efficiencies? In principle, the imposition of
economic rues could lead to some losses of economies of scale and scope.
However, imposing additional economic rules does not prevent the bank from
deciding to place many activities on either side of the fence, excess capital
could under certain conditions still be transferred among the entities within
the wider corporate group and customers could still use a single group for all
of their services, which means that a certain level of diversification benefits
would still remain (for more on economies of scale and scope see Annex A9).
Similarly, groups may continue to benefit from operating cost reductions from
pooling certain resources such as, for example, IT and finance systems and from shared marketing and advertising campaigns. Even
so, the introduction of separate debt issuance and individual/sub-consolidated
application of prudential requirements would be associated with a cost for the
bank. | |
| ·
Would the economic rules impact on
competition? To the extent that economic rules
could successfully and credibly remove the implicit public subsidy there would
be scope to argue for an improved level playing field. However, it is doubtful
that economic rules on their own would achieve that. | |
| As is illustrated above, economic rules can
be effective in terms of addressing the operation objectives of structural
reform. The effectiveness may depend on the combination of economic rules
imposed and, as for the legal rules, the effectiveness will increase when coupled
with also other types of rules. | |
| 4.1.3.
Social benefits and social costs of governance
rules | |
| The governance rules discussed in section 3.3.3
concerned: (i) the composition of the management body; (ii) the duties of the
management body; and (iii) remuneration. | |
| ·
Would the governance rules facilitate
recovery and resolution? Governance rules are
unlikely to have any significant impact on the resolvability of entities. | |
| ·
Would the governance rules reduce moral
hazard? Rules governing not only the composition of
management bodies but also the fiduciary duties of members of the management
body and senior management could have a rather significant impact on
disciplining incentives for excessive risk taking. | |
| ·
Would the governance rules facilitate
monitoring, management and supervision? Governance
rules regarding duties to uphold the objectives of the separation could
significantly impact on the way it operates with regard to excessive risk
taking. This could mean that the objectives and needs of each separate entity
would be even clearer and therefore easier for management to implement and
supervise. | |
| ·
Would the governance rules reduce conflicts
of interest? Governance rules would be of
significant importance to reduce conflicts of interest and of culture. | |
| ·
Would the governance rules reduce resource
and capital misallocation? To the extent governance
rules have an impact on incentives they are of some relevance. | |
| ·
Would the governance rules lead to a loss of
efficiencies? No. Long-term, dedicated governance
to specific business lines may improve managerial attention on mastering
associated risks, and running the specific business line in the most effective
way possible. | |
| ·
Would governance rules impact on competition? However, it is doubtful that governance rules on their own would
have enough impact on the implicit public subsidy to be able to significantly
improve the level playing field within Member States and across Member States
(and wider). | |
| As is illustrated above, governance rules
can be very effective with regard to in particular impact on moral hazard,
monitoring and supervision and managing conflicts of interest. The
effectiveness will, however, increase when coupled with additional rules of
both legal and economic nature. | |
| 4.1.4.
Conclusion on social benefits and social costs | |
| On the basis of the above, the following
table summarises how effective and efficient rules of legal, economic and
governance nature can be in achieving the specific objectives. This clearly
highlights that the different rules are largely complementary, as they achieve
the specific objectives in different ways. For example, rules providing for a
stricter economic separation are particularly effective in reducing moral
hazard, whereas rules providing for a stricter degree of legal separation are
particularly helpful in facilitating resolution, and stricter governance rules
address conflicts of interest particularly effectively. As could be expected,
the stricter the legal and economic separation, the higher the private cost in
terms of foregone efficiency (to the extent economies of scale and scope result
in such efficiency). Governance separation, while complementary to the other
restrictions, would in isolation not be associated with the same efficiency
loss. | |
| Table 1: Mapping the effectiveness and
efficiency of legal, economic and governance separation | |
| Objective || Moral hazard || Recovery and resolution || Monitoring, management, supervision || Conflicts of interest || Capital misallocation || Efficiency loss | |
| Legal rules || + || ++ || + || + || ≈ || + | |
| Economic rules || ++ || ++ || +/≈ || ≈ || ++ || + | |
| Governance rules || +(+) || ≈ || + || ++ || ≈ || ≈ | |
| 4.2.
Evaluation of different models of a fence | |
| As illustrated above, each category of
rules has a complementary role to play. In providing a robust degree of
separation, a combination of rules in these different categories is accordingly
likely to be necessary. However, the rules can be combined in many different
ways. To ensure an effective as well as efficient assessment, the rest of this Annex
assesses three different packages that combine these rules in different ways.
More specifically: | |
| ·
Separation 1 - subsidiarisation: This implies a limited, low fence and is based on subsidiarisation
only in according with current legislation and under the assumption that
amendments to current legislation suggested in section 3.2 have been implemented.
This provides for a degree of separation, mainly of economic nature. This fence
constitutes the base from which all other fences depart and is the least
“intrusive” for financial institutions because it leaves them more flexibility
to determine their internal structure and business models. This fence is
limited to separating certain activities to a separate legal entity which
(along with the deposit entity) will be subject to prudential and other rules
on an individual, sub-consolidated and consolidated basis as described in sections
3.1 and 3.2.[126] | |
| ·
Separation 2 – subsidiarisation+: Separation 2 provides for a stricter economic separation (e.g.,
separate debt issuance and arm’s length relations). Moreover, it also provides
for a somewhat stricter degree of legal (deposit entity not to own trading
entity) and governance separation (e.g., cross-membership of boards) where the
trading entity forms part of a wider corporate group; | |
| ·
Separation 3 – subsidiarisation++: This would provide a fence of maximum strength to protect the
objectives of the separation. Accordingly, this model would provide for
stricter independence of not only the separated trading entity but also the
deposit entity. This would include a provision that a trading entity could not
own a deposit entity (in addition to the prohibition on deposit entities owning
trading entities). For corporate groups, this would require a sibling structure
where the trading entity and the deposit entity are sister companies operating
entirely separately and with no connection other than ultimately sharing the
same parent company. This fence would also aim at limiting the interconnectedness
among various banking groups to dampen the impact of more systemic shocks. To
this end, it would be stipulated that current large exposures limits be made
more restrictive. Finally, the high fence under Separation 3 would limit the
number of board members from the parent sitting on the boards of the trading
entity and the deposit entity. | |
| Graph
1 illustrates the three different models discussed above and highlights the
corresponding restrictions. | |
| *TE = trading entity | |
| **DE = deposit entity | |
| 4.2.1.
Separation 1 - subsidiarisation | |
| An evaluation of subsidiarisation as a
stand-alone fence gives rise to questions as to its effectiveness: | |
| Would subsidiarisation facilitate
resolvability: Subsidiarisation requires the
trading entity and the deposit entity to maintain self-standing reserves of
capital and of loss-absorbing debt, as well as to comply with the other
prudential requirements on an individual or sub-consolidated basis which
facilitate resolution. Subsidiarisation would therefore likely bring more
clarity, transparency and structure to a banking group's internal organization
which could facilitate the architecture of a recovery and resolution plan and
also facilitate resolvability. This is because, in the first instance, the
economic, operational and governance separation facilitates the preservation of
the viable residual elements and the resolution and wind-down of non-viable
elements. In the second instance, if the whole entity is to be resolved, asset
valuation (and the application of pre-insolvency bail-in tools) is facilitated
by the easy identification of assets and losses. | |
| Would subsidiarisation reduce moral
hazard (excessive risk taking): Because subsidiarisation
requires the trading entity and the deposit entity to maintain self-standing
reserves of capital and of loss-absorbing debt (which may not be diminished
below safeguard levels set out in the CRR and the BRRD), as well as to comply
with the other prudential requirements on an individual basis, subsidiarisation
provides a certain degree of independence and to some extent also insulates the
deposit entity from shocks and losses affecting the trading entity. In
principle, it also means that risks and costs are shifted to who bears them. This
should have the effect of curbing the incentive to take excessive risks. | |
| However, if the trading entity is part of a
wider corporate group the parent company remains in control of the trading
entity and the deposit entity.[127]
This parent/subsidiary relationship may signal that the implicit safety net is
still present in which case the trading entity will continue to benefit from
"preferential" access to and cost of funding. This effect would be
exacerbated if the trading entity is the parent undertaking owning the deposit
entity. Moreover, because excess capital can be shifted around within the wider
corporate group there may be an additional incentive for the parent/trading
entity (and for the deposit entity especially if its board members'
remuneration schemes are based also on performance of the entire corporate
group) to encourage the allocation of capital and human resources to trading
and away from, for example, lending activity and continued excessive risk
taking. | |
| Would subsidiarisation facilitate
monitoring, management and supervision: Each of the
entities will be subject to separate capital requirements and a requirement to
maintain a sufficient level of loss-absorbing debt, which could impact on
shareholders’ incentives to monitor risk taking. Separation may also improve
transparency and therefore improve the ability for shareholders to better
monitor the activities. | |
| The responsibility and independence of
management could increase through separation and this may make it easier to
ensure that objectives and needs are more clearly defined. This could overall
benefit the management of these entities. Separation 1 would result in a clearer
corporate and business structure which could facilitate supervision and will
likely also facilitate the application of recovery and resolution measures. | |
| Would subsidiarisation reduce conflicts
of interest: Governance separation could contribute
to reducing conflicts of interest between the trading business and the deposit-taking
business. Because governance separation would to some extent enhance managers'
independence this could further contribute to reducing conflicts of interest
and culture shocks. However, because it is not excluded that the trading entity
would own the deposit entity and, if so, that they would be engaged in the same
or similar line of business,[128]
their interests inevitably would collide and, thus, the interest of creditors
or employees with stock options could be at stake. | |
| As long as there is no ownership
restrictions on the trading entity and as long as governance rules do not reach
further than the basics outlined in the CRDIV, and especially as long as there
is no duty on the parent to uphold the objectives of separation, it may be questioned
whether the objectives of the separation will be sufficiently safeguarded and
whether the risk taking management culture will not continue to influence the
operations of the deposit entity. | |
| Would subsidiarisation reduce resource
and capital misallocation: While separation of
certain activities and separate governance could contribute to limiting the
incentives for financial institutions to allocate resources and capital away
from lending activities to trading activities it is unlikely that this would
have a very significant impact under Separation 1. This is because excess
capital can be shifted around within the wider corporate group, which provides
an incentive for the parent - and for the deposit entity if its board members'
remuneration schemes depend also on performance of the entire corporate group -
to allocate capital and human resources to trading and intra-financial activity
rather than to lending activity. This could particularly be the case as there
is no duty on the parent board to maintain the objectives of separation. | |
| Would subsidiarisation lead to loss of
efficiencies: Separation 1 would have an impact on
a banking group's ability to benefit fully from diversification in the sense
that the scope for using income smoothing techniques through diversification of
activities and centralisation of liquidity and risk management would be
reduced. Therefore the increased costs would only reflect the loss of
diversification for meeting prudential needs on a stand-alone basis. However,
the option to place many activities on either side of the fence, the fact that
excess capital could under certain conditions still be transferred among the
entities within the wider corporate group, the ability to pull funding needs,
and the fact that customers could still use a single banking group for all of
their services means that a certain level of diversification benefits would
remain. Similarly, banking groups may continue to benefit from operating cost
reductions from pooling certain resources such as IT and finance systems, and
from shared marketing and advertising campaigns. | |
| Would subsidiarisation improve competition: Because Separation 1 does
not remove the implicit public subsidy any competitive distortions (large banks
versus small banks, within a Member State or across Member States or wider)
will remain. | |
| Based on the
above, this degree of separation is unlikely to be sufficiently strong to
effectively achieve the operational goals of
structural reform. | |
| 4.2.2.
Separation 2 – "subsidiarisation +" | |
| Separation 2 puts more emphasis on making
the trading entity and the deposit entity more self-standing and, where the
trading entity forms part of a wider corporate group, regulating the
intra-group relationship. | |
| To start with, it would therefore be
required that each sub-consolidated group of homogeneous entities (i.e., the
"deposit group," and the "trading group") would have to
issue its own debt independently from all other entities within the wider
corporate group (including the parent).[129]
This means that each sub-consolidated group would, to a large extent, have to
fund themselves independently from the group. | |
| To the extent that the trading entity forms
part of a wider corporate group, the CRDIV prudential rules regarding
disclosure need to apply fully to both the trading and the deposit entities on a
sub-consolidated basis. | |
| To reduce the interconnectedness of
entities that form part of a wider corporate group and to ensure a transparent
and appropriate relationship between them, it would first be required that a
deposit entity cannot own shares or voting powers in a trading entity. Second,
all intra-group contracts and other transactions would have to be made on an
arm's length basis and on normal commercial terms. The latter limits
intra-group relationships to the same general level as general third party
relationships. It would also be made clear that the trading entity could not
benefit from resolution support from the deposit entity. | |
| To further reduce conflicts of interests at
governance level it would be required that there be: (i) no cross-membership
between the boards of the trading entity and the deposit entity (or only a
minority of members can sit on both boards); and (ii) a statutory duty for the
parent and the deposit entity boards to uphold the objectives of the
separation. | |
| Finally, there would be an obligation
imposed on the parent to secure the deposit entity's operations (e.g., access
to critical infrastructure such as payments services, staff, data, information
and other services) irrespective of the wider group's financial health. | |
| The fence under Separation 2 would be of
virtually the same strength as the current UK fence. | |
| 4.2.2.1.
Social benefits and social costs | |
| Would subsidiarisation+ facilitate
resolvability: Separation 2 has the effect of
further insulating the trading entity from the deposit entity in terms of
funding; more insulation enhances resolvability without taxpayer support. This
would also curtail implicit government guarantees, reducing the risk to the
public finances and making it less likely that banks will run excessive risks
in the first place. In addition separate funding also reduces complexity of
funding sources. | |
| Would subsidiarisation+ reduce moral
hazard (excessive risk taking): The fence under Separation
2 focuses more on independence and regulating the relationship among entities
within the wider corporate group than the previous fence. The rule on separate
debt issuance would make it more difficult for the trading entity (and the
deposit entity) to get access to "intra-group funding" which means
that it has to procure funding from the "external" market place. This
would have the effect of making funding of risky activities more expensive as
the funding of operations would better reflect their underlying riskiness. Conducting
all transactions on an arm's length commercial basis would also most likely
lead to an increase in sales/service price. Cross-subsidization of trading
activities with "cheap" deposits would be significantly reduced. Compared
to Separation I, these higher costs should have the effect of restraining even
more the incentives of the trading entity to take excessive risks. However, to
the extent that the trading entity is part of a wider corporate group and
controls the deposit entity that effect would be countered. This could to some
extent be mitigated when the trading entity cannot get any support in
resolution from the deposit entity and when the management body of the parent
(i.e., possibly the trading entity itself) as well as the management body of
the deposit entity would be under a duty to uphold the objectives of the
separation. These requirements could provide additional credibility to the
fence and signal to the market place that the implicit safety no longer exists.
This should change the incentives for institutions to become more moderate in
risk-taking and therefore reduce moral hazard. | |
| Would subsidiarisation+ facilitate
monitoring, management and supervision: The more
the trading entity's funding has to come from external capital markets the more
shareholders should be incentivized to monitor risk taking. The fact that the
parent (possibly the trading entity itself) management body would be under a
duty to uphold the objectives of the separation could significantly impact on
the way it operates with regard to excessive risk taking. Again, more
insulation of the trading entity from the deposit entity would mean that the
objectives and needs of each separate entity would be even clearer and
therefore easier for management to implement and supervise. Reducing the
intra-group interconnectedness will make each entity's accounts more clear and
likely more transparent, which will facilitate supervision. | |
| Would subsidiarisation+ reduce conflicts
of interest: Prohibiting cross-management body
memberships could be very effective in reducing conflicts of interest and
culture between the trading business and the deposit taking business. However,
in case the trading entity is the parent of the deposit entity this requirement
would likely be far too strict as it would not allow the parent any influence
over wider corporate group strategies and would sever the line of
accountability through the parent to investors and likely make the banking
group significantly less attractive as an investment object. | |
| Importantly, the duty on the parent and the
deposit entity boards to uphold the objectives of separation could have a
significant impact on conflicts of interest as well as on the extent of risk
taking within each of the entities. This would particularly be the case if the
trading entity owns the deposit entity. | |
| Would subsidiarisation+ reduce resource
and capital misallocation: Notwithstanding the
ability to shift around excess capital within the wider corporate group, the
fence under Separation 2 restricts intra-group relationships and puts them on
the same base and terms as strictly third party commercial relationships. Coupled
with the governance duties to uphold the objectives of the separation,
Separation 2 could better contribute to limiting the incentives for financial
institutions to allocate resources and capital away from lending activities to
trading activities. | |
| Would subsidiarisation+ generate loss of
efficiencies: The stricter fence would make it more
expensive for the group to benefit from diversification and other economies of
scope. This would be reflected in higher funding costs of relatively risky
activities but possibly in even lower funding costs for safer activities. As
under Separation 1 there is still the option to place many activities on either
side of the fence, excess capital could under certain conditions still be
transferred among the entities within the wider corporate group and customers
could still use a single group for all of their services, which means that a
certain level of scope economies would remain. Similarly, groups may continue
to benefit from operating cost reductions from pooling certain resources such
as, for example, IT and finance systems and from shared marketing and advertising campaigns (operational efficiencies). | |
| Would subsidiarisation+ improve competition: Only to the extent that
Separation 2 could constitute a credible threat that the implicit public
subsidy would be reduced would competitive distortions (large banks versus
small banks, within a Member State or across Member States or wider) be lowered
correspondingly. | |
| Based on the
above, it is concluded that Separation 2 (subsidiarisation +) constitutes a
more credible fence than Separation 1, and, on a balance, it appears that the social benefits outweighs the social
costs; however, this fence remains permeable. | |
| 4.2.3.
Separation 3 - "subsidiarisation ++" | |
| Separation 3 aims at provide a fence of
maximum strength to protect the objectives of the separation while still
leaving room for banking groups to provide a universal set of services and thus
allowing for some efficiency and diversification benefits at the group level. It
builds on the model for Separation 2 as described above in section 4.2.2. | |
| To this end it would be stipulated that the
trading entity could not own a deposit entity (in addition to the prohibition
on deposit entities owning trading entities).[130] For corporate groups,
this would require a sibling structure where the trading entity and the deposit
entity are sister companies operating entirely separately and with no connection
other than ultimately sharing the same parent company. | |
| Separation 3 would also aim at limiting the
interconnectedness among various banking groups to dampen the impact of more
systemic shocks. To this end, it would be stipulated that current large exposures
be subject to stricter limits than currently applicable. | |
| Finally, the high fence under Separation 3
would limit the number of board members from the parent sitting on the boards
of the trading entity and the deposit entity. This would allow the parent to
contribute to strategy and objective setting while leaving each subsidiary
freedom to set its own agenda. | |
| 4.2.3.1.
Social benefits and social costs of Separation 3
(subsidiarisation ++) | |
| Would subsidiarisation++ facilitate
resolvability: It would be easier in a sibling
structure to deploy entirely different resolution tools for the trading entity
and the deposit entity. The risk of contagion would also be reduced as the
parent/holding company would act as a firewall between the two sister companies
and stricter large exposures would apply. I.e., if the trading entity were to
fail, the regulator could shut it down without affecting its deposit entity
sister firm in a critical way. | |
| Would subsidiarisation++ reduce moral
hazard (excessive risk taking): Separation 3 would
require some type of sibling structure for corporate groups. This type of
structure would be consistent with the principle of insulating the trading
entity from the deposit entity, which is what structural reform seeks to
achieve through subsidiarisation. The more independent the trading entity is
and the more intra-group relationships are assimilated to relationships with
third parties, the more credible it may be to the market place that the
trading entity will not benefit from government support in case of financial
trouble. Coupled with the fact that the trading entity would no longer have
access to cheaper internal funding, incentives for excessive risk taking should
be significantly reduced. The limit on the number of parent members sitting on
the boards of the trading entity and the deposit entity (coupled with the duty
of the parent to uphold the objectives of the separation) would also further
discipline any incentives for excessive risk taking as well as ensuring better
alignment of incentives. | |
| Would subsidiarisation++ facilitate
monitoring, management, supervision and regulation: Separation 3 would clearly separate banking groups' structures and
operations and make them clearer and transparent which makes it easier for
regulators, investors, creditors and managers to see potential weaknesses and
to discipline excessive risk taking. | |
| Would subsidiarisation++ reduce
conflicts of interest: Separate governance through
a sibling structure could contribute to reducing conflicts of interest between
the trading business and the deposit taking business and bring about thicker
walls between the sister companies. Limiting the number of parent members
sitting on the boards of the trading entity and the deposit entity could also
further reduce conflicts of interest between ultimate shareholders and the
trading and deposit entities. | |
| Would subsidiarisation++ reduce resource
and capital misallocation: A sibling structure
would further cement the separation of the trading entity and the deposit
entity and lend more credibility to the integrity of the fence between the two
entities. Since cheap access to internal funding would no longer be available,
the trading entity would have to rely more on the external market, which would
make its funding more risk sensitive and hence more expensive (at least for the
trading activities). Because of the additional insulation of the trading
entity, Separation 3, compared to the other fences, has a more credible
positive impact on reducing any implicit subsidy. Reduced incentives to invest
in projects which are not worthwhile on average, but risky enough to have at
least some chance of making money could then also lead to a better allocation
of capital in the economy. | |
| Would subsidiarisation++ generate loss
of efficiencies: Separation 3 would further make it
more expensive for the banking group to benefit from diversification and other
economies of scope. However, there is still the option to place many activities
on either side of the fence. Also, excess capital could under certain
conditions still be transferred among the entities within the wider corporate
group and customers could still use a single group for all of their services. This
means that a certain level of economies of scope would remain. Similarly,
groups may continue to benefit from operating cost reductions from pooling
certain resources, such as IT and finance systems, and from shared marketing and advertising campaigns. | |
| Would subsidiarisation++ improve competition: Next to ownership
separation, Separation III constitutes the most credible threat that the
implicit public subsidy would be eliminated. Removing the implicit subsidy
would contribute significantly to removing competitive distortions between
large banks versus small banks, within a Member State or across Member States
or widerBased on the above it
is concluded that Separation 3 (subsidiarisation ++) provides the most non-permeable
separation short of ownership separation but
also comes at a higher cost for financial institutions compared to Separation I
and II. For this reason it has not been retained for assessment in the main
body of the Impact Assessment. | |
| Annex A8 : Trading activities and Bank Structural Separation: Possible Definitions and Calibration of Screening exemption thresholds | |
| A. Pagano, J. Cariboni, M. Marchesi, N. Ndacyayisenga, M. Petracco Giudici, H. Joensson | |
| Forename(s) Surname(s) | |
| 2013 | |
| European Commission | |
| Joint Research Centre | |
| Institute for the Protection and Security of the
Citizen | |
| Contact information | |
| Jessica Cariboni | |
| Address: Joint Research Centre, Via Enrico Fermi 2749,
TP 361, 21027 Ispra (VA), Italy | |
| E-mail: jessica.cariboni@jrc.ec.europa.eu | |
| Tel.: +39 0332 78 9372 | |
| Fax: +39 0332 78 5733 | |
| http://ipsc.jrc.ec.europa.eu/ | |
| http://www.jrc.ec.europa.eu/ | |
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| JRC84704 | |
| © European Union, 2013 | |
| Executive summary | |
| Commission Services have undertaken work
with the aim of reviewing the examination thresholds suggested by the
High Level Experts Group (HLEG) to select bank to be subject to structural
separation. This work is focusing in particular on how to define trading
activity, estimating the institutional implications of different examination
thresholds, and benchmarking the results against other readily available
metrics. | |
| Commission Services have assessed a number
of options for defining trading activity in order to determine the scope of the
institutions subject to a separation requirement. Due to the absence of
publicly available data for banks’ specific business lines, this analysis has
been done on the basis of publicly available accounting (balance sheet) data
from commercial providers. The analyzed options are: | |
| • HLEG definition (assets held for trading and available for
sale); | |
| • a more narrow definition that excludes available for sale
assets as mostly composed of securities held for liquidity purposes ; | |
| • a definition focused on the gross volume of trading activity,
which is likely to focus on proprietary traders and market-makers; or | |
| • a definition focused on net volumes, which is likely to only
capture those institutions that have a higher share of unbalanced risk trading
(proprietary traders). | |
| For each of the last three options,
absolute and relative thresholds have been assessed. Depending on the option
chosen, about 30-35 banks are selected. Even though the selected banks
represent less than 20% of the sample, their assets account between 50% and 75%
of the assets in the sample, and by and large between 40% and 60% of EU banking
assets. It is important to remark that 20 banks are selected under all
definitions and they represent 50% of the sample in terms of total assets. By
considering only banks with total assets over 30 bn EUR, 16 banks are selected
by all definitions to be proposed for structural reform. | |
| Table of Contents | |
| 1. Introduction
and scope | |
| Following the
suggestions of the report by the High Level Experts Group (HLEG) on reforming
the structure of the EU banking sector, the so called Liikanen report,[131] Commission Services
have been investigating the impact that a functional structural reform could
imply. | |
| The
Liikanen report suggests that “proprietary trading and all assets or derivative
positions incurred in the process of market-making must be assigned to a
separate legal entity within the banking group”. Separation would only be
mandatory if trading activities amount to a significant share of balance sheet,
or if their volume can be considered significant from the viewpoint of
financial stability. In particular the HLEG suggests that separation should be mandatory
if the sum of “bank’s assets held for trading and available for sale“ is (i)
either a significant volume (above 100 bn EUR), or (ii) a significant share of
the bank’s balance sheet (between 15-25%). However, the Supervisors would
determine the activities that would actually need to be separated, so that
above mentioned thresholds would serve for “examination” purposes by
Supervisors (examination thresholds). | |
| During
the consultation[132],
HLEG definition of trading activities has been criticized, especially as
Available-For-Sale assets can be composed to a large extent by high quality
liquid assets: government or corporate bonds held by banks for liquidity rather
than for trading purposes. It was also pointed that current reforms, including European
Market Infrastructure Regulation[133],
Capital Requirement Directive IV[134],
Tax on Financial Transactions[135]
and the bank recovery and resolution directive (BRR), should also be considered
when analyzing the impact of functional structural separation. | |
| Within this context, this report analyses
how to possibly modify the definition of trading activities relying on balance
sheet data and how to calibrate examination thresholds for functional
structural separation. The alternative definitions proposed by Commission
Services are based on specific bank activities such as proprietary trading and
market making. | |
| The remaining
of the report is structured as follows. Section 2 describes the data public
available in SNL for analysing trading activities and introduces different definitions
of trading activities which will be analysed in the remaining of the report,
starting from the HLEG definition. Section 3 presents the results of the
cluster analysis for each definition and set potential thresholds. Section 4
compares results of the various definitions and Section 5 concludes. | |
| Some appendices
will provide additional analyses and technical details. Appendix A provides details
on the sample used for the analyses. Appendix B presents some additional graphs
on the banks selected under the HLEG definition but not under alternative
definitions. Appendix C investigates on the stability of thresholds across the
years. Appendix D discusses definitions taking into account EMIR/FTT
initiatives. Appendix E present an analysis based on balance sheet structural
indicators. Appendix F gives few technical details on the clustering techniques
used for setting the thresholds. | |
| 2. Data and
definitions of trading activities | |
| 2.1 Description of the sample and of the
data used | |
| The banks sample used is extracted from the
SNL database[136].[137] It covers 245[138] EU banks and spans
the years 2006-2011, for which consolidated balance sheet data have been
considered. Only banks with total assets higher than 1% of their home-country
GDP are included in this calibration exercise.[139] This set of banks
(see Table 1)
represents around 75% of the EU banking sector in terms of total assets with
respect to 2011[140]. | |
| Due to the presence of missing items the
number of banks may differ according to definitions and to the reference year.
In general there are around 190 banks for which all needed variables are
available. In all cases, most of the banks for which data are not available are
small[141].
In terms of total assets not including the banks with missing data reduces the
coverage of EU27 banking sector to 74%. Hence all the statistics dealing with
shares over total assets will refer to the entire sample set of 245 banks. | |
| Table 1: Breakdown of the sample in bucket of sizes based
on total assets averaged between 2006-2011. 500 bn EUR roughly corresponds to
the 75th percentiles of the total assets of the banks in the sample
of banks considered by the European Banking Authority in its capital exercise[142]. 30 bn EUR is the size
above which banks will be supervised directly by the SSM. | |
| Banks’ Buckets || Banks’ size (Total Assets) || Number of banks in the sample || Share of total assets in the sample | |
| Small banks || Up to 30 bn EUR || 141 || 4% | |
| Medium banks || between 30 and 500 bn EUR || 85 || 32% | |
| Large banks || larger than 500 bn EUR || 19 || 64% | |
| Total || 245 || 100% | |
| The balance sheet items reclassified in SNL
used to estimate trading activities are reported in Table 2. | |
| Table 2: Classes of
assets and liabilities used for estimate the size of the trading activity
available in SNL. | |
| Item || Label || Data definition | |
| Total Assets || TA || All assets held by the banks at the indicated date, as carried on the balance sheet and defined under accounting principles in use. | |
| Trading Securities Assets || TSA || Assets 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. | |
| Derivatives Assets || DA || Derivatives with positive replacement values not identified as hedging or embedded derivatives. | |
| Available For Sale Securities || AFS || Total securities designated as available for sale | |
| Derivatives Liabilities || DL || Derivatives with negative replacement values not identified as hedging instruments. | |
| Trading Liabilities || TSL || Liabilities taken with the intent on repurchasing in the near term, part of a portfolio managed as a whole, and for which where there is evidence of a recent actual pattern of short-term profit-taking, excluding derivative liabilities. | |
| Figure 1 plots the
average breakdown of trading activities under the HLEG definition (DA + TSA +
AFS) for each bank size bucket, using average 2006-2011 data. It can be
observed that: | |
| -
the share of total trading activities on total
assets is larger for large banks; | |
| -
larger banks have more derivatives and trading
securities; | |
| -
smaller banks focus relatively more on AFS. | |
| Figure 1: Average share of trading activities in the asset
side of the balance sheet on total assets by bucket of size. Data are the
average 2006-2011. Source: SNL and JRC calculations. | |
| Figure 2 shows how the share of trading
activities under the HLEG definition and the relative importance of the three
classes change over time for the large banks, highlighting how both the total
share and the relative share of derivatives or securities held for trading are
volatile. | |
| This implies that, in order to have
thresholds that remain stable over time, it is necessary to consider the
average behavior over a certain time horizon. In the present work a 6-year
average is considered.[143] | |
| Figure 2: Evolution of trading activities over time for the
large banks in the sample. Source: SNL and JRC calculations. | |
| Among the proposed alternative definitions,
trading liabilities are also considered. Figure 3 shows the shares of the two classes
of trading activities in the liability side over total assets. Large banks tend
to have large share of trading liabilities. | |
| Comparing Figure 3 with Figure 1, trading securities assets tend to
be higher than trading securities liabilities while derivative assets and
liabilities tend to be more balanced for all bank size bucket. | |
| Figure 3: Average share of trading activities on liability
side on total assets by bucket. Data are the average 2006-2011. Source: SNL and
JRC calculations[144]. | |
| 2.2 Use of
alternatives definitions of trading activities: discussion and proposition | |
| In this section, different definitions of
trading activities using balance sheet data are introduced and discussed and
eventually used to calibrate the de minimis exemption rule. | |
| Starting from the HLEG definitions and
alternative definitions are considered with the aim to take into account the
comments from stakeholders collected through the HLEG report consultation[145]. In particular: some
consultation replies have pointed out that Available-For-Sale assets are
normally composed of high quality liquid assets, such as government bonds or
corporate bonds of high-quality, held by banks for liquidity purposes rather than for trading
purposes. [146],[147] Some criticisms have also been raised on
the fact that the HLEG definition does not seem to provide a good proxy of the
risks undertaken through trading activities. | |
| These comments have led the Commission
Services to consider the removal of AFS from the definition of trading
activities and to consider some additional definitions which may better focus
on the two main risks due to trading: market risk and counterparty risk. While
market risk can be considered to be more related to one directional bets on
market movements, counterparty risk depends more on the volume of trading
undertaken by the bank[148]. | |
| On the basis of these considerations, the
Commission Services have decided to analyse the definitions presented in Table
3, also considering limitations due to the need to rely on publicly available
accounting data. | |
| Table 3: Definitions of trading activities
based on the labels of balance sheet items introduced in Table 1. | |
| || Definition || Description | |
| 1 || TSA + DA + AFS || HLEG definition | |
| 2 || TSA + DA || Exclusion of AFS under the assumption that they are mostly held for liquidity purposes | |
| 3 || (TSA + TSL + DA + DL)/2 || Exclude AFS + Gross volumes of securities and derivatives held for trading (to focus on market and counterparty risk) | |
| 4 || |TSA – TSL| +|DA - DL| || Exclude AFS + Net volumes of securities and derivatives held for trading (to focus on market risk) | |
| A second issue linked with the choice of
the definition is the scope of the separation. The HLEG recommends that assets or derivatives positions incurred in the
process of market-making must be assigned to a separate legal entity. The
Commission Services also consider the possibility that only proprietary trading
is separated.[149] | |
| It is still worth to notice that while
precise legal and economic definitions of proprietary trading and market making
is subject to a certain level of uncertainty[150],
one can - in very general terms - consider that proprietary trading is more
exposed to market risk while market making is more related to counterparty
risk. | |
| To capture both market makers and
proprietary traders, Commission Services propose to use definition 3, which
focuses on gross volumes of trading activities by summing assets and
liabilities. In fact, this measure could be considered a proxy for banks’
exposure to counterparty and market risk. | |
| To capture proprietary traders only,
Commission Services propose to use definition 4, which focuses on unbalanced
positions between assets and liabilities (net volumes). This idea is based on
the assumption that market makers normally try to keep a balanced net position
while still showing important gross positions; while proprietary trading is
based on directional bets that the market will move in a certain direction, so
that it generates asymmetric positions on the two sides of the balance sheet. | |
| Commission Services have also investigated
additional definitions (see Appendix D) aimed at taking into account some other
ongoing Commission legislative initiatives that might impact on the volumes of
trading activities, notably EMIR (European Market Infrastructure Regulation)
and FTT (Financial Transaction Tax). | |
| 3. Thresholds calibration | |
| The HLEG suggests examination thresholds
for functional structural separation based on the amount of trading
activities and share of trading activities on total assets, equal to 100
bn EUR or 15-25% respectively. The results presented in this report are based
on the assumption that the ‘or’ logical operator best suits for the purposes of
a functional structural separation. | |
| The scope of this section is to calibrate
thresholds for each definition of trading activities introduced in Table 3, using banks’ balance sheet data
spanning the period 2006-2011. | |
| We develop a clustering exercise[151] in the two
dimensional space (amount, share) to build banks clusters and set
the thresholds according to them. The analysis is based on averages of balance
sheet data over the considered period.[152] | |
| Given the results of the clustering
exercise, thresholds are chosen in such a way that | |
| -
respect the shape of clusters and avoid splitting
them; | |
| -
are multiple of 10 bn EUR for the amount
and of 2.5% for the share of trading activities;[153] | |
| -
show consistency across years; | |
| -
show as much consistency as possible with the
thresholds set by the HLEG. | |
| 3.1. HLEG
definition | |
| Figure 4 shows the
results of the clustering exercise for the HLEG definition. The top plot
presents all banks in the sample, while the bottom left one zooms on total
trading activities below 250 bn EUR, excluding the well separated group of very
large players (SocGen, HSBC, CrAgr, Barclays, RBS, BNPP, Deutsche Bank). The
bottom right plot is used to identify those banks which are close to the
thresholds. | |
| On the amount dimension (x-axis),
the presence of a stretched cluster of banks (green diamonds) between 30 bn
EUR and 150 bn EUR does not allow to fix a threshold on the amount
dimension in the neighbourhood of 100 bn EUR that does not intersect this
cluster. However, as shown in the bottom left plot, there is an important gap
between 50 bn EUR and 100 bn EUR, for shares lower than 15%. On this basis, a
threshold is suggested equal to 80 bn EUR. This smaller amount compared
to the 100 bn EUR is suggested by the following: | |
| the presence of
several banks belonging to the green diamonds cluster in the area close to
100 bn EUR;
the presence of
many fewer banks in the area close to 80 bn EUR, which could help the
threshold to be more stable over time. | |
| On the share dimension (y-axis),
it is more difficult to identify a unique threshold due to the very dense
presence of banks of smaller size. This difficulty is in line with the decision
of the HLEG to provide a range (15%-25%) instead of a single threshold on the share
dimension. The clustering analysis suggests that a threshold, within the
suggested range, could be fixed at 20%, so as to separate light blue stars from
the red circles. | |
| Fixing the examination thresholds at 80 bn
EUR for the amount or 20% for the share allows preserving the stretched cluster
of green diamonds. It can also be noticed that a rather populated cluster of
small banks with a high share of trading activities (light blue stars) would be captured with
this choice. Not considering AFS will reduce the number of very small banks
selected (see next sections). | |
| The bottom right plot of Figure 4 highlights those banks which are
close to the thresholds (see also Appendix C for a detailed discussion). The
use of a measure of distance from the thresholds would allow softening
the definition of hard thresholds resulting from cluster analysis and could be
used as additional information for supervisors to discretionally enlarge the
list of banks subject to separation.[154] | |
| Figure 4: Clusters
under Definition 1 (Liikanen) . | |
| 3.2. Alternative definitions | |
| In this section we use the cluster analysis
to set potential thresholds for the alternative definitions. To the list of
criteria we already mention to properly set the thresholds based on clusters we
add the need of having values differing as little as possible from thresholds
“equivalent” to the HLEG ones. | |
| The “equivalent” thresholds are obtained
shifting and/or rescaling the HLEG thresholds (80 bn EUR or 20%) using the
sample weighted average of the items of balance sheets cut, added or rescaled
in the various definitions.[155] | |
| Table 4 shows the equivalent thresholds. Table 5 presents a choice of potential
thresholds based on cluster analysis. Graphs are presented in Figure 5, 6 and
7. Comparing the equivalent thresholds in with those obtained via cluster
analysis we observe similar results. | |
| Table 4: HLEG
“equivalent” thresholds for the alternative definitions. | |
| HLEG “EQUIVALENT” THRESHOLDS | |
| Definition || THRESHOLDS || SELECTED BANKS || SELECTED BANKS BY SIZE | |
| TradAct bn EUR || Shar TradAct || Number || % of the sample || % of the sample in total assets || Large || Medium || Small | |
| 1 || TSA + DA + AFS || 80 || 20% || 52 || 21% || 75% || 19 || 16 || 17 | |
| 2 || TSA +DA || 66 || 12% || 40 || 16% || 65% || 14 || 13 || 13 | |
| 3 || (TSA+TSL + DA+DL)/2 || 62 || 10% || 36 || 15% || 65% || 13 || 16 || 7 | |
| 4 || |TSA-TSL| + |DA-DL| || 37 || 8% || 28 || 12% || 45% || 9 || 6 || 13 | |
| Table 5: Proposed
thresholds based on cluster analysis. | |
| THRESHOLDS FROM CLUSTERS | |
| Definition || THRESHOLDS || SELECTED BANKS || SELECTED BANKS BY SIZE | |
| TradAct bn EUR || Shar TradAct || Number || % of the sample || % of the sample in total assets || Large || Medium || Small | |
| 1 || TSA + DA + AFS || 80 || 20% || 52 || 21% || 75% || 19 || 16 || 17 | |
| 2 || TSA +DA || 70 || 15% || 32 || 13% || 60% || 13 || 10 || 9 | |
| 3 || (TSA+TSL + DA+DL)/2 || 70 || 10% || 36 || 15% || 65% || 13 || 16 || 7 | |
| 4 || |TSA-TSL| + |DA-DL| || 30 || 8% || 33 || 14% || 51% || 11 || 7 || 15 | |
| Figure 5: Cluster for Definition 2 (exclude AFS). | |
| Figure 6: Clusters for Definition
3 (volumes without AFS). | |
| Figure 7: Clusters for Definition 4 (net volumes
on derivatives and securities without AFS) | |
| From these scatter plots and the associated
cluster analyses, one can notice that the information about proximity to the
thresholds (bottom right plots) becomes more and more relevant in order to
better preserve similarity among selected banks which may be partly lost when
using hard thresholds. | |
| To have an insight in the characteristics
of the set of selected and non-selected banks for each definition, Figure 8 shows the two dimensional box-plot of
the share of trading activities (x-axis) versus share of covered
deposits on total assets (y-axis).[156]
This figure shows that the selected banks have much larger share of trading
activities (by definition), but smaller share of covered deposits[157]. This together with
the relative dimensions of the rectangles including the central values
(measures of dispersions) suggests that banks with large share of trading
activities tend to finance it with sources of funding other than covered
deposits. | |
| Figure 8: Boxplot in two
dimensions for the HLEG definition 1: the stars identify the median
values, the light cyan and orange rectangles include 80% central values while
the dark cyan and orange rectangles include the 50% central values | |
| Figure 9: Boxplot in two
dimensions for definition 2: the stars identify the median values, the
light cyan and orange rectangles include 80% central values while the dark cyan
and orange rectangles include the 50% central values | |
| Figure 10: Boxplot in two
dimensions for definition 3: the stars identify the median values, the
light cyan and orange rectangles include 80% central values while the dark cyan
and orange rectangles include the 50% central values. | |
| Figure 11: Boxplot in two
dimensions for definition 4: the stars identify the median values, the
light cyan and orange rectangles include 80% central values while the dark cyan
and orange rectangles include the 50% central values. | |
| 4. Comparison across definitions | |
| This section presents a comparison among
banks selected according to each definition (and relative thresholds). Twenty
banks are selected by all definitions which correspond to less than 10% of the
sample in terms of individuals. Considering the size, they actually account for
about 50% of the sample total assets. Other 44 banks are selected by at least
one definition, and, among them 17 are selected only by HLEG. In term of total
assets all 44 account for 30% of the sample. | |
| Further, it is worth noticing that: | |
| · among the 20 banks selected by all definitions (see Table 6) 10 are
large banks, 6 medium-sized and only 4 are small-sized. Ten of these banks are
in the list of the G-SIBs. | |
| · The 17 banks selected only by the HLEG (see Table 7) include 5 large
banks, 4 medium sized banks and 8 small banks. These small banks are selected
by HLEG due the size of their AFS assets (see Appendix B). None is a G-SIB,
although only recently Lloyds have been excluded from this list. | |
| · the 27 banks are selected according to more than one definition but
not all (see Table 8) include 4 large banks, 10 medium sized banks and 13 small
banks. These small banks are selected by the definition 4 and are mainly
located in Denmark (4 banks) and Italy (5 banks). | |
| · the 14 EU G-SIBs provided by the Financial Stability Board[158] are all selected by
at least one definition. While the HLEG definitions select all of them,
definitions 2 3 and 4 select 12, 13 and 11 G-SIBs respectively. BBVA and
Standard Chartered are selected by only one alternative definition (4 and 3
respectively). | |
| | |
| In Tables 6 to 9, a double-line frame circles banks with total
assets above 30 bn EUR. | |
| Table 6: List of
the banks selected by all definitions (ordered by size bucket). Size:
L=Large, M=Medium and S=Small | |
| || Bank || Size || MS || 1 || 2 || 3 || 4 || G-SIBs | |
| TSA+DA +AFS || TSA+DA || (TSA+TSL+DA + DL)/2 || |TSA - TSL| + |DA - DL| | |
| 1 || BNP Paribas || L || FR || Y || Y || Y || Y || Y | |
| 2 || Crédit Agricole Group || L || FR || Y || Y || Y || Y || Y | |
| 3 || SocGen || L || FR || Y || Y || Y || Y || Y | |
| 4 || Deutsche Bank || L || DE || Y || Y || Y || Y || Y | |
| 5 || Unicredit || L || IT || Y || Y || Y || Y || Y | |
| 6 || Santander || L || ES || Y || Y || Y || Y || Y | |
| 7 || Barclays || L || UK || Y || Y || Y || Y || Y | |
| 8 || HSBC || L || UK || Y || Y || Y || Y || Y | |
| 9 || RBS || L || UK || Y || Y || Y || Y || Y | |
| 10 || Nordea || L || SE || Y || Y || Y || Y || Y | |
| 11 || KBC || M || BE || Y || Y || Y || Y || | |
| 12 || Danske Bank || M || DK || Y || Y || Y || Y || | |
| 13 || DekaBank Deutsche GZ || M || DE || Y || Y || Y || Y || | |
| 14 || Portigon || M || DE || Y || Y || Y || Y || | |
| 15 || Mediobanca || M || IT || Y || Y || Y || Y || | |
| 16 || SEB || M || SE || Y || Y || Y || Y || | |
| 17 || Arbejdernes Landsbank || S || DK || Y || Y || Y || Y || | |
| 18 || DiBa Bank || S || DK || Y || Y || Y || Y || | |
| 19 || Banca Generali || S || IT || Y || Y || Y || Y || | |
| 20 || FIMBank || S || MT || Y || Y || Y || Y || | |
| Table 7: List of the
banks selected only in HLEG definitions. Size: L=Large, M = Medium and S=
Small. | |
| || Bank || Size || MS || 1 || 2 || 3 || 4 || G-SIBs | |
| TSA+DA+ AFS || TSA+DA || (TSA+TSL+DA + DL)/2 || |TSA - TSL| + |DA - DL| | |
| 1 || Lloyds Banking Group || L || UK || Y || || || || | |
| 2 || Rabobank Group || L || NL || Y || || || || | |
| 3 || Crédit Mutuel Group || L || FR || Y || || || || | |
| 4 || Dexia || L || BE || Y || || || || | |
| 5 || Intesa || L || IT || Y || || || || | |
| 6 || Landesbank Berlin Holding AG || M || DE || Y || || || || | |
| 7 || NORD/LB || M || DE || Y || || || || | |
| 8 || Banque Intl. Luxembourg || M || LU || Y || || || || | |
| 9 || Banque et Caisse d'Epargne || M || LU || Y || || || || | |
| 10 || Credito Emiliano SpA || S || IT || Y || || || || | |
| 11 || Aktia Plc || S || FI || Y || || || || | |
| 12 || AXA Bank Europe || S || BE || Y || || || || | |
| 13 || Banca Comerciala Carpatica SA || S || RO || Y || || || || | |
| 14 || Raiff. Landsbk Steiermark || S || AT || Y || || || || | |
| 15 || Getin Noble Bank || S || PL || Y || || || || | |
| 16 || ICICI Bank UK Plc || S || UK || Y || || || || | |
| 17 || SaarLB || S || DE || Y || || || || | |
| Table 8: Banks selected according to some but not all definitions (Y if
selected, empty otherwise).
Size: L=Large, M=Medium and S=Small. | |
| || Bank || Size || MS || 1 || 2 || 3 || 4 || G-SIBs | |
| TSA+DA+ AFS || TSA+DA || (TSA+TSL+DA + DL)/2 || |TSA - TSL| + |DA - DL| | |
| 1 || Groupe BPCE || L || FR || Y || Y || Y || || Y | |
| 2 || ING || L || NL || Y || Y || Y || || Y | |
| 3 || Commerzbank || L || DE || Y || Y || Y || || | |
| 4 || BBVA || L || ES || Y || || || Y || Y | |
| 5 || Belfius Banque || M || BE || Y || || Y || || | |
| 6 || DZ Bank AG || M || DE || Y || Y || Y || || | |
| 7 || Landsbk Baden-Württ. || M || DE || Y || Y || Y || || | |
| 8 || Bayerische Landesbk || M || DE || Y || || Y || || | |
| 9 || Monte Paschi Siena || M || IT || || || Y || || | |
| 10 || DNB ASA || M || NO || || || Y || Y || | |
| 11 || Helaba || M || DE || Y || Y || Y || || | |
| 12 || Swedbank || M || SE || || Y || Y || || | |
| 13 || Handelsbanken || M || SE || || || Y || || | |
| 14 || Standard Chartered || M || UK || Y || || Y || || Y | |
| 15 || Spar Nord Bank A/S || S || DK || || Y || Y || Y || | |
| 16 || Lån & Spar Bank || S || DK || || Y || || Y || | |
| 17 || Vordingborg Bank A/S || S || DK || || Y || || Y || | |
| 18 || Nordfyns Bank A/S || S || DK || || || || Y || | |
| 19 || Naspa Dublin || S || IE || Y || Y || || Y || | |
| 20 || Banca Finnat Euramerica || S || IT || Y || || || Y || | |
| 21 || Banca Pop di Sondrio || S || IT || || || || Y || | |
| 22 || Banca Pop di Spoleto || S || IT || || || || Y || | |
| 23 || Banca Sella Holding || S || IT || || || || Y || | |
| 24 || Istituto Centrale delle BP || S || IT || || || || Y || | |
| 25 || NIBC Bank NV || S || NL || Y || || Y || || | |
| 26 || Handlowy w Warszawie || S || PL || Y || || Y || || | |
| 27 || Banco Coop Español || S || ES || Y || Y || || Y || | |
| Table 9: G-SIBs. | |
| || Bank || Size || MS || 1 || 2 || 3 || 4 || G-SIBs | |
| TSA+DA+AFS || TSA+DA || (TSA+TSL+DA + DL)/2 || |TSA - TSL| + |DA - DL| | |
| 1 || BNP Paribas || L || FR || Y || Y || Y || Y || Y | |
| 2 || Crédit Agricole Group || L || FR || Y || Y || Y || Y || Y | |
| 3 || SocGen || L || FR || Y || Y || Y || Y || Y | |
| 4 || Deutsche Bank || L || DE || Y || Y || Y || Y || Y | |
| 5 || Unicredit || L || IT || Y || Y || Y || Y || Y | |
| 6 || Santander || L || ES || Y || Y || Y || Y || Y | |
| 7 || Barclays || L || UK || Y || Y || Y || Y || Y | |
| 8 || HSBC || L || UK || Y || Y || Y || Y || Y | |
| 9 || RBS || L || UK || Y || Y || Y || Y || Y | |
| 10 || Nordea || L || SE || Y || Y || Y || Y || Y | |
| 11 || ING || L || NL || Y || Y || Y || || Y | |
| 12 || Groupe BPCE || L || FR || Y || Y || Y || || Y | |
| 13 || BBVA || L || ES || Y || || || Y || Y | |
| 14 || Standard Chartered || M || UK || Y || || Y || || Y | |
| 5. Conclusions | |
| This report stems from the decision of the
Commission Services to investigate alternative definitions of trading
activities in order to address some of the questions raised during the
stakeholder consultation following the HLEG report. Various definitions of
trading activities have been analysed and corresponding examination
thresholds for functional structural separation have been identified on the
basis of cluster analysis. | |
| In total three alternative definitions of
trading activities have been proposed in addition to the HLEG one. In all of
them the AFS assets are not considered, since this class is mainly composed of
assets held for liquidity purposes, rather than for trading purposes. In
particular, one definition also focuses on total volumes of trading activities,
averaging the asset and liability sides, in order to capture both market and
counterparty risks. Finally, another definition focuses also on net volumes of
trading activities, netting assets and liability sides, to capture directional
bets on market movements (market risk). | |
| All definitions are based on publicly
available balance sheet data and they have been computed considering averages
over a 6-year period (2006-2011). Examination thresholds have been calibrated
via a cluster analysis, aiming at identifying banks (those above the
thresholds) that would be subject to functional structural separation, after a
supervisory scrutiny that would determine the part of their assets to be
separated. | |
| On the basis of the results presented in
the report and in the enclosed appendices the following conclusions can be
drawn: | |
| ·
independent of the definition of trading
activities the percentage of banks selected in our sample (composed of 245
banks[159])
is rather small in terms of individuals, varying in the range 13%-21% in terms
of number and between 50% and 75% in terms of total assets, i.e. by and large
between 40% and 60% of EU banking assets. Most G-SIBs are identified by all
definitions | |
| ·
with respect to HLEG definition, the cluster
analysis suggests thresholds of 80 bn EUR for the amount of trading activities,
20% for their share. These are to a large extent in line with the thresholds
proposed by the HLEG (100 bn EUR, 15%-25%).[160]
The HLEG definition selects more banks than the others, partly due to the
presence of the AFS assets (not considered in the other definitions). | |
| ·
20 banks are selected under all definitions
(around 10% of the sample). These banks represent a large share of the total
number of selected banks under all definition (varying roughly from 40% to
65%). They also account for almost 50% of the sample total assets. | |
| ·
the definition based on gross volumes is used to
have a proxy able to identify market making and proprietary trading. It shows a
quite stable pattern along the years; the total number of selected banks is
lower than for HLEG. | |
| ·
the definition based on net volumes is used to
identify proprietary trading only. In general the results based on this
definition are slightly less stable over time with respect to the others; the
total number of selected banks is lower than for HLEG. | |
| ·
the use of a measure of distance from the
thresholds would allow softening the definition of hard thresholds
resulting from cluster. | |
| Appendix A: Description of the SNL sample | |
| The analysis is based on the SNL database[161] since it allows for a detailed disaggregation of balance sheet
items related to assets held for trading and it allows distinguishing derivatives
for trading from derivative for hedging. This breakdown is not available in
other commercial databases such as Bankscope. | |
| However the coverage of SNL for EU
countries is still not complete, since SNL was historically focused on US. This
appendix presents quality checks made on the sample of banks from SNL and
quantifies how much this database is relevant for European banks. | |
| In SNL we found 244 banks that are
headquartered in EU27 and have a consolidated total assets available in 2011.
These banks have also total assets to GDP ratio larger than 1% in 2011. The
sample accounts for 75% of the total EU banking sector[162]. It contains most of the 65 banks listed by European Banking
Authority (EBA) in its capital exercise except Banco Espirito Santo (Portugal),
Raiffeisen Bank International (Austria), and KBC Bank (Belgium).These entities
are “replaced” in the sample by their holdings or by some other relevant entity
of the same financial group. | |
| Comparing the available sample with data
from another data provider (Bankscope) one can observe 8 large financial
institutions having total assets greater than 100 bn EUR missing in the SNL
sample: NatWest, Caisse de Depots et Consignations, Sparkasse
Hessen-Thueringen, BNG, Depfa, Exor, UKAR, Deutsche Pfandbriefbank. | |
| Table I.1 reports the repartition of the
SNL sample by countries. No bank is available in Czech Republic or Estonia.
Even if out of EU27, DNB ASA is in the sample as part of the capital exercise
of EBA. | |
| Table I.10: Geographical repartition of banks in SNL
(total assets are given in billion EUR) | |
| || Number of Banks || Total Assets in 2011 (bn EUR) || || Number of Banks || Total Assets in 2011 (bn EUR) | |
| BE || 7 || 1,044 || LU || 3 || 148 | |
| BG || 4 || 7 || HU || 2 || 35 | |
| CZ || 0 || 0 || MT || 2 || 7 | |
| DK || 28 || 798 || NL || 8 || 2,296 | |
| DE || 56 || 5,937 || AT || 17 || 669 | |
| EE || 0 || 0 || PL || 6 || 78 | |
| IE || 6 || 442 || PT || 5 || 293 | |
| GR || 5 || 296 || RO || 2 || 7 | |
| ES || 19 || 3,244 || SI || 3 || 27 | |
| FR || 7 || 6,983 || SK || 1 || 2 | |
| IT || 27 || 2,879 || FI || 3 || 106 | |
| CY || 4 || 80 || SE || 5 || 1,484 | |
| LV || 1 || 2 || UK || 21 || 7,747 | |
| LT || 2 || 2 || NO || 1 || 274 | |
| Depending on the definition of trading
activities considered, the number of banks included in the calibration exercise
might differ, since there are differences in the availability of the various
items considered in each definition. For example AFS and trading liabilities
are less populated than other items. | |
| To get an insight in the banks which are
not considered due to lack of data, Table I.2 provides the list of banks which
are excluded from definition 1 (HLEG) due to lack of AFS data. The sample
reduces from 245 to 185 banks. | |
| Table
I.11: 60 banks
(average total assets (2006-2011) have no data for the computation of HLEG
definition. These banks are located in DK, DE but also in AT, BE, and PL. | |
| || Company Name || Assets in bn EUR || || Company Name || Assets in bn EUR | |
| BE || Argenta Bank || 32 || DE || Kreissparkasse Heilbronn || 7 | |
| BE || Landbouwkrediet NV || 11 || DE || Kreissparkasse Köln || 24 | |
| DK || Djurslands Bank || 1 || DE || Kreissparkasse Ludwigsburg || 9 | |
| DK || DLR Kredit A/S || 18 || DE || Kreissparkasse Waiblingen || 7 | |
| DK || FIH Erhvervsbank A/S || 15 || DE || L-Bank Baden-Württemberg || 60 | |
| DK || Hvidbjerg Bank A/S || 0 || DE || LBS Baden-Württemberg || 10 | |
| DK || Jyske Bank || 30 || DE || LBS Norddeutsche || 8 | |
| DK || Kreditbanken A/S || 0 || DE || LBS Westdeutsche || 10 | |
| DK || Lollands Bank A/S || 0 || DE || MBS in Potsdam || 9 | |
| DK || Nordjyske Bank A/S || 1 || DE || MERKUR BANK KGaA || 1 | |
| DK || Nykredit Realkredit || 168 || DE || Münchener Hypothekenbank || 35 | |
| DK || Østjydsk Bank A/S || 1 || DE || Nassauische Sparkasse || 13 | |
| DK || Ringkjøbing Landbobank A/S || 2 || DE || National-Bank AG || 4 | |
| DK || Salling Bank A/S || 0 || DE || Sparda-Bank Baden-Württemberg || 11 | |
| DK || Skjern Bank A/S || 1 || DE || Sparda-Bank Südwest eG || 8 | |
| DK || Sparekassen Faaborg A/S || 1 || DE || Sparkasse Essen || 8 | |
| DK || Sparekassen Himmerland || 1 || DE || Sparkasse Hannover || 13 | |
| DK || Svendborg Sparekasse || 0 || DE || Sparkasse Herford || 5 | |
| DK || Sydbank || 19 || DE || Sparkasse Krefeld || 8 | |
| DK || Totalbanken A/S || 0 || DE || Sparkasse Leipzig || 9 | |
| DK || Vestfyns Bank || 0 || DE || Sparkasse Münsterland Ost || 8 | |
| DK || Vestjysk Bank A/S || 4 || DE || Sparkasse Nürnberg || 9 | |
| DE || Bausparkasse Mainz || 2 || DE || Sparkasse Saarbrücken || 6 | |
| DE || Bayerische Landesbausparkasse || 10 || DE || Stadtsparkasse Düsseldorf || 12 | |
| DE || Berliner Volksbank eG || 10 || DE || Stadtsparkasse München || 15 | |
| DE || Deutsche Apotheker || 38 || DE || UmweltBank AG || 1 | |
| DE || Die Sparkasse Bremen AG || 11 || DE || Wüstenrot Bank AG || 15 | |
| DE || Hamburger Sparkasse || 36 || AT || Raiffeisen Bausparkasse GmbH || 9 | |
| DE || Kreissparkasse Biberach || 6 || AT || Raiffeisen-Landesbank Tirol AG || 6 | |
| DE || Kreissparkasse Göppingen || 5 || PL || Getin Holding SA || 8 | |
| Appendix B:
Additional graphs on selected banks | |
| Figure II.1 shows the share of trading
activities component for banks selected only under HLEG definition. It shows
that their selection is mainly due to the size of their AFS (blue bars). Figure
II.2 plots the total amount of trading activities for these banks. The order is
given by their total assets. | |
| Figure II.12: Breakdown of
HLEG definition 1 trading activities, ordered by descending bank’s total
assets. | |
| Figure II.2: Size of trading activities (HLEG definition 1) ordered by descending
bank’s total assets. | |
| Appendix C: Stability over the time with respect to the proposed
thresholds | |
| Setting hard thresholds could raise
problems with respect to the stability of the set of selected banks over the
years. Being able to identify those banks which are close to the thresholds
(above or below) may help the supervisor to monitor borderline situations. For
instance banks closest to the thresholds could discretionally be added by the
supervisor to the list of selected banks. | |
| This appendix presents an analysis
investigating the stability of selected sample of banks across the years
focusing only on those which are “close” to the thresholds. We basically
compute the geometric distance of each bank from the two thresholds, and we
focus on the 10% banks with lowest distances (above or below the thresholds).[163] | |
| It is worth mentioning that banks which are
close to the thresholds considering the six year average, tend to be close to
thresholds also for the three year moving averages (see Table III.1-2-3-4). We
also observe that many of the banks close to the thresholds are medium sized
banks (notably BBVA, which has been recently added to the list of the G-SIBs)
that the supervisory authority might want to monitor. | |
| We start from HLEG and we present in Figure
III.1 the scatter plots relative to the six year average and also to the three
year moving periods. The straight lines in the graphs represent the thresholds
chosen under this definition (80 bn EUR in absolute term and 20% for the
share).[164] | |
| Figure III.13: 10% banks (red circles) with minimal
distance from the thresholds according to HLEG definition 1. | |
| Table
III.1 Banks with minimal distance from the
thresholds according to Definition 1 appearing in the 2006-2011 average and in
at least three other average periods. 1=banks included in the 10% set closest
to the thresholds; 0=banks not included in the 10% set closest. | |
| || Average 2006-2011 || Average 2006-2008 || Average 2007-2009 || Average 2008-2010 || Average 2009-2011 | |
| Allied Irish Banks || 1 || 1 || 1 || 1 || 0 | |
| Bayerische Landesbank || 1 || 0 || 1 || 1 || 1 | |
| BBVA || 1 || 1 || 1 || 1 || 1 | |
| BPI || 1 || 1 || 1 || 1 || 1 | |
| CGD || 1 || 1 || 1 || 1 || 1 | |
| Danske Bank || 1 || 1 || 1 || 1 || 1 | |
| HSH Nordbank || 1 || 1 || 1 || 1 || 0 | |
| Intesa || 1 || 1 || 1 || 1 || 1 | |
| Monte dei Paschi Siena || 1 || 1 || 0 || 1 || 1 | |
| Rabobank Group || 1 || 1 || 1 || 1 || 1 | |
| SEB || 1 || 0 || 1 || 1 || 1 | |
| Table III.2:
Banks with minimal distance from the thresholds according to Definition 2
appearing in the 2006-2011 average and in at least three other average periods.
1=banks included in the 10% set closest to the thresholds; 0=banks not included
in the 10% set closest. | |
| || Average 2006-2011 || Average 2006-2008 || Average 2007-2009 || Average 2008-2010 || Average 2009-2011 | |
| Bayerische Landesbk || 1 || 1 || 1 || 1 || 1 | |
| BBVA || 1 || 1 || 1 || 1 || 1 | |
| Belfius Banque || 1 || 0 || 1 || 1 || 1 | |
| Groupe BPCE || 1 || 0 || 1 || 1 || 1 | |
| Handlowy Warszawie || 1 || 1 || 1 || 1 || 1 | |
| Intesa || 1 || 1 || 1 || 1 || 1 | |
| KBC || 1 || 1 || 1 || 1 || 1 | |
| Landesbank BW || 1 || 1 || 1 || 1 || 1 | |
| Monte Paschi Siena || 1 || 1 || 1 || 1 || 1 | |
| Rabobank || 1 || 1 || 1 || 1 || 1 | |
| SEB || 1 || 1 || 1 || 1 || 1 | |
| Standard Chartered || 1 || 1 || 1 || 1 || 1 | |
| Swedbank || 1 || 1 || 1 || 1 || 1 | |
| Table III.3:
Banks with minimal distance from the thresholds according to Definition 3
appearing in the 2006-2011 average and in at least three other average periods.
1=banks included in the 10% set closest to the thresholds; 0=banks not included
in the 10% set closest. | |
| || Average 2006-2011 || Average 2006-2008 || Average 2007-2009 || Average 2008-2010 || Average 2009-2011 | |
| Bayerische Landesbk || 1 || 1 || 1 || 1 || 1 | |
| BBVA || 1 || 1 || 1 || 1 || 1 | |
| Belfius Banque || 1 || 1 || 1 || 1 || 1 | |
| HSH Nordbank || 1 || 1 || 1 || 1 || 1 | |
| Intesa || 1 || 1 || 1 || 1 || 1 | |
| Landesbank Berlin || 1 || 0 || 1 || 1 || 1 | |
| Landesbank BW || 1 || 1 || 1 || 1 || 0 | |
| Monte Paschi Siena || 1 || 1 || 1 || 1 || 1 | |
| NIBC Bank NV || 1 || 0 || 1 || 1 || 1 | |
| Rabobank Group || 1 || 1 || 1 || 1 || 1 | |
| SEB || 1 || 0 || 1 || 1 || 1 | |
| Spar Nord Bank A/S || 1 || 1 || 1 || 1 || 0 | |
| Standard Chartered || 1 || 1 || 0 || 1 || 1 | |
| Table III.4 Banks with minimal distance from the thresholds
according to Definition 4 appearing in the 2006-2011 average and in at
least three other average periods. 1=banks included in the 10% set closest to
the thresholds; 0=banks not included in the 10% set closest. | |
| || Average 2006-2011 || Average 2006-2008 || Average 2007-2009 || Average 2008-2010 || Average 2009-2011 | |
| Banco Popolare || 1 || 1 || 1 || 1 || 1 | |
| BBVA || 1 || 1 || 1 || 1 || 1 | |
| Commerzbank || 1 || 1 || 1 || 1 || 1 | |
| Danske Bank || 1 || 1 || 1 || 1 || 1 | |
| DZ Bank AG || 1 || 1 || 1 || 1 || 1 | |
| Intesa || 1 || 1 || 1 || 1 || 1 | |
| KBC || 1 || 0 || 1 || 1 || 1 | |
| Landesbank BW || 1 || 1 || 1 || 1 || 1 | |
| Nordea || 1 || 1 || 1 || 1 || 1 | |
| Portigon AG || 1 || 1 || 1 || 1 || 1 | |
| SEB || 1 || 1 || 1 || 1 || 1 | |
| Appendix D: Definitions of trading activities with EMIR/FTT
corrections | |
| IV.1 Additional definitions and
corresponding thresholds | |
| This appendix describes additional
definitions developed by Commission Services to take into account some other
ongoing Commission legislative initiatives that might impact on the volumes of
trading activities, notably EMIR (European Market Infrastructure Regulation),
which will promote netting of derivative through CCPs, and FTT (Financial
Transaction Tax), which will potentially reduce the size of traded derivatives. | |
| To account for the combined effects of
these two initiatives, we assume that only a fraction of the derivatives
exposure should be added to the trading estimate.[165][166] The additional definitions that we examine are shown in Table IV.1.
We repeat for these additional definitions the same analysis presented in the
main text. Results are presented in the following tables and graphs. | |
| Table IV.1: Additional definitions of trading activities to account for
EMIR/FTT. | |
| || Definition || Description | |
| 2b || TSA + 35% DA || Exclude AFS + EMIR/FTT effect | |
| 3b || (TSA + TSL + 35% (DA + DL))/2 || Exclude AFS + Gross volumes of securities + EMIR/FTT effect | |
| 4b || |TSA – TSL| + 35% |DA - DL| || Exclude AFS + Net volumes + EMIR/FTT effect | |
| Table
IV.2: Proposed thresholds for definitions
accounting for EMIR/FTT based on cluster analysis. | |
| || || || Cluster-based thresholds || Selected banks | |
| || Definition || Trading Activities (bn EUR) || Share of Trading Activities (% Total Assets) || Number || Share of the sample | |
| 2b || TSA + 35%DA || 50 || 10% || 36 || 15% | |
| 3b || (TSA + TSL + 35%(DA+DL))/2 || 50 || 8% || 34 || 14% | |
| 4b || |TSA – TSL| + 35% |DA - DL| || 30 || 8% || 31 || 13% | |
| Table IV.3:
HLEG equivalent thresholds for definitions of trading activities to account for
EMIR/FTT. | |
| || || || HLEG equivalent thresholds || Selected banks | |
| || Definition || Trading Activities (bn EUR) || Share of Trading Activities (% Total Assets) || Number || Share of the sample | |
| 2b || TSA + 35%DA || 53 || 10% || 36 || 15% | |
| 3b || (TSA + TSL + 35%(DA+DL))/2 || 49 || 8% || 34 || 14% | |
| 4b || |TSA – TSL| + 35% |DA - DL| || 36 || 8% || 25 || 10% | |
| Figure IV.1: Clusters
for definition 2b (HLEG without AFS and including EMIR/FTT effect) | |
| Figure
IV.2: Clusters for definition 3b (volumes
without AFS and including EMIR/FTT effect). Note: We note that set of 4 banks
are circled in Figure 13 (Deka bank, Portigon, DNB ASA, Swedbank). These banks
are characterized by a relatively high share of trading activities | |
| | |
| Figure
IV.3: Clusters for definition 4b (net
volumes without AFS and including EMIR/FTT effect). | |
| Comparing the
banks selected through the all 7 definitions we found that: | |
| ·
The 20 banks systematically selected in the 4
definitions without EMIR/FTT correction (main text) would be also proposed for
structural separation using the definitions corrected for EMIR/FTT reforms,
with the exception of KBC and Santander which are not selected by definition
4b. | |
| ·
None of the banks that were never selected by
any definition 1, 2, 3 or 4 is selected by any of these additional new
definitions. | |
| ·
G-SIBs are always selected by the definitions
with EMIR/FTT correction, except Santander under definition 4b. | |
| Figures
IV-4-IV-6 details on the differences between the selected banks with and
without EMIR/FTT correction. | |
| Figure
IV.4: Comparing definition 2 and 2b. | |
| Figure IV.5: Comparing definition 3 and 3b. | |
| Figure IV.6: Comparing definition 4 and 4b. | |
| IV.2 Sensitivity
to the parameter capturing EMIR/FTT effects for definitions 2b and 3b | |
| This section describes the sensitivty of
the thresholds to the parameter chosen to introduce the effect of EMIR/FTT. We
present the results obtained, for definition 2b (HLEG, no AFS and EMIR/FTT) and
definition 3b (volumes, no AFS and EMIR/FTT), using two different correction
coefficients: 45% and 25% instead of 35%. | |
| The following graphs show cluster analysis
results varying correction coefficients, while Table IV.4 shows shows the
variability of the thresholds. | |
| Table IV.4:
Sensitivity of the
thresholds to the EMIR/FTT correction parameter for definitions 2b and 3b. | |
| Definition 2b || 35% (baseline) || 25% || 45% | |
| Threshold Trading Activities (bn EUR) || 50 || 50 || 50 | |
| Threshold Share Trading Activities || 10% || 8% || 10% | |
| Definition 3b || 35% || 25% || 45% | |
| Threshold Trading Activities (bn EUR) || 80 || 80 || 80 | |
| Threshold Share Trading Activities || 10% || 10% || 12% | |
| With respect to the list of banks selected,
using the new correction coefficients, the differences with respect to the
baseline scenario (35% correction) are: | |
| -
For definition 2b | |
| o for 25% correction coefficient Raiffeisen-Landesbk Steiermark,
Bayerische Landesbank and BBVA (G-SIB bank) are added | |
| o for 45% correction coefficient only Bayerische Landesbank is added | |
| -
For definition 3b | |
| o for 25% correction coefficient Credito Emiliano, NIBC Bank NV and
Bank Handlowy w Warszawie SA are not selected and there is no new entry | |
| o for 45% correction coefficient only Credito Emiliano is not
selected while Intesa, Rabobank Group and Lloyds Banking Group are added | |
| We conclude by pointing out the the
possible effects of EMIR/FTT need to be further invesigated whenever more
accurate data on their impact would be available. | |
| Appendix E: Structural indicator analysis | |
| This appendix presents some statistics on a
set of structural indicators that can be computed using balance sheet data. The
aim is to show banks in the sample, apportioned into groups depending on their
distance from the thresholds behave in terms of such indicators. We focus on
the 4 definitions presented in the main text. | |
| For each definition banks in the sample are
assigned to four different classes, based on their distance from the thresholds[167]. In order to differentiate between selected and non-selected banks
the latter are assigned a "negative distance”. The four classes are the
following: | |
| ‘IN Top’
banks, i.e. 10% of banks in the sample with largest positive distance
from the thresholds (i.e. far away from the thresholds and selected).
2 groups are
identified around the thresholds:
1 slightly above
the thresholds’ values is called ‘IN Borderline’ and contains the
remaining banks proposed for structural reforms but not in the top 10%.
1 slightly below
the thresholds’ values is called ‘OUT Borderline’ and contains the
banks not proposed for this reform[168]. | |
| Both groups are
small in size (less than ten banking entities) and accounts for roughly 5-10%
of the sample. These groups are key elements to assess if the calibrated
thresholds for the choice of the listing: they need to make sense and be stable
over time. | |
| ‘OUT Bottom’
banks, the rest of the sample, i.e. banks not selected and most distant
from the thresholds. | |
| For each definition, the following
structural indicators are computed for the four classes above | |
| 1) Share of RWA for market risk on total
RWA | |
| 2) Number of branches (complexity) | |
| 3) Non loans assets on total assets | |
| 4) Adjusted IFRS Tier1 leverage ratio | |
| Share of RWA for market risk on total
RWA | |
| The following
graphs (VI.1-VI.4) represent the evolution over 2008-2011 of the share of RWA
for market risk on total RWA for the various groups of banks defined above
under the various definitions. | |
| Figure V.14: RWA shares
over total assets median values for the four groups with respect to definition
1-4 over the years | |
| One can observe that the share of RWA for
market risk is higher for selected banks. In particular banks that are “IN Top”
are systematically more exposed to market risk with respect to definition 1
and, in this case, there is also a clear distinction between “IN Borderline”
and “OUT Borderline”. The situation is less clear for the other three
definitions where only ‘OUT Bottom’ banks result to be systematically
distinguishable. | |
| Complexity | |
| The number of branches is considered in
order to proxy the complexity of banking groups. Complexity is here understood
as a factor of risk (in case of failure for example). The following graph
represent the number of branches grouped by distance from the threshold for
each definition. | |
| Figure V.5:Complexity calculated as the number of branches | |
| We observe that banks that are above the
threshold tend to have more branches except for definition 4 (netting) which
excludes some banks with significant number of branches. | |
| Share of non-loans on total assets | |
| The share of non-loans assets measures
non-retail banking activities. The following graphs represent the evolution the
share of non-loans assets (in %) grouped by distance from the thresholds. | |
| Figure V.9: RWA shares of non-loans over total assets median
values for the four groups with respect to definition 1-4 over the years | |
| We expect higher values of this ratio for banks
doing a lot of trading activities, thus for banks of groups ‘IN Top’ and ‘IN
Borderline’. This is the case for definition 1. For definition 2 we have a
switch between IN Top and IN Borderline while for definitions 3 and 4
Borderline groups are not clearly separated. | |
| Adjusted IFRS tier 1 leverage ratio | |
| Adjusted IFRS tier 1 leverage ratio
corresponds to a simple indicator which is comparable between banks and
transparent in its computation for measuring the risk of the banking entities.
This ratio is computed by SNL and corresponds to tier 1 capital divided by
tangible assets less derivatives liabilities in the attempt to replicate U.S.
GAAP standards by roughly netting the derivatives assets against liabilities.
The ratio is expected to be at least 4-5% for the banks that are well
capitalized. | |
| The following graphs represent the
evolution IFRS tier 1 leverage ratio grouped by distance from the thresholds. | |
| FigureV.13: Adjusted IFRS tier 1 leverage ratio median values
for the four groups with respect to definition 1-4 over the years | |
| We can observe that, based on this
definition, | |
| ‘OUT Bottom’ group is
consistenly showing ratio above 5% which indicates low risk.
Definition 3 show lower values
of IFRS tier 1 leverage Ratio for the “IN Top” group while with respect
we have a complete different picture. | |
| We conclude this annex highlighting the
following: | |
| “structural”
indicators distinguish the group of banks further above the threshold from
the others.
The
indicator share of market risk on RWA shows a greater capacity in
separating the four groups (IN Top, IN borderline, OUT Borderline and OUT
Bottom).
We
tackle complexity of the financial groups considering the number of
branches. There is also an increase of complexity within our four groups
except for definition 3 (volume). | |
| Appendix F:
Cluster methodology for thresholds’ calibration | |
| This appendix briefly presents the main
features of the clustering technique used for thresholds identification. | |
| K-means | |
| Statistical clustering is used to assign
banks into groups (called clusters) so that banks in the same cluster are “more
similar” respectively to the measures TradAct and ShareTradAct than to those in
other clusters. The algorithm requires choosing the number of clusters to be
built and then it searches for the centroids minimizing the dispersion of
points within each cluster. | |
| Clusters are built starting from random
centroids in the two dimensional space identified by the indicators and moving
the centroid positions so to minimize dispersion among the clusters. In order
to assures that the final positions of the clusters do not correspond to a
local minimum of the measure of dispersion we proceed as it follows: | |
| T-clustering | |
| For our data such models are insufficient,
because they do not account for the presence of outliers, which may occur as
noise-like structures or as a small tight group of observations in specific
areas of the space. In both cases, the presence of outliers can considerably
bias the estimation of the centroids and shape (covariance structure) of the
groups and seriously affect the final clustering. | |
| For this reason, we opted for a robust
counterpart of the Normal Mixture Modeling known in the literature as Robust
Trimmed Clustering TCLUST, | |
| The robustness capacity of TCLUST comes
from the trimming approach, i.e. the possibility to leave a proportion of
observations, hopefully the most outlying ones, unassigned. | |
| The TCLUST approach is defined through the
search of k centers and k shape matrices solving a double
minimization problem. | |
| The method has been implemented in Matlab
in the framework of the FSDA project | |
| Annex
A9: Summary of the main findings in literature on Economies of scale and scope
in the banking sector | |
| 1.
Introduction | |
| Banks have been rapidly increasing in size
and scope over the two decades leading up to the financial crisis. For example,
Wheelock and Wilson (2011) estimate a five-fold increase in the average size of
US banks in terms of inflation-adjusted total assets in the period 1984-2008.
Also, many banks diversified and expanded their activities, contrary to
non-financial firms, in the years leading up to the financial crisis (Elsas et
al. (2009)). There is a significant body of literature on economies of scale
and scope trying to explain the reasons why banks have chosen to expand their
size and range of activities. | |
| As structural reform sets limits on the
activities of banks, this literature contributes to the understanding of
efficiency benefits that would be lost as a result of the new requirements.
Understanding whether there are efficiency gains from scale and scope, and if
so, to what extent, until what level, and for which activities, serves as an
important element for this impact assessment for structural reform. Structural
reform may interfere with the extent to which banks' activities experience
economies or diseconomies of scale and scope, as some options may impose full
separation of certain activities. Limits on the organizational complexity and
diversification of large financial institutions may have important implications,
not only for risks and market valuation of large financial firms, but also for
corporations, households and other financial institutions through the supply of
financial services, the sources of credit available to borrowers, and the
allocative efficiency of capital markets. | |
| There are three critical questions on the
structural reform proposal: which banks are subject to structural reform, which
activities will need to be separated, and what will be the strength of this
separation requirement. These questions are linked with the question of
economies of scale and scope. The first question, which banks are subject to
structural reform, relates to the literature on scale. Since only relatively
large banks are likely to be affected by structural reforms proposals, one
needs to assess whether, in particular, economies of scale exist for these
levels of assets, or if they are exhausted past a certain size. The second
question is directly linked to the diversification benefits and synergies
between different bank activities. If there are no real (net) synergies, then
the fact that banks engage in both types of activity may be interpreted as
resulting from regulatory distortions, such as implicit government subsidies.
The third question, on the strength of separation, relates to whether any
potential efficiencies of scale and scope will be affected given the strength
of separation requirements, and to what extent. Except for the case of full
separation, other options impose specific legal, economic, and operational
restrictions on deposit-taking entities, but allow banks to continue to offer a
broad spectrum of services and obtain any related benefits. | |
| The evidence on economies of scale and
scope are ambiguous. Studies by the industry (IIF (2010), the Clearing House,
(2011)) find significant economies of scale and scope, arguing that larger and
more diversified banks are in a position to realise synergies, and therefore
promote safer and more stable banks. As a result, structural reform would be
detrimental not only for the bank's shareholders, but also for society.
Academic studies, however, are more cautious in their conclusions concerning
the existence of economies of scale and, in particular, scope. There is no
consensus on the optimal size of banks, and there is no evidence that they
exist for high levels of bank assets. Similarly, on economies of scope, while
there is some evidence that there are benefits from loan and geographic
diversification, the evidence for other activities is mixed, and there is a large
body of literature suggesting that product diversification has detrimental
effects (diseconomies of scope) that outweigh any benefits. | |
| This Annex provides a summary of the main
findings of the literature on economies of scale and scope in the banking
sector. Section 2 discusses economies of scale and section 3 economies of
scope. Section 4 discusses the impact of structural reform requirements on
these (potential) efficiencies, and Section 5 concludes. | |
| 2.
Economies
of Scale | |
| A firm is said to be operating with
increasing returns to scale if it can lower average cost of production by
increasing its size. There are several sources of economies of scale. Firstly,
economies of scale may arise as larger banks would benefit from spreading
overhead costs (reducing unit operating costs). Secondly, economies of scale
may be the result of better diversification, as large banks are more likely to
achieve wider scope in multiple activities, while at the same time maintaining
scale in an individual activity. Similarly, banks might enjoy economies of
scale from the diversification of risk obtained from a larger portfolio of
loans and a larger base of deposits (i.e. increased ability to better match
assets and liabilities due to scale). | |
| The most direct source of economies of
scale arises from spreading overhead costs, in particular those associated with
information technology. Given that fixed costs are not very significant for
some banking activities, economies/dis-economies of scale are unlikely to
affect all types of activities in the same way. Activities with high fixed
costs include payment systems, market infrastructure, and technology. The
Liikanen report (2012) considers scale economies to be more prominent in
payment and clearing services (due to the importance of fixed costs) compared
to securities underwriting (which requires a more individual assessment of the
relevant, individual deal). Also, Humphrey (2009) finds evidence of strong
economies of scale for certain traditional banking services, such as the provision
and processing of payment transactions. By observing the market
structure in certain activities, Gambacorta and van Rixtel (2013) claim that
scale (however not necessarily scale economies) is a defining characteristic in
banks' capital market activities, as evidenced by the large share of the top 3
players in total trading volumes for cash equities, fixed income, FX,
structured products, and listed derivatives. | |
| On the other hand, there are several
adverse effects of larger scale. Firstly, there are concerns that as banks get
larger their market power increases, and thereby the likelihood that they would
abuse their market position becomes greater. Secondly, larger banks may imply
larger risks for a country's public finances as they are more likely to benefit
from TBTF subsidies. Thirdly, consolidation may lead to credit availability
composition effects as smaller banks tend to have stronger relationships with
smaller firms. Also, consolidation may be driven by managerial benefits, which
increase with a bank's size. | |
| a.
Economies
of scale in empirical studies | |
| The estimates on the significance of
economies of scale vary significantly. At one extreme, there are some industry
studies that claim significant economies of scale. For example, a study by the
Clearing House (2011), puts the estimate of economies of scale to around USD 25
to 45 billion annually in the US, by comparing the actual costs of the banks to
the costs in a (hypothetical) system under which no bank would be larger than
USD 50 billion in assets. They find that the largest benefits are in payment
(USD 10-20 billion) and capital markets (trade processing USD 5-15 billion).
This study however, is based on a static comparison between institutions
without controlling for any underlying differences of the banks. | |
| The results of academic studies are
ambiguous on what is the optimal size of banks and in particular on whether
there are economies of scale at high levels of bank assets. Early studies have
difficulties in establishing significant and substantial economies of scale, at
relatively moderate levels of banks size (USD 100 billion). Some recent studies
even though provide evidence of economies of scale at high levels of assets they
do not show that these dominate the diseconomies of scale (such as higher
risk-taking) and do not control for the impact of implicit subsidies. Once
implicit subsidies are accounted for, diseconomies of scale arise at relatively
moderate levels of bank size. As structural reform would only apply to very
large banks, the pertinent question for assessing the impact of the structural
reform proposal is whether economies of scale get exhausted, and if so, at what
level of bank size as for example it is unlikely that banks in excess of this
threshold will be subject to structural reform requirements (see Annex A8 for
the discussion on thresholds). | |
| Empirical literature typically explores the
cross-sectional efficiency of banks of different sizes at a given point in
time. This is achieved by deriving a minimum cost function after first
calculating input prices. Then, by applying this to bank data, scale economies
are computed from the fitted cost function. An alternative method is to look
into the time series efficiency of banks on either side of a bank merger. | |
| b.
Cross
sectional data | |
| Early empirical academic analysis based on
cross-sectional data has found limited evidence of scale economies which only
peak at relatively low levels of assets of USD 10-100 million (see Saunders
(1996) and Berger and Mester (1997)). However, more recent work on
cross-sectional efficiency based on more recent data and improved methodology
find stronger evidence of economies of scale. Wheelock and Wilson (2011), for
example, consider that there are both methodological and structural reasons
that early work could not detect economies of scale at high levels of assets.
Firstly, they consider that the empirical methods used for estimating the cost
function use models that do not capture key features of bank production. [169]
Secondly, more recent work could find evidence of scale due to regulatory
changes that has made it less costly to become larger (such as relaxation of
restrictions on geographic branching and product expansion). Thirdly,
technological advances may have had a greater impact in recent years (e.g. information
processing equipment and software entails relatively high fixed costs and at
the same time the costs of acquiring information about potential borrowers,
which has been the competitive advantage of smaller banks, has fallen). | |
| Also, Hughes et al. (2001) consider that
there is an additional reason for the lack of strong evidence of economies of
scale in the early studies. They claim that there is an issue of identification
in such studies, as managerial inefficiencies related to scale may mask positive
economies of scale. This phenomenon would occur if there are two opposing
effects: on one hand, a positive effect from scale and, on the other hand, if
banks respond to the lower cost by taking on more risk, there would be a
second, adverse effect, which is linked to the risk-taking effect if banks
spend more resources to manage increased risk. Their work (as well as work by
Hughes and Mester (2011)) has taken into account output measures corrected for
banks' risk and find evidence of economies of scale at much higher levels, that
is, above USD 100 million. Hughes and Mester (2011) under such a setting not
only find economies of scale but also that these scale economies may continue
to increase with bank size. They also claim that their estimates are not driven
by TBTF considerations, as economies of scale apply also to smaller banks too.
They find that when a bank changes size there are two beneficial effects: one
"pure" size effect and one due to a "change in output mix"
(an activity mix that is more consistent with the size of the bank) and claim
that the latter effect is slightly greater than the first. However, while their
approach allows identifying a scale effect, they do not examine whether this
effect outweighs the negative effects of managerial diseconomies (i.e. the
second adverse effect) related to size.[170]
Furthermore, they acknowledge that TBTF considerations cannot be dismissed as
an additional factor in explaining the banks' increasing size. | |
| In contrast with the more recent work on
economies of scale that find increasing evidence at higher levels of assets,
Haldane (2012), referring to work by Davies and Tracey (2012),[171] considers that when
taking into account TBTF implicit subsidies, these strong results on the
existence of economies of scale disappear. The authors employ credit rating
data to adjust the cost of debt by considering only the standalone rating of
banks, rather than the rating including government support (see also Annex A4.1
and A4.2 for details on the different credit agency ratings). Through this
adjustment, they control for the implicit government subsidy and they find that
the banks' funding costs increase with size, lowering the estimates of bank
value-added and the measured economies of scale. In particular, they claim that
there are no scale economies in a sample of large international banks with
assets above USD 100 billion, as shown in the second chart below. Their
findings support the claim that efficiency benefits gained from scale are
potentially offset by diseconomies arising from the fact that some banks become
too large to maintain effective management. Haldane (2012) therefore claims
that implicit subsidies may have artificially increased the privately optimal
banking scale compared to the optimal level from the social perspective. | |
| Chart 1: Scale economies, from a standard model of bank production(a),(b),(c) || Chart 2: Scale economies, adjusting for the implicit subsidies(a),(b),(c) | |
| || | |
| (a) The results are for scale economies estimates over the period 2001 to 2010. A value equal to one, less than one, or greater than one implies constant returns to scale, scale diseconomies, and scale economies, respectively. || (b)Total assets have been adjusted to constant year-2010 prices using country level inflation rate data. (c) Presented results are estimated at the median and interquartile range for each bank in each time period. The scale economies mean is evaluated at the mean of the data. Source: Davies and Tracey (2012) | |
| Therefore overall, academic studies that find
evidence of economies of scale at relatively high level of bank assets identify
this effect separately from any diseconomies of scale such as increased risk
taking related to higher bank size and from the implicit subsidies. | |
| c.
Time
series data | |
| There are also a number of studies that
look into the efficiency of banks on either side of a bank merger. Such studies
do not provide strong evidence of ever-increasing economies of scale (see for
example Berger and Humphrey (1997), Berger at al (1999) and De Long (2001)).
Berger at al (1999) argues that even if there are some economies of scale,
these may have been offset by managerial difficulties in monitoring the larger
organizations, conflicts in corporate culture, or problems in integrating
systems. Also, Amel et al. (2004) find that mergers may be beneficial up to a
relatively small size, and they find little evidence that mergers yield
significant gains in efficiency. | |
| Overall, while there appears to be
relatively strong evidence for economies of scale at relatively low bank sizes,
there is no consensus on the optimal size of banks, and there is no strong
evidence that the economies of scale apply at very large bank sizes (for
example above $500 million in assets). This is particularly relevant for the
current proposal of structural reform as its provisions only applies to banks
above the thresholds as discussed in Annex A8, that is, to very large banks in
the EU. | |
| d.
Dis-economies
of scale | |
| Furthermore, even if economies of scale do
arise, the question that arises is whether or not these benefits are likely to
be passed on to customers (through changes in prices or quality of service
because of competitive pressures) and why smaller firms would not be able to
form consortia or outsource some activities to realise similar levels of
economies of scale as larger banks. Moreover, as explained above, the
literature has identified a number of disadvantages related to increased size
that relate to the following: | |
| 1. By expanding in scale and scope, banks may be able to raise prices
above marginal costs, exploiting their stronger market position (market power).
However, the literature on banking sector concentration and prices is not
clear-cut, largely because studies on mergers do not always control for the
efficiency effects of a merger (see for example Herring and Carmassi (2008) and
Berger et al. (1999)). | |
| 2. Larger banks are more likely to take higher risks. As explained
above, Hughes et al. (2001) claim that there is an adverse effect associated
with increased size, the risk-taking effect, if banks spend more resources to
manage the increased risk and monitoring costs associated with larger size.
Haldane (2009) considers that "at least during this crisis, big banks have
if anything been found to be less stable than their smaller counterparts,
requiring on average larger-scale support".[172] This may be related
to the TBTF status of larger banks. The expectation that some banks benefit
from TBTF subsidies provides an incentive to banks to artificially increase
their size to benefit from such subsidies. This positive relation between size
and implicit subsidy is also documented in the literature (see Annex A4.1 and
A4.2). As the implicit subsidies increase for a given bank this also leads to
less effective market monitoring of the banks effectively subsidising
risk-taking by systemically important financial institutions. | |
| 3. Larger banks pose greater systemic risks, and this is likely to
imply large risks to a country's public finances. There are a number of studies
that find that larger banks pose greater systemic risks. Boyd et al. (2006)
show that in countries with more concentrated markets, banks have taken a
disproportionate amount of risk, relative to their capital buffer. Boyd and
Heitz (2012) estimate that the social cost of too-big-to-fail banks due to
increased systemic risk is significantly higher than the benefits due to
economies of scale. Also Baele et al. (2007) for a European sample, find that
larger and more diversified banks have higher systemic risk. On the other hand,
Beck et al. (2006) find evidence that concentrated systems have a lower
probability of financial crisis, potentially due to better diversification of
risks within large banks, leading to a correspondingly lower probability of
failure. Demirgüc-Kunt and Huizinga (2011) distinguish between a banks'
absolute size and its systemic size measured with respect to the size of the
economy. They conclude that while there may be some benefits from absolute size
(returns on assets increase with absolute size, even though bank risk
increases), systemic size is unambiguously bad (returns on assets falls with
banks liabilities-to-GDP ratio and bank risk is unaffected) meaning that the
optimal bank size may be larger for banks in larger economies. | |
| 4. Greater consolidation may also have consequences in the composition
of companies to which funding is channelled in the real economy. Small banks
tend to be better at relationship-lending based on "soft
information", such as reliability of the firm's owner versus lending by
big banks that is based on "hard information" such as financial
statements and credit scoring (Berger et al. (2005)). Therefore, greater
consolidation may affect the ability of small firms to secure credit
availability. | |
| 5. Principal-agency problems, and in particular managerial benefits,
may have also led to higher than optimal bank size. Anderson and Joeveer (2012)
show that there is stronger evidence of returns to scale to bankers as compared
to returns to investors, and that these returns to bankers are particularly strong
in banks that have a large share of non-interest income. Also, Hughes et al. (2003)
find empirical evidence that bank managers may sacrifice value to build empires
(through mergers) and not all consolidation that has taken place is
value-enhancing. | |
| 3. Economies of Scope | |
| There is a substantial and diverse
literature on the subject and yet lack of unanimous evidence supporting the
existence of economies of scope. While there are several source of economies of
scope such as revenue and cost economies of scope and risk diversification
benefits, there are also important diseconomies of scope. Conflicts of interest
between different activity business lines, increased risk-taking and complexity
as well as systemic risk and cultural contamination are reported as factors
that lead to adverse effects of extending banks' scope of activities. The
empirical evidence is a relatively stronger for geographic diversification. | |
| As previously described with regards to
economies of scale, if the net benefits of economies of scopes are passed on to
customers, the client may benefit from a greater range of products on offer by
a single institution, and potentially lower prices. In answering whether or
not economies of scope exist, for what activities, and at what levels, one must
analyse existing literature. The sections that follow will analyse in further
detail examples of evidence for or against the enjoyment of economies of scope
when a bank diversifies its activities, domestically through loan and portfolio
diversification, and geographically. | |
| a.
What
are the economies of scope that a financial institution may enjoy? | |
| Economies of scope relate to efficiency
gains of diversifying business activities across products and services provided
(product diversification), as well as geographical diversification, or a
combination of the two. The possibility of a financial institution benefiting
from economies of scope is somewhat related to that of scale: as a financial
institution grows in size, it may enjoy improved efficiency associated with
diversification, and thus, reduced costs of funding. | |
| The sources of economies of scope and
therefore underlying reasons for which a bank may choose to diversify their
business practices, functions, or products offered can generally be attributed
to: | |
| Revenue economies of scope: clients may place
additional value in being able to seek multiple products at a single bank
offering diversified services. Additionally, in providing a service, the
bank gains valuable information about their client that may provide
process and pecuniary advantages in the provision of other services;
Cost economies of scope: banks may reduce their
operating costs in engaging in a wide range of activities from pooling
their resources. Sources of these reductions in costs could be from
operating centralised IT and finance systems, for example; and
Risk diversification: an extension of the cost
economies of scope, risk diversification implies that undertaking a wide
range of activities (or operating in more geographic areas) with less
than perfectly correlated income stream may benefit the overall banking
group by diversifying assets and earnings thus rendering them more
resilient to shocks, and reducing costs. Also, diversification across activities
may lead to a more efficient use of capital for the bank which may be
affected by structural reform as under several options the two entities
would be required to meet these requirements on a solo basis. The ICB
(2011) acknowledges that scope benefits arising from moving excess capital
between the different parts of a corporate group may be lost. If there is
less than perfect correlation in the capital of these two entities then
such separation requirements will increase the capital needs of the
banking entities. | |
| Contrastingly, most literature refers to
the following drivers of inefficiencies associated with diversified
institutions: | |
| Conflicts of interest: conflicts of interest
between banks' employees and banks' customers when banks engage in several
activities may arise in several forms. For example, banks can use the
informational advantage they gain from conducting several activities to
their own advantage. Also the combination of different banking activities,
and therefore of multiple clients and interests provides the opportunity
to serve some client categories better to the detriment of others.
Potential conflicts between traditional banking and securities
underwriting business, for instance, led to the 1930 Glass Steagall Act;
Increased complexity: diversification of banks tends
to increase their organisational and operational complexity, especially if
they are large to begin with, which can increase their risk management
costs. This complexity can also lead to reduced transparency, making
effective supervision harder and complicating resolution;
Increased risk-taking: lower costs of funding due
to diversification may contribute to the diversified bank taking on
additional and excessive risk. While many studies recognise a certain
degree of risk diversification benefits, many note that the expansion of
types of activities usually enters the realm of much riskier activities,
and in parallel with this expansion, these banks often hold less capital
than undiversified banks;
Increased systemic risk: while individual activity,
and therefore risk diversification, can benefit the single bank, it has
been found to contribute to overall systemic risk as banks typically
diversify into each other's' traditional areas. As a result, the financial
system as a whole becomes less diversified;
Cultural contamination: an increasingly-discussed
disadvantage of practicing varied banking activities since the beginning
of the financial crisis is the changing of attitudes towards business
practices. The transferral of behaviours typical of the trading floor in
banking activities into the commercial side causes a lack of confidence in
the sector, and is seen as detrimental to the proper, useful functioning
of the European economy. | |
| As a result of the above mentioned drivers,
benefits of functional and organisational diversification may manifest
themselves in having better access to internal capital markets and lower risk,
increased supply of financial services, and operational synergies. On the
other hand, potential diseconomies of scope could arise from intensification of
agency problems between the divisions of the conglomerate and between the
conglomerate and its outsiders, bargaining problems and higher regulatory
costs, inefficient rent-seeking, increased systemic risk due to negative
externalities and more interdependencies and cultural contamination. | |
| b.
Economies
of scope in the empirical literature | |
| Empirical literature provides mixed
evidence for significant efficiency gains generated by large and diversified
banks, very often concluding that there are diseconomies of scope, making it
difficult to ascertain the value added of bigger and more varied banks. Much of
the existing literature in the field refers to the Diamond (1984) model of
banking activity, which provides the theoretical rationale for a bank acting as
an intermediary in the financial market. This model, which focuses on deposits
and loans, finds that diversification benefits are inherent in the role
of the bank as an intermediary (delegated monitor) in this market. Furthermore,
banks' activities of providing commitment-based loans and accepting deposits
are very similar services. That is, in both cases they provide liquidity on
demand to accommodate unpredictable needs. If the two activities' demands for
liquidity are imperfectly correlated then the two activities can share the
costs of the liquid asset stockpile, or buffer, through a single bank (Kashyap,
Rajan, and Stein (2002) and see also Gatev and Strahan (2006)). Overall, while this
literature suggests economies of scope between deposit taking and loan
provision there is limited evidence of such benefits for other kinds of activity
diversification. | |
| Economic literature on the subject of
economies of scope is rich. One strand of literature looks directly at the
effect of diversification (either activity or geographic) on the market
valuation of the specific bank. These studies find the net effect of economies
and diseconomies of scope directly from stock market valuations. Other empirical
analyses focus specifically on some categories of economies or diseconomies of
scope. Therefore they are analysed under the prism of the categories identified
in the section above. | |
| c.
Market
Valuation studies | |
| Without identifying the underlying drivers,
the following studies draw links between the degree of operational
diversification (either activity or geographic) of the bank and the value the
market places on it. Overall, estimates of such valuation studies, in line with
other studies, fail to provide robust evidence on the existence of economies of
scope. | |
| At one extreme, Laeven and Levine (2007)
investigate whether the market valuation of a diversified bank is more or
less than the value it would have if the conglomerate were broken into a
portfolio of banks each specialising in the interest and non-interest
earning activities of the conglomerate (chop-shop approach that compares
these entities with similar entities specialising in interest and
non-interest income activities). The paper finds for a sample of banks
across 43 countries a diversification discount in the conglomerates'
valuation, as those banks that engage in multiple activities are valued
lower by the market than the individual specialised units. These results
suggest that any economies of scope in diversification are not
sufficiently large to compensate for the detrimental effects of
diversification. Schmid and Walter (2009) find similar results for US
financial conglomerates.
Other studies find that diversification has no
material impact on the valuation of a financial conglomerate. Lelyveld and
Knot (2009) find for 45 large financial conglomerates (firms that are
active in both banking and insurance) in the EU that there is no uniform
diversification discount or premium. When the conglomerate is split into a
banking unit and an insurance unit, 52% of the sample shows a premium, and
48% show a discount. These effects are significantly variable in
magnitude, depending on size, complexity, and risk. They also show that
while small conglomerates witness a premium on average, larger conglomerates
tend to face a discount. Similarly, DeLong (2001) studies US mergers over
the period 1988-1995 and finds that activity-diversifying mergers do not
have a positive announcement effect on share prices, contrary to focused
mergers.
At the other extreme, in a study of large
international banks from 1996-2008, Elsas et al. (2009) find evidence for
a diversification premium. They test how revenue diversification and
increasing bank size affects bank value. They show that revenue
diversification enhances bank profitability, and in turn higher
profitability translates into higher market valuations. They find the
diversification effects materialise through an indirect effect on current
operating performance and not through direct effects (of examining the interest
vs non interest income of the two business units as in Laeven and Levine
(2007)). Similarly, Baele et al. (2007), in a European sample, also find a
positive relationship between franchise value and diversification.
There are also a few studies on the effects of
geographic diversification on market valuation. Gulamhussen et al. (2010),
in an international sample across 56 countries, find that internationally
diversified banks trade at a premium. However, they also show that
geographic diversification has an inverse U-shape effect on bank value in
that increased diversification increases the bank's value, only until a
certain threshold, after which it starts to decline. Furthermore,
Gulamhussen et al. (2012) show that this overall value enhancement comes
at a cost: multinational banks have higher expected probability of
default. They show that any positive effect of loan and asset
diversification in the reduction of bank risk is outweighed by the
negative effects of skewed incentives and complexity originating in
international diversification and the creation of large multinational
corporations.
Economies of scope | |
| The empirical literature on economies of
scope has focused mostly on the benefits of risk diversification and
informational advantages. | |
| d.
Revenue
and cost economies of scope | |
| The works of Diamond (1991), Rajan (1992),
Saunders and Walter (1994), and Kashyap et al. (2002), for example,
theoretically suggest that banks acquiring information about clients during the
process of making loans facilitates the efficient provision of other financial
services, including securities underwriting. This positive information-sharing
process can also work in the opposite direction, whereby underwriting,
brokerage and mutual fund services, and other activities may improve
loan-making procedures. | |
| Drucker and Puri (2005) empirically show for the US
that there may be economies of scope to be enjoyed in concurrent lending
and equity underwriting from spreading fixed costs of acquiring
information. They argue that the concurrent deals could provide benefits
for the issuers in lower costs, and the degree of economies of scope
enjoyed could be greater for commercial banks than investment banks, given
their well-established lending business. These efficiency gains and resultant
savings could be particularly pronounced for the issuers who are
noninvestment grade-rated. They indicate that beyond an optimal volume of
underwriting deals, which is however not specified, the bank would
experience diseconomies of scale.
Other papers suggest that there is a positive
reputation effect of mixing different activities. For example Ang and
Richardson (1994), Kroszner and Rajan (1994) and Puri (1994) find that
commercial banks did not try to mislead the public in investing in poor securities
in the years leading up to the Glass-Steagall Act, as the performance of
commercial and investment bank issues does not differ. | |
| e.
Risk
diversification | |
| If the returns of two or more sources of
income are less than perfectly correlated, then it is possible to reduce risk
through diversification. However, it may be that multinational banks may take
on excessive risks (see below).[173]
Overall, there is lack of robust evidence on the effectiveness and the benefits
related to risk from activity and geographic diversification. Literature
considers two potential sources of risk diversification: activity and
geographic. | |
| Concerning activity diversification,
certain papers analyse banks' income sources into interest-based and
non-interest based (fee- or commission-based, for example) categories. | |
| The IMF Staff Discussion Note (2013) finds evidence
that a bank benefits from diversifying its business. They find that the
returns from the retail section of a sample of seven G-SIBs complement
those from wholesale and trading banking in the particularly prosperous
times (2003-2007), and vice-versa in economically tougher times
(2008-2011). | |
| They claim that
the trading banking segment complements retail and wholesale banking via
product structuring, hedging, and income enhancements through proprietary
risk-taking. Banks may diversify their risk portfolio by maintaining all three
business lines. However this might not have a direct impact on the probability
of default of different types of banks. For example, an earlier IMF staff
discussion note (Ötker-Robe et al., 2011) shows from data throughout the crisis
that the frequency of distress was notably higher for banks that practiced
investment and universal banking activities than for commercial banks (likely
reflecting more reliance on more volatile sources of funding and balance sheets
more sensitive to mark-to-market accounting). | |
| Some papers underline the value of derivative
activities within banks to allow diversification of risk. Brewer et al.
(2000) focus on derivatives contracting and find in the US 1985-1992 that
those commercial banks that engaged in the interest-rate derivative
products markets have greater growth in lending in commercial and
industrial loans than those banks that did not. They claim that their
results are consistent with the role of banks as delegated monitors as in
Diamond (1984): derivatives trading enables banks to increase their
reliance on their comparative advantage as delegated monitors, and allows
them to hedge their risks, and this leads to a reduction in delegation
costs. This reduction in delegation costs, in turn, provides incentives
for banks to increase their lending activities.[174] A
similar point is made by Purnanandam's (2007). He shows that banks that make
use of derivatives remained more insulated from monetary policy shocks
during the period 1986-2003 compared to banks not using derivatives which
instead decreased their lending following money supply contractions.
Therefore, derivatives may contribute to maintain smooth operating
policies in the event of external shock.
Baele et al. (2007), on a European sample (over the
period 1989–2004), find that a higher share of non-interest income in
total income affects banks’ franchise values positively, reduces idiosyncratic
risk, and makes banks safer. Nevertheless, they also find that the
systematic risk of banks increases. Similarly, Rossi et al. (2009) examine
data on Austrian commercial banks (1997 to 2003) and find that
diversification reduces risk, in line with the classical diversification
hypothesis. Their results point also to a negative effect of
diversification on cost efficiency (as it is associated with higher
monitoring costs) but overall diversification increases profit efficiency
and reduces banks’ risk.
On the other hand, there is a series of articles
(Stiroh (2004a), (2004b) and DeYoung and Roland (2001), for example), that
claims that increased diversification leads to increased complexity, and
excessive risk-taking, leading to overall higher bank risk (see section
2.2.5 below)
In terms of geographic diversification,
Amihud et al. (2002) study the effect of geographic diversification on
risk. They show that cross-border mergers and acquisitions have no net
effect on the risk (and returns) of the acquiring banks. They also find
this to hold for both total risk and systemic risk as compared to their
home market.
On the other hand, Deng and Elyasiani (2008) find
that geographic diversification (using distance metrics within the US
only, for BHCs) is associated with risk reduction (and lower stock price
variability), along with value enhancement. However, geographic
diversification across more remote areas (measured as the distance between
the holding company and its branches) is associated with smaller risk
reduction. Furthermore, Deng et al. (2007) show that geographic
diversification can lead to a funding advantage. They study a sample of
over 60 US BHCs from 1994 to 1998 and find that domestic diversification
of deposits reduces the bond-yield spread. They also show that
medium-sized BHCs experience a greater reduction in bond yield-spread than
small-sized and large-sized BHCs, which, they argue, is consistent with
TBTF effects in the banking industry. | |
| f.
Diseconomies
of scope | |
| A number of diseconomies of scope have been
identified above. Below we discuss the academic literature on each of these
categories. There is an extensive literature discussing, in particular,
conflict of interest as well as increased complexity and risk (both in terms of
excessive risk-taking and increased systemic risk). Before going in detail in
the empirical finding, one should note that, as discussed in the section of
economies of scale, studies measuring economies of scope should also take into
account the benefits from safety nets. Indeed, economies of scope may arise due
to the presence of the implicit subsidy and banks may be tempted to extend
their activities in order to benefit from the safety net over all their
activities. For example, when publishing their final report, the ICB received
very little quantitative evidence of the magnitude of these claimed
diversification benefits or customer synergies (ICB 2011). The lack of evidence
stems from a difficulty in separating the two effects that may lower the
funding costs of universal banks: an implicit government guarantee, and
diversification benefits that result in a pecuniary advantage. However, there
are no such studies. | |
| g.
Conflicts
of interest | |
| A conflict of interest in general can arise
when an agent is serving two or more interests and has the ability to put one
party in a better position at the expense of the other. Conflicts of interest
become particularly important with increased scope, as service-providers have
clients from distinct or opposing business lines. Conflict of interest may
arise among different areas of activities and large literature has focused on
universal bank's underwriting activities. | |
| A conflict of interest may arise in the universal
banking model if authorities allowed banks to underwrite their borrowers'
capital market issues (Bhattacharya, Boot, and Thakor, 1998). A
theoretical paper on combining lending and underwriting is provided by
Kanatas and Qi (1998), who assess the conditions needed for the separation
of lending and underwriting to be optimal. They suggest that there is a
social cost related to the bank's reduced incentive to monitor its
borrowers, as credit risk can be shifted to uninformed public investors
when the borrower's project is not performing well. The authors show that
legal separation of lending and underwriting may improve social welfare if
firms recognise the intermediary's subsequent incentive when choosing
projects to be funded and there are large social costs associated with the
bank's funding of poor-quality projects (for example through an increased
likelihood of runs on banks).
The Glass-Steagall Act prohibited commercial banks
from underwriting or dealing in corporate securities to prevent lenders
with adverse private information from selling securities of weak firms to
an unsuspecting public, to offload credit risk. Studies from underwritings
in the period pre- Great Depression (pre GSA) such as Kroszner and Rajan
(1994) and Ang and Richardson (1994), however, find no evidence that
commercial banks misled the public (by for example comparing the relative
performance of securities offered by commercial and independent investment
banks). Kroszner and Rajan (1994), however, find evidence that the
conflict of interest exist and the market and the affiliates adapt their behaviour
(for example the market would request a "lemons" discount and
affiliates have avoided information-intensive securities and focused on
better-known firms than investment banks). In addition to these research
on the pre GSA period in the US, there are also some recent studies on the
UK and Canadian experience (Hebb and Fraser 2002, 2003) which find
evidence that commercial and investment bank issues do not differ in
performance.
However, other recent studies such as Johnson and
Marietta-Westberg (2009) find evidence of conflicts of interest in
relation to underwriting, when it is combined with asset management
divisions. They show that universal banks with asset management divisions
tend to use asset management funds as vehicles to help them earn more
equity underwriting business. Similar results are obtained by Ber et al. (2001),
who claim that banks must choose between selling the IPO stocks at a high
price, generating a substantial amount of cash, and selling these stocks
at a low price, generating good returns for investors. Bessler and Stanzel
(2009) study conflicts of interest when the asset management analyst is
affiliated with the underwriter of an IPO in a sample of German universal
banks. They find that the analysts belonging to the lead underwriter tend
to produce inaccurate and positively biased stock recommendations to
public.
Xie (2007) also studies the issue of conflict of
interest in relation to securities underwriting and trading. She
finds that the negative effect of conflicts of interest dominates the
positive benefits of economies of scale and scope in universal banking.
This negative effect is weaker in the countries with stronger protection
of creditor's rights (higher institutional development, stronger security
laws, higher accounting standards) or higher information efficiency of the
stock market, as the conflict of interest are less likely. Relating to
the question on the strength of the fence, she also finds evidence to
support that a subsidiary structure of separation of banking activities
would reduce the likelihood of conflicts of interest.
Fecht et al. (2010) report empirical evidence for
the German banking sector that proprietary trading can negatively affect
retail customers. Stocks sold to retail customers of the bank underperform
compared to other stocks in the bank’s proprietary portfolio and other
stocks in the households’ portfolios. Customer portfolio performance is
also significantly worse in banks that do proprietary trading. The authors
attribute banks pushing stocks to their customers to the banks avoiding
direct and indirect transaction costs, as well as not wanting to disclose
their possible informational advantage to the market. They argue that
conflicts of interest are at the source of these findings. | |
| h.
Increased
complexity | |
| An adverse effect of engaging
into more activities is that the institutional complexity increases, increasing
the risk management costs. | |
| ·
Klein & Saidenberg (2010) suggest that the
diversification discount found in the literature (see market valuation studies,
discussed above) reflects not only industry diversification, but also
organisational structure. Potential costs of organisational structure include
bureaucratic rigidity and bargaining problems, and these should be
distinguished from the pure activity and geographic diversification benefits.
The authors show that BHCs with many subsidiaries have lower profits and market
valuations than similar BHCs with fewer subsidiaries, and accordingly argue
that the cost of managing complex organisations increases with the degree of
heterogeneity of the institution’s subsidiaries. | |
| ·
This increased complexity may create problems
for market participants and regulators to appropriately value and monitor the
banks. Flannery et al. (2010), from pre- and mid-crisis data, argue that
complex, diversified banks are seen by many as less transparent than other
companies, and so the monitoring of their activities becomes more difficult.
Iannotta (2006) analyses the opinions of credit ratings agencies to suggest
that the greater complexity of large, diversified banks results in greater
opacity. In particular, bank opaqueness increases with size and with the volume
of financial assets. | |
| ·
Increased complexity can also arise from
geographic diversification. As explained above, Gulamhussen et al. (2012) show
that any positive risk-reducing effect of portfolio and international
diversification is outweighed by the negative effects of skewed incentives and
complexity originating in the creation of large multinational corporations. | |
| i.
Excessive
risk-taking | |
| Banks may benefit from activity and
geographic diversification, which could reduce their overall riskiness, but
this positive effect may be more than or partially offset by opposing
incentives, leading the banks to take on excessive risks. Some studies have
underlined the potential of excessive risk-taking in banks as a result of
consolidation and expanding activities in new markets. | |
| While internationalisation, consolidation, and
conglomeration offer potential benefits to financial institutions,
diversification may also lead to shifts in risk-taking behaviour and the
development of new and more sophisticated mechanisms to transfer risk
(FSOC 2011). The Financial Stability Oversight Council (FSOC 2011) explain
that pre-crisis, supervisors knew that much financial activity had moved
from the banking sector to capital markets, but they did not fully
appreciate the risks that certain activities posed to the institutions
they supervised and to the financial system as a whole.
De Nicoló et al. (2004) study the risk profile of
financial conglomerates[175]
compared to other financial institutions in an international sample of
banks. In a cross sectional analysis of financial institutions, the
authors find that the financial conglomerates exhibited higher levels of
risk-taking than smaller, specialised firms. Since they control for any
positive effects on risk from diversification, their results suggest that
the incentives for firms to take on more risk, including moral
hazard-induced incentives, appear to have outweighed the risk reductions
that would be achieved through scale or scope economies, or through
geographic or product diversification. They consider that this increased
risk-taking may be the result of an extension of the safety net to
non-bank financial firms if banking and non-banking activities are not
effectively ring-fenced.
Other papers study the effects of combining
interest and non-interest activities on risk. Stiroh (2004a), for US
community banks, and Stiroh (2004b), for US commercial banks, find that
non-interest share of revenue enhances risk and return volatility, and is
negatively related to risk-adjusted profits. This result suggests a
robust, negative relationship between non-interest income and performance.
Some studies have shown that in financial institutions, marginal increases
in revenue diversification are not associated with a significant change in
performance (DeYoung and Roland, 2001, for example), which may reflect
either a change in managerial focus or may represent the endogenous nature
of the diversification decision. It is argued that this problem arises as
managers may enter businesses where they have little experience or
comparative advantage.
In their study of US financial holding companies,
Stiroh and Rumble (2006) find that even though diversification benefits
exist, they are more than offset by the increased exposure to more
volatile non-interest activities. One proposed reason for this
relationship may be that FHC managers have overestimated the benefits of
diversification. If managers privately reap the gains of higher profits,
but do not bear all the social costs from increased risk, there is indeed
scope for risk mismanagement and managerial hubris. Lepetit et al. (2007)
find similar results for European banks. Their findings show that banks
expanding into trading and fee and commission-earning activities present
higher levels of risk and insolvency measures than banks mainly performing
deposit-based banking activities. Upon further division of the sample,
the study demonstrates that smaller banks may benefit from a degree of
decreased risk when they engage in trading activities. Contrastingly, both
the overall asset growth and the increased share of non-interest income
are positively related to risk for large banks. Other explanations may
include empire-building, over-diversification to protect firm-specific
human capital, or corporate control problems. One of the proposed
justifications for the shift in activity in these banks is the mismanagement
and estimation of risk, and managers seeking higher expected.
There are also some studies focusing on the effects
of securitisation on risk. For example, Nadauld and Sherlund (2009) and
Keys et al. (2010) provide evidence to suggest that securitisation
encouraged underwriters to relax credit quality standards during the peak
of the housing bubble. In particular, the former construct a measure of
geographic diversification and concentration to show that the
securitisation process, including the assignment of credit ratings,
provided incentives for securitising banks to purchase loans of poor
credit quality in areas with high rates of house price appreciation.
Therefore, they argue that securitisation allowed banks to transfer risk
and discouraged banks from devoting as many resources as it normally would
to screening and monitoring loans.
Fang, Ivashina, and Lerner (2013) focus on private equity investments. to carry a high degree
of risk, and find US bank-affiliated private equity investments in the
period 1978-2009 to be highly procyclical, and worse-performing than those
of non-bank affiliated private equity deals over the same period. These
investments thus have potential to aggravate any prevailing risk in the
system, if bank managers' incentives to grow and maximize utility entail
diversifying into private equity investments.
j.
Increased
systemic risk | |
| In addition to excessive risk for the
individual banks several papers show that increased diversification may have an
adverse effect on systemic risk. | |
| Wagner (2010) provides a
theoretical setting in which diversification of individual institutions
deteriorates systemic stability. Diversification, as a
"stand-alone" effect, lowers a bank’s probability of failure.
However, widespread diversification makes banks more similar to each other
by exposing them to the same risks, and thus they are more likely to fail
simultaneously following a negative shock to the system. In addition
to the theoretical framework, he finds evidence indicating that very large
banks became increasingly similar in the years leading up to the crisis,
and argues that the current level of diversification likely exceeds the
optimal level for social welfare. A similar paper is by De Nicoló and
Kwast (2002) who claim that while individual banks have become more
diversified the systemic risk potential in the financial sector may have
increased. They argue that firm interdependencies provide an indicator of
systemic risk potential and they measure interdependencies with
correlations of stock returns. The authors find that stock return
correlations among large and complex banking organisations in the US over
the period 1988-99 have increased, which is consistent with greater
potential for economic shocks to become agents of systemic risk in the
financial sector Baele et al. (2007), find similar results for European
banks. De Nicolo et al. (2004), in an international sample of banks, find
that complexity resulting from conglomeration and consolidation increases
systemic risk.
Nijksens and Wagner (2010)
focus on the effect of trading credit risk transfer instruments (CDSs and
CLOs) on banks' risk. They argue that while securitisation may allow banks
to purchase protection in the CDS market to shed idiosyncratic exposure,
banks also simultaneously buy other credit risk by selling protection in
the CDS market. As a result banks may end up being more correlated with
each other and this may amplify the risk of systemic crisis. Their
analysis of an international sample of banks between 1996 and 2007 shows
that the adoption of risk transfer methods by banks increased their
riskiness due to higher systemic risk. The authors conclude that
credit risk transfer reduce banks’ idiosyncratic risk, but increase
systemic risk, by increasing banks’ exposure to risk in the system
overall.
Brunnermeier et al. (2012)
find evidence for US financial institutions over the period 1986-2008 that
banks with higher non-interest income make a greater contribution to
systemic risk than those practicing "traditional" banking
activities. This suggests that activities that are not linked with
deposit taking and lending are associated with a larger contribution to
systemic risk. Furthermore, after splitting total non-interest income into
(i) trading income and (ii) investment banking and venture capital, they
find that both components are roughly equally related to systemic risk.
FSOC (2011) explains that securitisation has also
increased systemic risk even if the creators of ABS did retain a
considerable amount of risk on their portfolios. Systemic risk would
increase because the regulatory environment allowed creators of ABS to
hold less capital than if they had simply held the original assets on
their balance sheets. Therefore some activities might contribute disproportionately
to systemic risk.
Focusing on the use of derivatives, Stulz (2010)
argues that while derivatives may provide credit protection however those
that provide such protection need to have the ability to repay their
obligation. When derivatives shift credit risk from banks to less
regulated parts of the financial system then credit derivatives could
increase systemic risk.
k.
Cultural
contamination | |
| An additional concern of combining deposit
taking and trading activities is the risk that the trading culture contaminates
and dominates over commercial bank culture. The transferral of behaviours
typical of the trading floor in banking activities into the commercial side
causes a lack of confidence in the sector, and is seen as detrimental to the
proper, useful functioning of the European economy. For example, Kay (2012)
considers that there has been a systematic and deliberate replacement of a
culture based on relationships by one based on trading increasingly
characterised by anonymity, and the behaviours which arise from that
substitution, which has led to a wide erosion of trust in financial
intermediaries and in the financial system as a whole. The Commission’s
December 2012 8th edition of Consumer Markets Scoreboard shows that consumer
trust in the EU banking sector is at an all-time low. | |
| Many proponents of stricter or more banking
regulation have noted the negative aspect of cultural impetus and have stressed
the importance of re-establishing trust in banks. For example, the European
Parliament report on reforming the structure of the EU banking sector stress
the important of reforms to change the banking culture.[176] The rapporteur of the
report, European Parliamentarian McCarthy, has said that the customer should
trust his banker in the same way he trusts his family doctor and that
“piecemeal” legislation will not serve the purpose of changing the culture of
banking. She considers that structural reform is a necessary addition to the
current reform package. "This separation is necessary if we want to change
the culture of the retail side of banks, because the investment banking
mentality currently pervades retail banking."[177] Also, in the UK, the
House of Parliament has established a Parliamentary Commission on Banking
Standards (2013) to make recommendations on how to promote a better culture in
the banking system. | |
| l.
Industry
and other studies | |
| In this section we review some studies from
the industry examining why banks expand their scope of activity. Some industry
studies find significant benefits related to both size and diversification (IIF
(2010); The Clearing House (2011, Annex C and D)). Their argument is that
larger banks and their scope for achieving greater diversification across
business lines and geographies may realise significant synergies, promoting safer,
more stable, and ultimately more valuable banks. Continuing this logic, they
argue that structural bank regulation initiatives and the separation of
business lines would imply costs, not only for banks and their shareholders,
but for the economy as a whole. | |
| The Clearing House (2011), an American
banking association, estimates for the US that the 26 largest US banks provide
an estimated USD 15-35 billion in direct value to customers every year by
providing a wide range of activities. They reach this number by analysing the
products and services in which banks provide a unique benefit and quantifying
the benefit that each subscribing customer receives. The authors acknowledge
that this process is an imperfect method, but, in particular, estimate that
banks with assets of over USD 500 billion are responsible for USD 10 - 20
billion of the total, not counting "indirect benefits to the economy at
large." They suggest that the benefits are found in the four product areas
of banking (retail, payments and clearing, commercial, and capital markets),
though least of all in retail banking. Within the payments and clearing
category of banking activity, securities servicing is seen to be the main
source of benefits in product scope that large banks provide, contributing an
estimated USD 4-8 billion in related annual benefits. | |
| The Institute of International Finance's
(2010) report on systemic risk and systemically important firms finds
"considerable real-world evidence" of economies of scale, scope, and
diversity among large, international firms with assets in excess of USD 100
billion. They claim that imposing limits on the activities a bank may perform
could severely limit the enjoyment of economies of scope and how they pass
these on to the customer, however, without quantifying such a loss, and that
there is likely to be "no real gain" for financial stability from
such an "arbitrary measure." | |
| Industry estimates of economies of scope
and subsequent effects of structural reform also highlight diversification's impact
on the risk involved in banks taking part in varied activities. While during
the recent financial crisis banks of all types have failed, Barclays Capital
(2011) claims that during the period 1988-2009, universal banks defaulted less
frequently than retail banks, which in turn defaulted less frequently than
investment banks. Santander's response (2011) to the ICB's consultation,
however, notes that a retail bank's assets are less volatile in value than for banks
dealing with non-interest-earning activities. Other studies (see for example
Van Ewijk and Arnold (2012)) argue that traditional relationship banks were
better positioned to deal with the financial crisis than diversified
transaction-oriented banks. CEPS (2011) provides a review of banks and an overview
of their performance over the crisis for a sample of major European banks. The
authors conclude that retail banks were the best-performing during the period 2006-2009,
with less need for state support, and by continuing to fund the real economy, unlike
investment and wholesale banks. Since these banks provide a net benefit to the
wider economy and in light of these findings, the authors suggest that the
authorities' crisis responses should have increased pressure on banks to
operate with less complex business structures, therefore justifying the
movement back towards the traditional retail banking model. | |
| Frontier Economics (2013) study the
economies of scope for banks engaging into private equity. They argue that that
private equity attracts a large range of investors, including banks, and has
potential for many advantages for the investors' portfolios. Given the
attractiveness of diversifying the portfolio and the possibility of earning
greater returns from this diversification, the preservation of private equity
activities within the deposit-taking bank may prove advantageous for the bank,
as well as the bank's customers. Nevertheless, banks still run serious risks
when investing in private equity funds, which have been known to experience
substantial losses. For instance, the Finnish Venture Capital Association
(2009) states that default rates of private equity-backed companies increases
during downturns (which is similar to empirical evidence explained above from
Fang et al. (2013)). A systemically important bank bearing the burden of a
failing private-equity backed company is extremely dangerous for the company
and all the relevant stakeholders, as well as the bank's other customers and
the overall financial system. | |
| 4.
Economies
of Scale and Scope and Structural Reform | |
| If economies of scale and scope are
present, will banks be in a position to enjoy them post-structural reform? The
answer to this question depends on several parameters. Firstly, as discussed in
various sections of this Annex, there is evidence that economies of scale are
likely exhausted at levels of assets below the thresholds considered by the
Commission. Secondly, concerning economies of scope, there is greater evidence
for loan portfolio and geographic diversification effects, which are not
affected by the structural reform proposal, while for other types of activity
diversification results suggest that diseconomies of scope are likely to
outweigh any efficiency. Thirdly, the strength of separation requirements has a
direct effect on this relationship. At one extreme, accounting separation
allows banks to essentially enjoy the same level of economies of scale and
scope. At the other extreme, ownership separation would deprive banks of any
economies of scale and scope. Functional separation through subsidiarisation
would allow some benefits to be maintained depending on the precise requirements. | |
| An advantage of separation through
subsidiarisation is that retail banking operations would be protected from
investment banking, while some economies of scale and scope advantages that
exist within a group could be maintained. These advantages can be preserved, as
the overall banking group can stay the same size, and practice the same
activities, provided they meet regulatory requirements on a solo basis. Separation
through subsidiarisation can be seen as a driver of "net" economies
of scope in a banking group. The ability to allow one line of banking business
to fail without disturbing overall business functioning and customer
relationships could help address the moral hazard created by bank rescues and
therefore the subsidiarisation avoids such diseconomies of scope (see ICB
(2011) and CEPS (2012)). Transfers of informational knowledge and cost
advantages could be enjoyed depending on the precise requirements associated
with subsidiarisation requirements, however some duplication of infrastructure
would be necessary and a less efficient use of capital would arise (due to
regulatory restrictions). | |
| 5.
Conclusion:
Economies of Scale and Scope | |
| Evidence of economies of scale and scope
are, at best, mixed. A recurrent problem in the literature is that the presence
of implicit subsidies is not typically controlled for, and therefore it is more
likely that evidence is found of economies of scale (at relatively larger
levels of bank assets) as well as of scope. Furthermore, some studies argue
that there are economies of scale or scope but do not comment on the net effect
of the economies and diseconomies of scale and scope. | |
| On economies of scale, initial studies have
found evidence of such benefits at moderately low levels of assets (USD 100
billion). Given the relatively high thresholds for banks to fall under the
requirements of the structural reform proposals, it is likely that the vast
majority of these banks will exceed this level of assets. More recent studies
that find evidence of higher optimal banking levels either only focus on the
positive effects of scale, or do not take into account implicit subsidies (or
both). | |
| Concerning economies of scope, the evidence
is again mixed. On activity diversification there is some evidence of economies
of scope in combining deposit-taking and loan provision, but there is weak
evidence that such benefits are significant for other kinds of activity
diversification. On the contrary, some activities are likely to lead to
conflicts of interest between business lines, increased business complexity,
and have an adverse effect on risk-taking and systemic risk. There is a large
empirical body of literature suggesting that these diseconomies dominate
economies of scope for product diversification. In addition, cultural
contamination from investment banking into retail banking has an adverse effect
as for example for proprietary trading the bank's aim is to make a profit without
providing services to its customers. There is some more positive evidence of
economies of scope from geographic diversification. Therefore, while
diversification of activity and product lines is mostly associated with
significant increases in individual and systemic risk, overall positive effects
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diversification. | |
| Given the relatively weak evidence on
economies of scale and scope, the business model of large and complex global banking
organisations may have been, at least partly, induced by regulatory
considerations, rather than inspired by efficiency gains. In this context,
obtaining the status of “too big to fail” may have played a role. Therefore,
there is lack of evidence on the existence of sufficiently large efficiency
benefits that would make such activity restrictions economically suboptimal or
even counterproductive. | |
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| Annex A10 Quantitative Estimation of a part of the Costs and Benefits of Bank Structural Separation | |
| G. Cannas, J. Cariboni, M. Foryś, H. Joensson, S. Langedijk, M. Marchesi, N. Ndacyayisenga, A. Pagano, M. Petracco-Giudici | |
| Forename(s) Surname(s) | |
| 2013 | |
| European Commission | |
| Joint Research
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Protection and Security of the Citizen | |
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| JRC88531 | |
| © European Union, 2013 | |
| Executive summary | |
| This report provides a quantitative
contribution on the assessment of costs and benefits in support of the impact
assessment of the Banking Structural Reform proposal. The analysis looks at the
effects of structural separation on 29 large-sized EU banks which could be
affected by the reform according to criteria being proposed for adoption by the
Commission. | |
| This report is based on the Systemic Model
for Bank Originate Losses (SYMBOL) for the simulation of banking losses and
uses balance sheet data for the analysis of allocation of losses and of changes
in cost of capital. Policy assumptions and scenarios are provided by DG MARKT. | |
| To estimate the costs and benefits of the
structural reform, the balance sheets of the selected sample of banks are
separated into a Trading Entity and a Deposit Taking Bank on the basis of
publicly available data. Then SYMBOL simulations are run for these separated
entities to estimate losses in a financial crisis. Losses are allocated to
different private (equity owners and bondholders) and public stakeholders
(public finance and Deposit Guarantee Schemes (DGS)/Resolution Funds (RF))
based on available balance sheet data and regulatory scenario assumptions. All
simulations assume that Capital Requirements Directive IV (CRD IV) will be
implemented and a fully effective bail-in regime will be in place, in line with
the Bank Recovery and Resolution Directive Proposal (BRRD). These simulated
losses after separation are compared to losses in a baseline without separation
for each category of stakeholders. | |
| Separation of banks into a Trading Entity
and a Deposit Taking Bank shifts risks and losses towards stakeholders of the
Trading Entity as it can no longer rely on capital support from the deposit
taking bank to finance its more risky activities. In response, behavioural
responses are introduced to the Trading Entities’ balance sheets to reduce
their riskiness back to that of the original undivided universal banks. The
possible balance sheet adjustments include increased capital, reduced activity
and reduced riskiness of assets portfolios. A new set of simulations is
performed to assess the overall impact of the reform after behavioural
responses. | |
| Aggregate benefits are measured as the
reduction in gross and excess losses across all banks due to the behavioural
response following structural separation. Aggregate costs are measured as
reduced revenues of the TE due to the reduced (risk weighted) assets.
Distributional effects are estimates, by measuring benefits (costs) for
different stakeholders as the reduction (increase) in expected losses in case
of a financial crisis before and after structural separation. These changes in
expected losses for the different bank creditors and shareholders are used to
estimate changes in risk premia, which are added to the costs of holding
additional capital and ‘loss absorbing capacity’ (LAC) to obtain changes in the
weighted average cost of capital (WACC) for TEs and DTBs. Possible reduced
revenues of the Trading Entities due to behavioural responses are also
estimated using an average return on risk weighted assets. | |
| For a financial crisis with losses
comparable to the 2008-09 banking crisis, and subject
to the caveat that the division of assets and risk-weighted assets between
trading and deposit-taking entities and the simulation methodology are
uncertain, the simulations show: | |
| ·
A reduction in gross losses plus
recapitalisation needs across all banks in the sample from € 629 bn to a range
of €504-583 bn, depending on the behavioural response. The largest loss
reductions are the result of reduced activity or risk taking of the banks. | |
| ·
The amount of losses potentially allocated to
bail-in under the BRRD is reduced from € 250 bn to a range of €192-219 bn,
mitigating potential financial stability risks and contagion effects. | |
| The impact on banks’ funding costs depends
on the extent to which changes in expected losses affect risk premia on equity
and bonds: | |
| ·
If changes to expected losses on capital and
bonds are not reflected in lower funding costs, the average WACC across
all banks in the sample increases by up to 3 bps as the Trading Entities need
to hold more capital and Loss Absorbing Capacity (LAC) which increase their
WACC by up to 9 bps. For the Deposit Taking Banks: their probability of default
and expected losses decrease; however as they cannot decrease their capital and
LAC below the minimum requirements, their average WACC will not change. | |
| ·
If changes in expected losses are fully
reflected in risk premia, the average WACC across all banks in the sample
decreases (by 1 to 9 bps) as gross losses reduce. The WACC for the Deposit Taking
bank is reduced by 4 to 9 bps as it no longer supports the more risky Trading
Entity activities. The increase in WACC for the Trading Entities is
limited due to the reduced riskiness for bail-inable creditors (following
behavioural responses). The behavioural responses however also reduce the
return on equity. | |
| The analysis does not find a direct beneficial effect
of structural separation on losses to public finances in case of a financial
crisis. This is the result of the assumption that both CRDIV and BRRD are
considered as fully effective before the introduction of separation, thus
leaving limited scope for further reductions in pass-through to the safety net.
This assumption implies a conservative estimate of net public finance benefits
of the structural reform. | |
| Broader and indirect costs and benefits -
through e.g. market liquidity, lending and investment, asset prices and
macroeconomic competition effects - may be substantial as the banks concerned
play an important role in providing credit to the economy and market liquidity.
These effects are not quantified within this report. | |
| Table of Contents | |
| Executive summary.. 205 | |
| 1..... Introduction
and objectives. 208 | |
| 2..... The
dataset. 210 | |
| 3..... Methodology.. 211 | |
| 3.1. Allocation of assets, RWA and capital 211 | |
| 3.2. Simulation methodology. 211 | |
| 3.3. Calibration of market behavioural responses. 213 | |
| 3.4. Costs and benefits. 214 | |
| 4..... Balance
sheet allocation upon separation.. 216 | |
| 4.1. Allocation
of assets. 216 | |
| 4.2. Allocation
of Risk Weighted Assets and Capital 218 | |
| 5..... Results:
costs and benefits. 221 | |
| 5.1. Simulations
of separation before behavioural responses. 221 | |
| 5.2. Behavioural
responses. 222 | |
| 5.3. Simulations
of separation after behavioural response. 224 | |
| 5.4. Impact
on Funding costs. 226 | |
| 6..... Conclusions. 234 | |
| Annexes | |
| APPENDIX A - List of banks. 236 | |
| APPENDIX B - Sample statistics before and after
structural separation 237 | |
| APPENDIX C - The SYMBOL model.. 239 | |
| APPEDIX D - The Implied Obligor PD for the Trading
Entities. 240 | |
| APPENDIX E - SYMBOL simulated losses and historical
losses during the recent crisis. 242 | |
| APPENDIX F - Assets of large banking groups within the
EU-27. 244 | |
| 1.
Introduction and objectives | |
| This report
provides a contribution on quantification of costs and benefits to the impact
assessment of bank structural separation. The analysis is based on the Systemic
Model for Bank Originate Losses (SYMBOL)[178]
for the simulation of banking losses and on balance sheet data for the analysis
of allocation of losses and of changes in cost of capital. | |
| Benefits of the reform are calculated based on overall differences
in simulated losses in a financial crisis under scenarios with and without
structural separation. Scenarios with separation include the effect of
behavioural responses to the reform. Changes in losses are estimated for
different public (public finances, safety nets) and private (equity owners,
bail-inable bondholders) stakeholders. Costs are obtained by calculating the
impact on the Weighted Average Cost of Capital (WACC) due to variations in the
balance sheets following behavioural responses to structural separation and the
ensuing reduced revenues of the Trading Entities. Variations in the funding
costs of equity and bail-inable liabilities following variations in expected
losses after the introduction of the reform can also be considered. | |
| Results are subject
to the caveat that the division of assets and risk weighted assets between
trading and deposit-taking entities, the simulation methodology and the
modelled behavioural responses are susceptible to a degree of uncertainty.[179] | |
| The analysis
is based on the sample of 29 banks which could be affected by the reform
according to criteria being proposed by the Commission.[180] | |
| Policy
assumptions and scenarios to be analyzed are provided by DG MARKT, in
particular, this costs-benefit analysis is performed under the assumption that
bail-in of liabilities in resolution is fully used and effective before the
structural reform, as foreseen in the BRRD.[181]
This implies a conservative estimate of net social benefits of the structural
reform.[182] | |
| The analysis
does not take into account other social and private costs and benefits that
might be incurred due to separation such as loss of economies of scope and
scale, legal costs, relocation costs, effects on asset pricing and knock-on
effects due to reduced market liquidity, reduced conflicts of interest within
banks, reduced misallocation of resources, facilitated supervision.[183] | |
| The remainder
of the report is structured as follows: in Section 2 the dataset. Section 3
outlines the methodology. Section 4 details how the balance sheet is split
between the TE and the DTB upon separation and what adjustments are applied to
the data to reflect the impact of the introduction of CRD IV (Basel 3). Section
5 presents the results of the simulations and their translation into costs and
benefits. The last section concludes. | |
| Several appendices
are enclosed to present detailed figures and technicalities. In Appendices A
and B the sample is described. Appendix C describes the SYMBOL model and Appendix
D the methodology and adjustments applied for applying SYMBOL to the trading entity.
A comparison of historical losses with simulated losses is provided in Appendix
E. The estimated share of assets of large banking groups within the EU-27 are
summarized in Appendix F. | |
| 2.
The dataset | |
| The sample of 29 EU banks used in the
simulation exercise (see appendix A and B for a full list and descriptive
statistics) is identified based on the methodology presented in the JRC report “Trading
activities and functional structural separation: possible definitions and
calibration of de minimis exemption rule”. In particular the focus is on
definition 3 of trading activities introduced in that report.[184] Small-sized bank (assets below 30 bn€) are excluded[185]. | |
| It should be noted that possibly not all
candidate banks could be subject to separation, and that actual banks selected
for separation will depend on the criteria eventually adopted in the
legislation. In the absence of further details this seems however a reasonable
selection on which to base the exercise. | |
| Total assets of the sample amounts to
22.653 bn€ by end 2011, i.e. roughly 56% of European banks assets (Appendix B).
All the banks in the sample are included in the European Banking Authority
(EBA) capital exercise sample, excluding one medium-sized bank (Mediobanca). | |
| The source of data for SYMBOL simulations
is Bankscope, a proprietary database of banks' financial statements produced by
Bureau van Dijk. The inputs needed for SYMBOL simulations are Risk Weighted
Assets (RWA), regulatory capital and total assets. SNL Financial data (see Appendix
B for descriptive statistics) are used to calculate the split of the balance
sheet for each bank, as detailed in Section 3.[186] All data are consolidated as of 2011. | |
| 3. Methodology | |
| The SYMBOL model is used to simulate the
losses of the sample of these 29 banks in case of a financial crisis under
regulatory scenarios with and without bank structural separation and balance
sheet data are used for the analysis of allocation of losses and of changes in
cost of capital and revenues. All scenarios assume that CRD IV will be
implemented and that an effective bail-in regime as contained in the Bank
Recovery and Resolution Directive Proposal (BRRD) will be in place. | |
| 3.1. Allocation of assets, RWA and
capital | |
| In order to simulate the effects of
structural reform, each bank in the sample is separated into a Trading Entity
(TE) and a Deposit Taking Bank (DTB) using publicly available balance sheet
data. The allocation of assets is based on definition 3 of trading activities
presented in the JRC report “Trading activities and functional structural
separation: possible definitions and calibration of de minimis exemption rule”,
which includes securities (excluding loans) and derivatives held for trading.[187] | |
| RWA and capital are allocated between the
DTB and the TE following the methodology described in the Commission Services
report “Analysis of possible incentives towards trading activities implied
by the structure of banks’ minimum capital requirements”, which is based on
obtaining average risk weights for each category of assets using a panel
regression, predicting risk weighted assets for each separated entity based on
this estimated weights and the allocation from the previous step and obtaining
minimum capital requirements based on this predicted risk weighted assets and
capital adequacy ratios.[188] | |
| Adjustments are introduced to take into
account the impact of the introduction of Basel 3 (CRDIV) on RWA, regulatory
capital and minimum capital requirements. These are implemented using the
average EU results of the 2011 Quantitative Impact Study (QIS) by the EBA.
These adjustments imply increased RWA, a more strict definition of regulatory capital,
and the introduction of the Capital Conservation Buffer. Regulatory capital is
then topped up to 10.5% of RWA to meet the minimum capital requirements of Basel 3. | |
| In this step, the implicit assumption that
separation along these lines will effectively be possible is implicitly
maintained.[189] | |
| 3.2.
Simulation methodology | |
| SYMBOL (SYstemic Model of Banking
Originated Losses) is a micro-simulation model[190] which makes use of individual banks’ balance sheet and regulatory
capital data to simulate banks’ losses due to the failure of its obligors and
to derive the (aggregated) distribution of losses originated in the banking
system. The main idea behind this model is that it is possible to estimate and
average Probability of Default (PD) of the portfolio of obligors of a
bank (the so called implied obligors’ PD) by inverting the Basel
FIRB (Foundation Internal Ratings Based) formula for capital requirements.[191] The base SYMBOL methodology is used both for the DTB and for the
TE, after taking into consideration the difference in confidence for
calibration purposes (i.e. inverting the FIRB at 99% and not at 99.9%).[192],[193] | |
| The distributions of systemic losses (both
gross and in excess of banks’ regulatory capital[194]) are then simulated using the SYMBOL model. All simulations are run
without contagion effects between the banks in the sample.[195] Adjustments to the final distribution of losses are also made to
account for banks assets outside the EU based on detailed unconsolidated
balance sheet data, such that losses are reduced proportionally for each banks’
estimated share of non-EU subsidiaries.[196] Losses are allocated to equity, bail-inable liabilities, safety-net
tools (DGS, RF) and public finances based on available balance sheet data. | |
| To determine financial crisis losses in the
baseline no-reform scenario, Gross Losses are separately simulated for
the TE and the DTB and are then summed to obtain total gross losses of the
undivided bank.[197] Total regulatory capital of the undivided bank is used to absorb
combined losses of the DTB and TE activities in the baseline scenario; the
total bail-in capacity[198] is applied to the undivided bank’s Excess Losses after depletion of
the capital. This allows calculating the changes in simulated losses affecting
the different stakeholders with respect to a baseline where the same two
activities are conducted within the same entity. | |
| 3.3.
Calibration of market behavioural responses | |
| To quantify the effects of separation, a two-step
approach is taken. In the first step, simulations
are used to estimate Gross Losses, Losses in Excess of Capital and
Recapitalization needs[199] for the undivided universal banks as well as separated TEs and DTBs
in a systemic crisis of the same magnitude as the recent one.[200] The sum of the two distributions of gross losses against the total
capital of the two entities represents the baseline situation where the two
entities are joined in a single universal bank. Comparison with the results
obtained by considering only capital in each separated entity against its own
losses give the effect of effects of separation before behavioural response of
the TE. This allows estimating the shift in “simulated losses in case of a
crisis” across stakeholders as the equity and the bail-in capacity (LAC) can no
longer be pooled. Under this approach, the separation does not directly change
the overall gross losses in the system but leads to changes in the allocation
of losses across stakeholders. Five groups of private stakeholders are
considered (DTB shareholders, TE shareholders, DTB bail-inable creditors, TE
bail-inable creditors), as well as two safety nets (DGS, RF and public
finances)). | |
| These shifts in risks affect risk premia
and bank funding costs by changing expected losses of the different
stakeholders as activities of the TE are more risky than those of the undivided
bank and as capital and bail-in capacity can no longer be pooled with the DTB..
As a result, the separated banks will have incentives to change their balance
sheets. These behavioural responses are calibrated such that the riskiness
of the TE matches that of the original universal banks before separation.[201] Note that DTBs cannot adjust their balance sheets as they are
constraint by minimum regulatory requirements on the MCR (>10.5% RWA) and
the LAC (>8% TA). Three alternative ways by which the TE can reduce the
riskiness to its shareholders and creditors are considered in the analysis: | |
| -
Increasing regulatory capital, maintaining the risk weights and total assets at the same level. | |
| -
Reducing riskiness while keeping total assets and the regulatory capital constant. In
the SYMBOL model this is simulated through a reduction in risk weights (RWA). | |
| -
Reducing riskiness through a reduction in
total assets, while keeping the risk weight per
unit constant and the regulatory capital the same (i.e. reducing leverage). | |
| In the second step, losses are re-simulated
taking account of these behavioural responses affecting the balance sheet of
the TEs and the effects of separation including behavioural responses
can be calculated. Note that behavioural responses are not only redistributing
losses but also cause a change in the total amount of losses that need to be
absorbed by the system. | |
| In this part, an implicit assumption is
made that capital and debt necessary will be available from the markets to
recapitalize the separated entities after separation in case they show a
shortfall. Assumptions preventing substitution of capital for bail-in capacity
are also introduced, in order to keep risk for creditors of the trading entity
in line with those of creditors of the universal bank.[202] | |
| 3.4. Costs and benefits | |
| Costs and benefits of the reform are then
calculated based on changes (with respect to the baseline) in estimated losses
for different stakeholders in case of a financial crisis and on changes in the
Weighted Average Cost of Capital (WACC).[203] Possible reduced revenues of the Trading Entities due to
behavioural responses are also estimated using an average return on
risk-weighted assets, and the reduction in risk-weighted assets due to
behavioural responses.[204] The related changes at economy-wide level such as pass-through of
variations of DTB’s WACC to the cost of capital for borrowing firms and reduced
value added in the economy (e.g. market liquidity) are not explicitly
calculated. | |
| Distributional effects are estimated by
measuring changes in estimated losses for different stakeholders in case of a
financial crisis before and after structural separation. | |
| For the changes in the WACC two scenarios
are developed, thus providing a range for the likely WACC effect. One in which
risk premia on equity and bail-inable bonds do not reflect changes in expected
losses. In this case, changes in WACC are estimated exclusively based on
changes in the capital structure of entities following separation. In the
second scenario, risk premia are allowed to vary reflecting changes in expected
losses in a financial crisis after separation. In this part, implicit
assumptions are made that changes in default risk and expected loss evaluated
in the case of a financial crisis can be used to estimate changes in risk
premia, and that changes in simulated default risk and expected loss (i.e.
excluding other factors which are not included in the simulation model
employed) are a sufficient proxy to estimate changes in risk premia. Moreover,
as we cannot observe and do not have a reliable estimate of risk premia after
the introduction of the recovery and resolution framework (which are already
partly reflected in market prices of subordinated and senior debt), available
data on current risk premia will be used as baseline which may imply a small
underestimation of the WACC impact. | |
| 4.
Balance sheet allocation
upon separation | |
| Each bank in the sample is split into a DTB
and TE. First, the total assets of the banks are split on the basis of data from
SNL (in particular its classification of financial assets and liabilities). In
addition, RWA, total regulatory capital and the minimum capital requirement are
split between the two entities as described below. | |
| 4.1.
Allocation of assets | |
| In line with the definitions of trading
activities introduced in the abovementioned JRC report, assets allocated to TEs
are: Securities Held for Trading (STA) (excluding loans and derivatives) and
Derivative Assets Held for Trading (DTA). This split of the balance sheet does
not depend on the particular type of trading activity effectively undertaken by
each bank.[205] | |
| The DTB is instead allocated all loans to
banks, loans to customers, all other assets held at amortized cost, securities
held to maturity, available. for sale securities and securities held at fair
value (see Table 1). | |
| Remaining total assets (including other
assets such as cash) are allocated between the TE and DTB, proportionally to
the already allocated SNL financial assets. | |
| Derivatives held for hedging purposes are
allocated proportionally to the allocation of RWA based on explicitly allocated
classes (see next section). | |
| Table 1 - SNL
Financial Assets considered for the allocation following separation. | |
| SNL Balance sheet Items || TE || DTB | |
| Net Loans to Banks (NLB) || || X | |
| Net Loans to Customers (NLC) || || X | |
| Securities Held at Amortised Cost (SAC) || || X | |
| Securities Held to Maturity (STM) || || X | |
| Securities Held for Trading (STA) (excluding loans and derivatives held for trading) || X || | |
| Derivative Assets Held for Trading (DTA) || X || | |
| Securities Held at Fair Value (SFV) (excluding loans held at fair value) || || X | |
| Available for Sale Securities (SAFS) (excluding loans available for sale) || || X | |
| All other assets not explicitly allocated (excluding derivatives held for hedging purposes) || Divided proportionally to explicitly allocated financial assets | |
| Average Share of Financial Assets || 31% || 69% | |
| Note: Derivatives
Assets Held for Hedging Purposes are split proportionally to Risk Weighted
Assets calculated based on other classes (see section 4.2) | |
| Figures 1 and 2 show the average TE and DTB
assets as a share of total assets following the banks split of assets. | |
| The table of Appendix B shows the result of
the allocation of total assets for each individual bank in the sample. | |
| Figure 1 - Average
TE assets as a share of total assets following structural separation | |
| Figure 2 - Average
DTB assets as a share of its total assets following structural separation | |
| Source: SNL
database and JRC estimates | |
| 4.2.
Allocation of Risk Weighted Assets and Capital | |
| RWA and capital are allocated between the
DTB and the TE following the methodology described in the Commission Services
report “Analysis of possible incentives towards trading activities implied
by the structure of banks’ minimum capital requirements”. | |
| A fixed effects regression model has been
estimated allowing assigning risk weights to the different banking activities,
as shown in Table 2. | |
| Table 2 - Estimated risk weights across banking activities
(EU sample) | |
| || NLB || NLC || SAC || STM || SAFS[206] || SFV || STA || DTA+DTL[207] || DHA+DHL | |
| RWA coefficient || .18 || .52 || .31 || 0[208] || .39 || .23 || .099 || .024 || -1.95 | |
| Note:
NLB = Net Loans to Banks; NLC = Net Loans to Customers; SAC = Securities Held at Amortised Costs;
STM = Securities Held to Maturity; SAFS = Available For Sale Securities
(excluding loans); SFV = Securities held at Fair Value; STA = Securities (excluding loans) Held
For Trading as Assets; DTA= Derivatives Held For Trading as Assets; DTL = Derivatives Held For Trading as
Liabilities | |
| These estimated risk weights for the
different balance sheet components are used to estimate how the RWA of
the original undivided bank should be split between the TEs and the DTBs.[209] The total regulatory capital of the two entities under Basel 2 is then apportioned using the obtained split of RWA. | |
| The split Basel 2 RWAs are adjusted to take
into account future changes introduced by Basel 3 to RWA definitions and
requirements. Average EU results of the 2011 Quantitative Impact Study (QIS)[210] are employed for the adjustments, as detailed in the table below.
The changes are allocated between the DTB and the TE as described below. | |
| Table 3 - Average EU (weighted on total assets) corrections
for RWA and regulatory capital from EBA as of 30/06/2011 | |
| || G1 Banks || G2 Banks | |
| Relative Change in RWA for the whole bank (%) || 21.20 || 6.90 | |
| Relative Change in Regulatory capital for the whole bank (%) || -34.35 || -7.76 | |
| Source: EBA | |
| Note: In this exercise G1 - Tier 1 Capital > 3 bn€, G2 - Tier 1 Capital <3 bn€ | |
| The Basel 3 increase in the RWA
is allocated based on a breakdown of the changes in RWA published by EBA[211], reported here in Table 4. In particular, the Table shows
the part of the total percentage increase in RWA due to: | |
| a) the change in
RWA following changes in the ‘definition of capital’[212], which is split proportionally to the share of total assets
allocated to the TE and the DTB. | |
| b) counterparty
credit risk, which is allocated to TE for the share due to Credit Valuation
adjustment (CVA) and to the DTB for the part due to the higher asset
correlation parameter included in the IRB formula. | |
| c)
securitization in the banking book, which is fully allocated to the DTB. | |
| d) to market
risk (including securitisation in the trading book) is fully allocated to the
TE. | |
| Table 4 - EBA split of the increase in RWA due to
Basel 3 (average %-increase) | |
| Type || Total relative increase in RWA || Part due to definition of capital || CCR banking book || CCR trading book || Securitisation banking book || Trading book | |
| G1 || 21.2 || 7.9 || 1.2 || 6.9 || 1.0 || 4.2 | |
| G2 || 6.9 || 3.4 || 2.9 || 0.2 || 0.4 | |
| Source: EBA | |
| Results are presented in Table 5 both for Basel 2 and for Basel 3. | |
| Table 5 - Allocation of total RWA between the TEs
and the DTBs under Basel 2 and Basel 3 | |
| || Basel 2 || Basel 3 | |
| DTB || 91% || 79% | |
| TE || 9% || 21% | |
| The new Basel 3 definition of the
quality of capital affect both entities, thus the decrease in the
regulatory capital is split proportionally to the capital allocated to the two
entities. For banks with adjusted regulatory capital below 10.5% of RWA, the
capital is topped up to meet the Basel 3 minimum required capital including the
capital conservation buffer (10.5% RWA). | |
| Appendix B shows the result of the
allocation of RWA for each individual bank in the sample. | |
| 5.
Results: costs and benefits
5.1. Simulations of separation before behavioural responses | |
| This section presents the SYMBOL simulation results. As the very
severe crisis (with excess losses at the 99.95th percentile) shows
most similarity to real state aid figures during the last crisis in terms of
banks' losses, all figures and calculations in the tables reflect simulations
of a crisis of that severity (see Appendix D). | |
| Table 6 shows gross losses (in row 1) and excess losses (i.e. losses
in excess of capital) plus recapitalisation needs[213] in row 3, before (column A) and after (column B to D) bank
structural separation, before taking into account market behavioural responses. | |
| Table 6 – Effects of separation on distribution of
losses for bank sample before market behavioural responses – bn€ | |
| Losses || Undivided Bank || Structural Separation before Market Behavioural Responses* | |
| Sum TE+DTB || TE || DTB | |
| || A || B=C+D || C || D | |
| 1 - Gross Losses and recapitalisation needs || 629 || 625 || 242 || 383 | |
| 2 - Losses on equity || 380 || 339 || 108 || 231 | |
| 3 – Excess Losses and recapitalisation needs encumbering bail-in and resolution || 250 || 286 || 134 || 152 | |
| 4 - Bail-in losses (LAC = 8% TA) || 201 || 196 || 94 || 102 | |
| The total
amount of bank gross losses plus recapitalisation needs are simulated at EUR
629 bn before separation. They are virtually the same after separation EUR 625
bn. These need to be borne by equity, bail-in, safety nets and the public
sector. Row 2 and 4 show that losses on equity and – to a lesser extent –
losses bail-in losses are lower after separation than for the undivided bank.
The simulation results of Table 6 are used as input for Table 7 that shows in
more detail the effect on the different bank creditors of the separation. | |
| 5.2. Behavioural responses | |
| As expected,
gross losses (plus recapitalisation needs) over total assets are higher for the
TE than for the undivided bank and for the DTB they are lower (Table 7). As
losses would increase by about 20% (from 2.8% to 3.4% as a share of total
liabilities plus equity) for the TEs with respect to the original undivided
banks in the absence of any response, it is foreseeable that TEs will be
required by the markets to change the structure of their balance sheets in
response to separation. The effect of separation is particularly significant on
equity, as – compared to the undivided bank- losses on equity in case of a very
severe financial crisis would increase by more than 1/3 for the TE, while they
would reduce by almost ¼ for the DTB. The effect of separation on bail-in
losses is smaller. | |
| Table 7 –
Losses for the bank sample for the undivided bank and after separation before
market behavioural responses | |
| || Gross losses and recapitalization needs as a share of total liabilities plus total equity || Losses on equity as a share of total equity || Bail-in losses as a share of LAC minus equity | |
| 1 – Undivided Bank || 2.8% || 40.4% || 23.0% | |
| 2 - DTB || 2.5% || 31.1% || 20.5% | |
| 3 – TE || 3.4% || 55.2% || 24.6% | |
| Note: The figures in this table reflect averages across
all banks. They should not be compared to the calibration of the required LAC
in the BRRD of 8% TA . | |
| As detailed in section 4.2, the TE’s
adjusted balance sheets are calibrated so as to pose the same probability of
default to creditors as the initial undivided bank posed. It should be noted
that also LAC is subject to a behavioural response. LAC is calibrated such that
it is at least 8% TA for all banks and LAC on top of equity as a share of TA is
at least as high as in the undivided universal bank. The latter condition is to
avoid that behavioural responses increasing capital/TA would only substitute
bail-in capacity and that capital/TA would be higher than LAC/TA in a number of
cases. | |
| Table 8
presents the key data of the original and adjusted balance sheets for the
banks. | |
| Table 8 –
Key balance sheet data for the undivided bank, the DTB and TE before and after
market behavioural responses – bn€ | |
| || TA || Regulatory capital (B3) || LAC on top of equity || RWA | |
| 1 – Undivided Bank || 22,653 || 939 || 874 || 8,945 | |
| 2 - DTB || 15,463 || 744 || 495 || 7,089 | |
| 3 – TE || 7,191 || 195 || 381 || 1,856 | |
| 4 – TE with increased capital || 7,191 || 322 || 381 || 1,856 | |
| 5 – TE with reduced RWA || 7,191 || 195 || 392 || 1,134 | |
| 6- TE with reduced TA || 4,152 || 195 || 179 || 1,134 | |
| Note: The
behavioural responses of the TE are calibrated such that the probability of
default of the TE matches that of the undivided universal bank after the
behavioural response. | |
| The actual bank response can be a
combination of these illustrative behavioural responses. It would depend inter
alia on bank specific characteristics and market specific risk appetite and
regulation. | |
| 5.3. Simulations of separation after behavioural response | |
| Based on the adjusted balance sheets
following the behavioural response, SYMBOL simulations are run to capture the
combined effects of the separation on the different stakeholders and the system
as a whole. | |
| Table 9 –
Losses for bank sample for the undivided banks and after structural separation
after market behavioural responses – bn€ | |
| Losses || Undivided Bank || Structural Separation after Market Behavioural Responses | |
| Sum TE+DTB || TE || DTB | |
| || A || E=F+G || F || G | |
| 1 - Gross Losses and recapitalisation needs || 629 || 504-583 || 121-200 || 383 | |
| 2 - % on Equity || 60% || 61%-63% || 61%-67% || 60% | |
| 3 – Excess Losses and recapitalisation needs encumbering bail-in and resolution || 250 || 192-219 || 39-67 || 152 | |
| Table 9 shows gross losses (in row 1) and
excess losses (i.e. losses in excess of capital - in row 3) plus
recapitalisation needs[214] before (column A) and after (column E
to G) bank structural separation taking into account market behavioural
responses. (They can be compared to columns B to D of Table 6 showing the
effects before market behavioural responses). | |
| Benefits from structural separation can be
seen along the following metrics: | |
| - the reduction in the sum of gross
losses and recapitalisation needs following structural separation, compared
to the situation prior to structural separation. Gross losses can in particular
decrease from 629 bn € in column A to as low as 504 bn€ as shown in in column E
in row 1. The lower gross losses reflect the reduction in gross losses of the
TE following market behavioural responses and will vary according to the type
of market behavioural response that will prevail. For the behavioural responses
with lower risk (i.e. RWA), the lowest gross losses are generated.[215] When considering net benefits, the loss in bank revenues on these
activities and the related reduced value added in the economy (e.g. market
liquidity, provision of credit and capital, etc) needs also to be taken into
account (see costs section below); | |
| - the reduction in the sum of excess
losses plus recapitalisation needs before application of bail-in compared
to the situation prior to structural separation. Excess losses plus recapitalisation
needs before bail-in can in decrease from 250 bn € in column A to 192 bn € as
shown in in column E in row 3. This means that the banking system – and in
particular the trading activity undertaken by the part of the banking system
subject to structural separation – can be expected to become less risky for the
rest of the financial system as potential financial stability risks and
contagion due to bail-in are reduced. This is due, in particular, both to the
reduction in generated risks (i.e. gross losses), and to the fact that a higher
share of these losses are absorbed by the shareholders of the TE, as shown in
row 2. This means a better alignment of the incentives driving TEs, i.e. a
reduction of potential moral hazard by TEs.[216] | |
| Focusing on the resolution process, Table
10 presents how excess losses plus recapitalisation needs before application of
bail-in are split between bail-inable creditors and the safety net tools/public
finances. Bail-in is assumed to take place up to a Loss Absorbing Capacity
(LAC) equal to 8% of Total Assets (in line with the June 2013 Council position[217] on the BRRD). The LAC considered for bail-in can nonetheless be
higher than 8% of Total Assets in case of market behavioural responses: in
behavioural response 1, where TEs increase their capital, the LAC is increased
by the corresponding amount so that there is no substitution between capital
and bail-in-able liabilities and bail-in capacity in excess of capital is
unchanged. In line with response 1, in behavioural response 2 and 3, residual
LAC (i.e. bail-in capacity in excess of capital) is assumed at least as high as
a share of total assets as in the original undivided bank. This ensures that a
higher capital ratio to total assets in the behavioural response does not lead
to a perverse automatic reduction in the bail-in capacity.[218] | |
| Table 10 –
Allocation of excess losses plus recapitalisation needs after market
behavioural responses– bn€ | |
| || Undivided Bank || Structural Separation after Market Behavioural Responses* || | |
| || Losses || || Sum TE+DTB || TE || DTB | |
| || A || E=F+G || F || G || | |
| 1 - Excess Losses and recapitalisation needs before application of bail-in || 250 || 192-219 || 39-67 || 152 || | |
| 2 - Bail-in (LAC = 8% TA or higher as per behavioural response) || 201 || 129-149 || 27-47 || 102 || | |
| 3 - Excess Losses and recapitalisation needs after application of bail-in (i.e. contingent liabilities on public finances and the safety net tools - DGS and Resolution Fund - ) || 49 || 62-70 || 12-19 || 50 || | |
| The amount of losses not absorbed by
bail-in and potentially affecting the safety net and/or public finances
increases. On the one hand, the loss of the ability to pool capital and LAC
across the entities implies that they can absorb a lower share of losses. On
the other hand, gross losses and excess losses in the system are reduced due to
the behavioural responses of the trading banks. While the overall safety net
and public finance losses show some increase, the safety net can focus more on
the risks stemming from the DTB, while the risks stemming from trading
activities are mostly absorbed by the LAC through the application of bail-in. | |
| 5.4. Impact on Funding costs | |
| Impacts on the
costs of capital are evaluated by looking at variations in Weighted Average
Costs of Capital (WACC) due to changes in the structure of the balance sheets
of banks after behavioural responses and by (a) considering a situation
where risk premia do not vary in response to changes in the expected losses in
financial crises and (b) one where they do vary in response to changes
in risk.[219] | |
| In all, as far as costs are concerned, the
changes in banks' funding costs post structural separation are in essence due
to the following effects. | |
| (i) Increases in the capital share of total funding by the TE due to
behavioural response. | |
| (ii) Increases in LAC over the 8% TA minimum by the TE due to behavioural
response. | |
| (iii) Changes in
the risk premium on equity as markets perceive changes in riskiness and
expected losses. | |
| (iv) Changes in
the risk premium on bail-inable bonds as markets perceive change in expected
losses. | |
| (v) Reduced revenues and return on equity due to reduction in TE
(risk-weighted) assets.[220] | |
| For case (a), where risk premia do
not vary, we measure changes in the WACC for the TE and the DTB based on
effects (i) and (ii) by multiplying the increases on capital and LAC by the
currently observed premiums. | |
| For case (b), where risk premia vary
in response to changes in expected losses in case of crisis, in addition to (i)
and (ii), we also estimate effects (iii) and (iv) by adjusting risk premiums
proportionally to the variation in expected losses.[221] | |
| Effect (v) is calculated based on currently
observed returns on RWA and is relevant for the behavioural responses with
reduced RWA. | |
| Table 11 shows effects (i) to (iv) and the
total change in the WACC for the DTB (Row 1), the TE under different
behavioural responses (Row 2-4) and the range spanned by the weighted averages[222] of the impacts for the two entities across scenarios (Row 5). The
first 4 columns of Table 11 (A to D) are based on calculations that are
presented and explained in Tables 12 to 15 below. | |
| Column A and B of Table 11 show,
respectively, the change in WACC due to the increases in capital and LAC.
Tables 12 and 13 provide the underlying calculations. Columns C and D provide
the estimated changes in risk premium due to changes in expected losses on
equity and first bail-inable bonds (BiB). The calculations for these are
presented in Tables 14 and 15. Column E provides the total estimated impact on
WACC in case the changes in expected losses on BiB and equity compared to the
undivided bank do not affect risk premia. Column F provides the total effects
with changes in risk premia on equity and debt due to changes in expected
losses. | |
| Results are presented as ranges of point
estimates across combinations of behavioural scenarios and cases (i.e. including
variations in risk premia or not when calculating WACC). While sensitivity
analysis to different starting levels of risk premiums is not included, it
should be noted that relative changes would not be much affected by variations
in initial risk premia, as these would imply a change both in the absolute
variation and in the baseline level. | |
| Without changes in risk premia, the average WACC in the system increases as the TEs need to hold
more capital and LAC. The increase in WACC for the TEs is estimated at 9 bps in
case of behavioural responses with increased capital and reduced total assets
and 0 bps for the behavioural response in which the TE reduces RWA but leaves
its liability structure unchanged (column E). The DTB does not need to hold
capital or LAC above minimum requirements as its probability of default and
expected losses decrease. However, as the DTB cannot decrease its capital and
LAC below the minimum requirements, the weighted average WACC across all banks
in the sample increases by 2 to 4 bps. | |
| With changes in risk premia, the average WACC across the sample banks decreases (by 1 to 9 bps)
as the gross losses go down (column F). The WACC of the DTB is reduced by 4 to
9 basis points as it no longer supports the more risky TE. The reduced expected
losses on capital and LAC reduce the risk premia on equity and subordinated
debt. For the TEs, the reduced riskiness for bail-inable bonds as a result of
the behavioural responses in particular limit the increase in the WACC. In the
behavioural response with reduced RWA, the overall WACC for TEs decreases by 8
to 9 bps. This effect is smaller for the behavioural response with reduced
total assets, as the bail-in capacity (LAC-capital) is significantly reduced
with the reduction of total assets.[223] Estimated reductions for the part related to bail-inable bonds in
TEs are due to lower gross losses, the shifting of losses towards capital and
reduced pooling (see also Table 15 and its discussion). | |
| The reduction in the WACC of up to 9 bps
for the TE in case of a behavioural response with reduced risk weighted assets
should be considered together with the accompanying loss of revenues per unit
of assets due to the lower RWA. In addition to the change in funding costs,
this loss of revenues per unit of assets represents a further ‘cost’. While the
reduced RWA concerns both behavioural responses in rows 3 and 4, the effect is
particularly important for the behavioural response in row 2 with reduced risk
weighted assets as the quantity of total assets and thus the overall funding
quantity is unchanged. Lost revenue due to lower RWA should thus be counted in
full,[224] whereas for the behavioural response in row 3, RWA, total assets
and thus funding needs go down proportionally such that revenues per unit of
assets should not change. | |
| The costs estimates are in line with
ex-ante expectations and the objectives of the structural separation. | |
| Table
11 - Estimated change in WACC in different
behavioural responses due to increased capital (A) and LAC (B), changed risk
premium due to changed expected losses on BIB (C) and changed risk premium on
capital due to changed expected losses (D) (in bps). | |
| || Change in WACC due to : || || | |
| || increase in capital (Table 12) || increase in LAC above 8% TA (Table 13) || change in risk premium due to change in expected losses on equity (Table 14) || change in risk premium due to changed expected losses on BIB (Table 15) || Total without changes in risk premia || Total with changes in market risk premia || || | |
| || A || B || C || D || E=A+B || F=A+B+C+D || || | |
| 1 - DTB || 0 || 0 || -8 to -3 || -1 || 0 || -9 to -4 || || | |
| 2 – TE with increased capital || 7 || 2 || <1 || -7 || 9 || 2 to 3 || || | |
| || | |
| 3 – TE with reduced RWA* || 0 || 0 || <1 || -9 || <1* || -9* to -8 || || | |
| 4- TE with reduced TA* || 8 || 1 || <1 || -4 || 9 || 5 to 6 || || | |
| 5 – Range (Weighted Averages on TA) || 0 to 2 || <1 || -6 to -2 || -4 to -2 || 0* to 3 || -9* to -1 || || | |
| Notes:(*) The reduction
in the WACC of up to 9 bps for the TE in case of a behavioural response with
reduced total assets or risk weighted assets should be considered together with
the accompanying loss of revenues due to the lower risk weighted assets. See
the discussion on previous page and in footnote 47. | |
| - The risk premium
on senior unsecured debt is assumed at 174 bps; on subordinate debt it is at
307 bps, and the equity risk premium is 700 bps. Therefore, costs of increasing
capital while keeping LAC unchanged are 393 bps per unit (difference of risk
premium on subordinate debt versus equity risk premium). Costs of increasing
LAC are 133 bps per unit (difference of the risk premium on senior debt and
subordinate debt).[225] It should be noted that while absolute
results would exhibit sensitivity to the particular levels of risk premiums
chosen to base the analysis, relative results would not exhibit much variation. | |
| Table 12 shows the estimated change in the
weighted average costs of capital (WACC) due to change in the share of capital
over total assets following the different behavioural responses. Column C shows
capital/TA for the different scenarios. The change in capital/TA due to the
behavioural response is given in Column D. Column E shows the costs of the
increase in the capital share in total funding on the WACC. The estimated cost
of capital is 393 bps reflecting the difference between the risk premium on
equity (700 bps) and the risk premium on bail-inable bonds (307) which it
replaces.[226] | |
| The effect on WACC for the TE is estimated
to be in the range of 0 to 8 bps depending on the behavioural response, while
the DTB does not need to hold any capital in excess of the regulatory minimum. | |
| Table 12 -
Estimated change in WACC due to increase in capital/TA due to behavioural
response | |
| || Total Assets (bn) || Capital (bn) || Capital/TA (%) || Change in Capital/TA due to behavioural response* (%) || Estimated effect on WACC due to change in Capital/TA (bps) | |
| || A || B || C = B/A || D || E = D*393bps | |
| 1 - DTB || 15,463 || 744 || 4.8% || 0.0% || 0 | |
| 2 – TE with increased capital || 7,191 || 322 || 4.5% || 1.8% || 7 | |
| 3 – TE with reduced RWA || 7,191 || 195 || 2.7% || 0.0% || 0 | |
| 4- TE with reduced TA || 4,152 || 195 || 4.7% || 2.0% || 8 | |
| Notes: Costs of
additional capital are 393 bps per unit (replacing subordinate debt (BiB) by
equity). | |
| *Capital of the TE before behavioural
response is EUR 195 bn (2.7%TA), and of the DTB EUR 744 bn (4.8%TA). | |
| Table 13 shows the estimated change in the
weighted average costs of capital (WACC) due to LAC held over the minimum
required 8% TA following the different behavioural responses. Column C shows
the amount of LAC (as a share of total assets) that the banks hold in excess of
8% TA under the different scenarios. Column D shows the costs of this LAC on
the WACC. The estimated cost of the LAC is 133 bps reflecting the difference between
the risk premium on bail-inable first debt (in the form of subordinated debt)
and senior debt which it replaces. | |
| The effect on WACC for the TE is estimated
to be in the range of 0 to 2 bps depending on the behavioural response, while
the DTB does not need to hold any LAC in excess of the regulatory minimum. | |
| Table 13 - Estimated
change in WACC due to holding LAC over 8% TA due to behavioural response | |
| || Total Assets (bn) || LAC over 8% TA held due to behavioural response (bn) || LAC over 8% TA as a share of total assets || Estimated change in WACC due to LAC over 8% TA (bps) | |
| || A || B || C = B/A || D = C*133bps | |
| 1 - DTB || 15,463 || 0 || 0 || 0 | |
| 2 – TE with increased capital || 7,191 || 127 || 1.8% || 2 | |
| 3 – TE with reduced RWA || 7,191 || 12 || 0.2% || 0 | |
| 4- TE with reduced TA || 4,152 || 42 || 1.0% || 1 | |
| Note:
Costs of additional LAC (BiB) are 133 bps per unit (replacing senior debt by
subordinate debt). | |
| Table 14 provides an estimate of changes in
the WACC as result of the changed risks for bank capital (either in the form of
equity or subordinate debt) after structural reform and behavioural response.
In columns A to D the change in expected losses on capital compared to the
undivided bank are calculated. If markets anticipate these changes in
riskiness, the change in expected losses will be reflected in the risk premia.
Column E and F provide a minimum estimate of the risk premium impact (on
capital and on the WACC respectively) if the initial risk premium is the risk
premium on subordinated debt, while column H and I show the maximum of the
range based on an initial risk premium assuming all capital is plain equity. | |
| The effect of a changed risk premium on
capital on the WACC for the TE is estimated to be in the range of 0 to 1 bp, as
the behavioural responses are calibrated such that the probability of default is
equal to that of the undivided bank. While losses on capital increase in the
behavioural responses, there is a reduction in the losses per unit of capital
because of the increase in total capital. The WACC of the DTB declines due to
lower expected losses on equity by 3 to 8 bps, as market risks are allocated to
the TE activities and capital pooling is no longer possible. | |
| Table 14 - Estimated
change in WACC due to changes in the capital risk premia after behavioural
response | |
| Bank || Capital (% TA) || Expected losses on capital (% TA) || Expected losses on capital as a share of total capital || %-change compared to undivided bank || Change in risk premium on capital, compared to undivided bank (bps) || Change in WACC due to capital risk premium change (bps) Minimum || Estimated change in risk premium on capital, compared to undivided bank (bps) || Change in WACC due to capital risk premium change (bps) Maximum | |
| || A || B || C=B/A || D=(C-�)/� || E=D*307bp || F=E*A || H=D*700bp || I=H*A | |
| 1– Undivided Bank || 4.1% || 1.7% || 40% (�) || - || - || - || - || - | |
| 2 - DTB || 4.8% || 1.5% || 31% || -23% || -71 || -3 || -162 || -8 | |
| 3 – TE with increased capital || 4.5% || 1.9% || 41% || 3% || 8 || <1 || 18 || <1 | |
| 4 – TE with reduced RWA || 2.7% || 1.1% || 42% || 3% || 8 || <1 || 19 || <1 | |
| 5- TE with reduced TA || 4.7% || 2.0% || 42% || 3% || 10 || <1 || 22 || 1 | |
| Note: Initial
average risk premium on capital is 307 bps in the minimum (assuming capital is
at the cost of subordinate debt) and 700 bps in the maximum (assuming plain
equity). | |
| Table 15 provides an estimate of changes in
the WACC as result of the changed expected losses for first bail-inable bond
(BiB) holders after structural reform and behavioural response. In columns A to
D the change in expected losses on first bail-inable bonds compared to the
undivided bank are calculated. Columns E and F provide the risk premium impact
on capital and on the WACC respectively. | |
| The effect of a changed risk premium on
bail-inable first debt on the WACC for the TE is estimated to be in the range
of -4 to -9 bps depending on the behavioural response. This result is driven by
lower gross losses, the increased share of losses that are absorbed by capital
and the lower pooling of the LAC (as it is no longer shared across the DTB and
the TE of each “group”). The WACC of the DTB is estimated to go down by 1 bp
due to the lower expected losses on DTB BiB holders. | |
| Table 15
- Estimated change in WACC
due to changes in the risk premium on first bail-inable bonds (BiB) after
behavioural response | |
| Bank || Minimum bail-in capacity (excl. capital) (% TA) || Expected losses on BIB (%TA) || Expected losses on BIB as a share of minimum BIB || %-change compared to undivided bank || change in risk premium on BIB, compared to undivided bank (bps) || Change in WACC due to BIB risk premium change (bps) | |
| || A || B || C=B/A || D=(C-�)/� || E=D*307bp || F=E*A | |
| 1 – Undivided Bank || 3.9% || 0.9% || 23% (�) || - || - || - | |
| 2 - DTB || 3.2% || 0.7% || 21% || -11% || -33 || -1 | |
| 3 – TE with increased capital || 5.3% || 0.7% || 12% || -46% || -142 || -7 | |
| 4 – TE with reduced RWA || 5.5% || 0.5% || 10% || -56% || -173 || -9 | |
| 5- TE with reduced TA || 4.3% || 0.7% || 15% || -34% || -104 || -4 | |
| Note: Initial
average risk premium on subordinate debt is 307 bps. | |
| 6. Conclusions | |
| SYMBOL simulations show that the effects of
separation and the TEs possible behavioural responses lead to : | |
| ü
A reduction in gross losses plus
recapitalisation needs across all banks in case of a financial crisis. | |
| ü
A reduction of the losses that can fall on
bail-inable creditors in line with the BRRD, reducing potential financial
stability risks and contagion. | |
| The funding cost impact of the separation
and behavioural responses depend on the extent to which changes to expected
losses for the different stakeholders affect market risk premia on equity and
bonds: | |
| ü If lower expected losses on capital and bonds are not
reflected in lower funding costs, the weighted average WACC across all banks in
the sample increases by up to 3 bps as the Trading Entities need to hold more
capital and Loss Absorbing Capacity (LAC) which increase their WACC by up to 9
bps. The Deposit Taking Banks have an unchanged WACC as they do not need to
hold capital or LAC above minimum requirements as their probability of default
and expected losses decrease, and they cannot reduce capital or LAC below
minimum requirements to lower its WACC. | |
| ü
With changes in risk premia, the average WACC
across all banks in the sample decreases (by 1 to 9 bps) as gross losses reduce
and are partly allocated to the safety net and/or public finances. The WACC for
the Deposit Taking bank is reduced by 4 to 9 bps as it no longer supports the
more risky Trading Entity activities, while the increase in WACC for the
Trading Entities is limited due to the reduced riskiness for bail-inable
creditors (following behavioural responses). The reduction in the WACC should
be considered together with an accompanying loss of revenues due to the lower
RWA. | |
| The
analysis does not find a direct beneficial effect of structural separation on
losses to public finances. This is the result of the assumption that both CRDIV
and bail-in under the BRRD are considered as fully effective before the
introduction of separation, thus leaving limited scope for further reductions
in pass-through to the safety nets. | |
| In a comprehensive assessment further
social and private costs and benefits and macro-economic impacts that cannot be
modelled with the SYMBOL model also need to be considered: e.g. loss of
economies of scope and scale, legal costs, relocation costs, effects on asset
pricing due to reduced liquidity effect, as well as other social and private
benefits such as avoiding conflicts of interest, misallocation of resources,
facilitating supervision, possible bank lending effect by the DTB. | |
| Appendix section for Annex A10 | |
| Appendix A: List of banks | |
| Table - List of banks in the sample in alphabetical order. | |
| || Institution Name || Label || Country | |
| 1 || Banca Monte dei Paschi di Siena SpA || MPS || IT | |
| 2 || Banco Santander SA || Santander || ES | |
| 3 || Barclays Plc || Barclays || UK | |
| 4 || Bayerische Landesbank || BayerLB || DE | |
| 5 || Belfius Banque SA || Belfius || BE | |
| 6 || BNP Paribas SA || BNPP || FR | |
| 7 || Commerzbank AG || Commerz || DE | |
| 8 || Crédit Agricole SA || CA || FR | |
| 9 || Danske Bank A/S || Danske || DK | |
| 10 || DekaBank Deutsche Girozentrale || Deka || DE | |
| 11 || Deutsche Bank AG || Deutsche || DE | |
| 12 || Deutsche Zentral-Genossenschaftsbank AG || DZG || DE | |
| 13 || DNB ASA || DNB || NO | |
| 14 || Groupe BPCE || BPCE || FR | |
| 15 || HSBC Holdings Plc || HSBC || UK | |
| 16 || ING Bank NV || ING || NL | |
| 17 || KBC Group NV || KBC || BE | |
| 18 || Landesbank Baden-Württemberg || LBBW || DE | |
| 19 || Landesbank Hessen-Thüringen Girozentrale || LBHT || DE | |
| 20 || Mediobanca - Banca di Credito Finanziario SpA || Mediobanca || IT | |
| 21 || Nordea Bank AB || Nordea || SE | |
| 22 || Portigon AG || Portigon || DE | |
| 23 || Royal Bank of Scotland Group Plc || RBS || UK | |
| 24 || Skandinaviska Enskilda Banken AB || SEB || SE | |
| 25 || Société Générale SA || SocGén || FR | |
| 26 || Svenska Handelsbanken AB || Svenska || SE | |
| 27 || Swedbank AB || Swedbank || SE | |
| 28 || UniCredit SpA || UniCredit || IT | |
| 29 || Standard Chartered Plc || StdCh || UK | |
| Appendix B: Sample statistics before and after structural separation | |
| Table - Summary of split of assets, RWA and capital for the sample in bn€,
data as of 2011. Source: Bankscope, SNL and Commission elaboration. | |
| || Universal || DTB || TE | |
| Total assets (b€) || 31/12/2011 balance sheet || Basel III compliant || Total assets (b€) || 31/12/2011 balance sheet || Basel III compliant || Total assets (b€) || 31/12/2011 balance sheet || Basel III compliant | |
| Reg. Capital (b€) || RWA (b€) || Regulatory Capital (b€) || RWA (b€) || Reg. Capital (b€) || RWA (b€) || Regulatory Capital (b€) || RWA (b€) || Reg. Capital (b€) || RWA (b€) || Regulatory Capital (b€) || RWA (b€) | |
| 1 || Banca Monte dei Paschi di Siena || 241 || 11 || 105 || 13 || 127 || 214 || 9 || 103 || 11 || 107 || 27 || 2 || 2 || 2 || 21 | |
| 2 || BancoSantander SA || 1,252 || 51 || 566 || 72 || 686 || 1,062 || 42 || 547 || 59 || 566 || 189 || 9 || 19 || 12 || 119 | |
| 3 || Bank DnB A/S || 274 || 11 || 137 || 18 || 174 || 254 || 9 || 127 || 15 || 138 || 20 || 2 || 10 || 4 || 35 | |
| 4 || Barclays Plc || 1,870 || 50 || 468 || 59 || 566 || 970 || 38 || 411 || 45 || 426 || 899 || 12 || 57 || 15 || 139 | |
| 5 || BayerischeLandesbank || 309 || 12 || 118 || 15 || 144 || 258 || 10 || 115 || 13 || 119 || 51 || 2 || 3 || 3 || 24 | |
| 6 || Belfius Bank &Verzekeringen || 233 || 5 || 53 || 7 || 64 || 196 || 4 || 52 || 6 || 54 || 36 || 1 || 1 || 1 || 11 | |
| 7 || BNP Paribas || 1,965 || 57 || 614 || 78 || 744 || 1,103 || 41 || 520 || 57 || 541 || 862 || 15 || 93 || 21 || 201 | |
| 8 || BPCE Group || 1,138 || 30 || 388 || 52 || 499 || 970 || 25 || 376 || 43 || 412 || 168 || 5 || 12 || 9 || 86 | |
| 9 || Commerzbank AG || 662 || 24 || 237 || 30 || 287 || 500 || 20 || 225 || 24 || 233 || 162 || 4 || 12 || 6 || 53 | |
| 10 || CréditAgricole-SA || 1,724 || 30 || 274 || 42 || 404 || 1,214 || 23 || 250 || 33 || 316 || 509 || 6 || 24 || 9 || 88 | |
| 11 || Danske Bank A/S || 461 || 14 || 122 || 15 || 148 || 327 || 11 || 113 || 12 || 118 || 133 || 3 || 8 || 3 || 30 | |
| 12 || DekaBank Deutsche Girozentrale || 134 || 3 || 25 || 3 || 27 || 94 || 2 || 22 || 3 || 26 || 40 || 0.4 || 3 || 0.5 || 5 | |
| 13 || Deutsche Bank AG || 2,164 || 36 || 381 || 48 || 462 || 968 || 26 || 316 || 35 || 329 || 1,197 || 10 || 65 || 14 || 132 | |
| 14 || HSBC Holdings Plc || 1,975 || 87 || 931 || 119 || 1,133 || 1,516 || 69 || 860 || 94 || 895 || 459 || 18 || 71 || 25 || 236 | |
| 15 || ING Bank NV || 961 || 31 || 330 || 42 || 400 || 865 || 26 || 321 || 35 || 333 || 96 || 5 || 9 || 7 || 67 | |
| 16 || KBC GroepNV || 285 || 13 || 126 || 16 || 153 || 259 || 11 || 124 || 13 || 128 || 26 || 2 || 3 || 3 || 25 | |
| 17 || Landesbank Baden-Wuerttemberg || 373 || 12 || 108 || 14 || 131 || 265 || 9 || 97 || 11 || 100 || 108 || 3 || 11 || 3 || 30 | |
| 18 || Landesbank Hessen-ThueringenGirozentrale - HELABA || 164 || 6 || 57 || 7 || 69 || 124 || 4 || 51 || 6 || 53 || 40 || 1 || 6 || 2 || 16 | |
| 19 || MediobancaSpA || 75 || 5 || 55 || 7 || 67 || 60 || 4 || 52 || 6 || 54 || 16 || 1 || 3 || 1 || 12 | |
| 20 || Nordea Bank AB (publ) || 716 || 16 || 185 || 28 || 271 || 479 || 13 || 171 || 22 || 214 || 238 || 3 || 14 || 6 || 57 | |
| || Universal || DTB || TE | |
| Total assets (b€) || 31/12/2011 balance sheet || Basel III compliant || Total assets (b€) || 31/12/2011 balance sheet || Basel III compliant || Total assets (b€) || 31/12/2011 balance sheet || Basel III compliant | |
| Reg. Capital (b€) || RWA (b€) || Regulatory Capital (b€) || RWA (b€) || Reg. Capital (b€) || RWA (b€) || Regulatory Capital (b€) || RWA (b€) || Reg. Capital (b€) || RWA (b€) || Regulatory Capital (b€) || RWA (b€) | |
| 21 || Portigon AG || 168 || 4 || 48 || 6 || 59 || 109 || 3 || 45 || 5 || 47 || 59 || 1 || 3 || 1 || 12 | |
| 22 || Royal Bank of Scotland Group Plc || 1,804 || 48 || 526 || 67 || 636 || 964 || 35 || 451 || 49 || 468 || 839 || 13 || 74 || 17 || 167 | |
| 23 || SkandinaviskaEnskildaBanken AB || 265 || 8 || 76 || 12 || 113 || 212 || 6 || 72 || 10 || 91 || 53 || 1 || 4 || 2 || 21 | |
| 24 || SociétéGénérale || 1,181 || 27 || 349 || 44 || 423 || 736 || 21 || 306 || 33 || 317 || 446 || 7 || 44 || 11 || 105 | |
| 25 || Standard Chartered Plc || 456 || 24 || 208 || 27 || 253 || 391 || 20 || 203 || 22 || 210 || 66 || 4 || 6 || 4 || 43 | |
| 26 || SvenskaHandelsbanken || 275 || 8 || 57 || 14 || 134 || 253 || 7 || 56 || 12 || 113 || 22 || 1 || 1 || 2 || 21 | |
| 27 || SwedbankAB || 208 || 7 || 55 || 11 || 103 || 178 || 6 || 53 || 9 || 84 || 30 || 1 || 2 || 2 || 18 | |
| 28 || UniCreditSpA || 914 || 38 || 460 || 58 || 558 || 789 || 31 || 449 || 49 || 464 || 125 || 6 || 12 || 10 || 93 | |
| 29 || Deutsche Zentral-Genossenschaftsbank AG || 406 || 8 || 100 || 13 || 121 || 112 || 6 || 92 || 10 || 95 || 294 || 2 || 8 || 3 || 25 | |
| || TOTAL || 22,653 || 676 || 7159 || 937 || 8,956 || 15,442 || 531 || 6580 || 742 || 7051 || 7,210 || 140.4 || 580 || 198.5 || 1892 | |
| Appendix C: The
SYMBOL model | |
| SYMBOL (SYstemic Model of Banking
Originated Losses) is a micro-simulation model[227] which makes use of individual banks’ balance sheet data to simulate
banks’ losses due to the failure of its obligors and to derive the (aggregated)
distribution of losses originated in the banking system. The main idea behind
this model is that it is possible to estimate and average Probability of
Default (PD) of the portfolio of obligors of a bank (the so called implied
obligors’ PD) by inverting the Basel FIRB (Foundation Internal
Ratings Based) formula for capital requirements. | |
| The model is implemented in the following
four steps: | |
| Estimation of the
implied PD for the obligors’ portfolio of any individual bank by inverting
the Basel FIRB capital requirement formula. Under the FIRB approach the
total capital can be written as a function of the average obligor’s PD,
of the Loss Given Default LGD, of the maturity T and of the
correlation R between the assets of the corresponding obligors (for
more details see (De Lisa et al., 2010)): | |
| CapRequirement=f(PD, LGD, T, R) | |
| Being the
capital requirement publicly available and being all the other parameters set
to their regulatory average values, the formula can be inverted to numerically
estimate the implied PD. | |
| Generation, via a Monte Carlo simulation, of portfolio losses for individual banks. Once the implied average
PD are estimated, individual bank losses are generated via a Monte Carlo
simulation, taking into account the correlation between the assets of
different banks due to the presence of common shocks in the economy.
Banks’ losses are simulated on the basis of the loss distribution assumed
in the Basel FIRB approach[228]. | |
| 3. The output of the simulation is a matrix of gross losses
Li,n where i labels the bank and n the
simulation run. In each run Li,n is compared with the amount
of bank’s capital Capi. If Li,n is lower
than Capi the bank does not default but could need to recapitalize
to a level equal to 8% of its RWA. On the other hand, if Li,n
is greater than Capi the capital the bank holds is not enough
to cover the loss and this implies that the bank is in insolvency, suffering
from an excess loss ELi,n: | |
| ELi,n =( Li,n - Capi){Li,n - Capi>=0} | |
| 4. Aggregation of individual banks’ Li,n, ELi,n
and of recapitalization needs to obtain aggregate losses at
country/banking system’s level. | |
| Appendix D: The Implied Obligor PD for the Trading Entities | |
| As set out in Annex C, the SYMBOL model
inverts the FIRB approach (Vasicek) credit risk formula for banks minimum
capital requirement to estimate the probabilities of a default of bank obligors
as assessed by the bank and the country's banking system regulator. Vasicek[229] shows that the model can also be used to simulate losses on a
traded portfolio exposed to market and default risk, subject to the
introduction of a correction term for the difference between the maturity of
the traded securities and the holding horizon and to a market correlation
factor. In addition Vasicek shows that the mark-to-market loss distribution of
a traded portfolio would coincide with the standard FIRB loan-loss distribution
if the maturity and holding horizon were to coincide.[230] | |
| The base SYMBOL methodology, Vasicek
formula, can therefore also be used to simulate losses on the portfolio of the
TE, subject to some assumptions and conditions. In particular, the issues which
need to addressed are: i) Differences between the confidence levels required
for market risk and credit risk; ii) Assumptions and requirements regarding the
holding horizon of the securities; iii) treatment of the additional
“multiplicative factor” of 3 to 4 to be applied to calculated market risk
according to the AIRB framework. | |
| Regarding the first point, given that the
Basel accord proposes a target MCR for the market risk which is based on a
confidence level of 99%, we perform the inversion of the FIRB formula to
recover the riskiness parameter at this level instead of the 99.9% required for
credit risk. | |
| Regarding the second point, we introduce
the simplifying assumption that the holding period and maturity of the
portfolio coincide (thus eliminating the need to consider the adjustments for
market correlation and time horizon differences), as it is usually done on the
credit side, and that the Basel 3 adjusted MCR is representative of the risk
incurred over the whole simulation period. | |
| Regarding the third point, the multiplicative factor of 3, could be interpreted[231] as a correction factor for model uncertainty. If this
interpretation is adopted, then this can be thought as an estimator correction
factor. The implied obligor probability of default should therefore be obtained
based on the estimated MCR including the correction factor. | |
| Given the above, we use the FIRB standard
loss distribution also as a basis for the simulations of losses of the TE after
taking into consideration the difference in confidence for calibration purposes
(i.e. inverting the FIRB at 99% and not at 99.9%) and without applying any
further correction to reported MCRs.[232] | |
| It should be noted that the choice of a 99%
confidence implies an increase in the riskiness of trading entities, while the
choice of ignoring the difference between the holding horizon of trading
securities and the simulation horizon implies a decrease. A precise
quantification of the impact of these two drivers was not possible. | |
| Appendix E: SYMBOL simulated losses and historical losses during the recent crisis | |
| Table A3 present the results of the SYMBOL
simulations for the structural separation compared to historical losses of the
recent crisis. To estimate the representative loss simulations for all EU
banks, simulation results for the sample of 29 banks is divided by its share in
total EU assets (about 56%). These simulations differ from those reported in
Table 1, Section 1 of Annex XIII of the BRRD IA due to the different
methodology required to simulate the effects of the structural separation. As
the trading and banking portfolio of the banks are simulated separately, the
correlation of losses across these portfolios is reduced from 1 (when they are
simulated as a single undivided portfolio), to 0.5 which is the standard
setting for the correlation of losses across banks in SYMBOL.[233] | |
| As the very severe crisis (with excess
losses at the 99.95th percentile) simulation is the most similar to
real state aid figures during the last crisis in terms of banks' losses, also
including recapitalization needs, the analysis in this report is developed for
that simulation. | |
| Table A3 - Aggregated losses in EU banking sector simulated
with the SYMBOL model under Basel 3 10.5% minimum capital requirements (no
contagion) and aggregated EU state aid used in recent crisis between 2008-2012
(€ billion. In brackets: values presented in the BRD IA on the basis of banks'
2009 and data and on state aid used between 2008 and 2010. | |
| || Severe crisis (99.90%[234]) || Very severe crisis (99.95%) || Recent crisis (Data 2008-2012)[235] || Extremely severe crisis (99.99%) | |
| Extra-Losses (not absorbed by capital) || 44.3 (36.2) || 72.6 (79.9) || 116.8 (121.2) || 172.8 (266.7) | |
| Extra-Losses (not absorbed by capital) + Recapitalisation funding needs to meet 8% MCR || 340.8 (295.6) || 447.8 (466.7) || 439.0+114.6=553.6 (409.0) || 750.7 (668.3) | |
| Source:
European Commission elaborations | |
| Appendix F: Assets of
large banking groups within the EU-27 | |
| Table shows the share of total consolidated
assets within the EU-27 for the largest EU banking groups included in the
simulation exercise. These represent roughly 83% of the total sample’s assets.
The second column reports the 2011 total consolidated assets, downloaded from
Bankscope, the third column shows estimations of the percentage of these assets
within EU-27 borders. | |
| Table A4: Share of
activity in the EU-27 for a number of large EU banking groups. Consolidated
data from 2011 | |
| Bank Name || Country || Total Assets (b€) || Estimated % of total assets inside EU-27 | |
| Deutsche Bank AG || DE || 2,164 || 79.31% | |
| HSBC Holdings Plc || UK || 1,981 || 41.05% | |
| BNP Paribas || FR || 1,965 || 85.57% | |
| Barclays Bank Plc || UK || 1,818 || 56.34% | |
| Royal Bank of Scotland Group Plc || UK || 1,752 || 77.96% | |
| Crédit Agricole S.A. || FR || 1,724 || 97.74% | |
| Banco Santander SA || ES || 1,252 || 77.81% | |
| Société Générale || FR || 1,181 || 90.11% | |
| ING Bank NV || NL || 961 || 85.38% | |
| UniCredit SpA || IT || 927 || 93.54% | |
| BPCE SA || FR || 796 || 97.10% | |
| Nordea Bank || SE || 716 || 87.70% | |
| Commerzbank AG || DE || 662 || 97.09% | |
| Danske Bank A/S || DK || 460 || 99.44% | |
| Weighted Average for all banks || || || 79.05% | |
| Source:
ECB, Bankscope, European Commission elaborations (*) | |
| ANNEX
A11 Selected observations on submitted data templates | |
| Introduction | |
| As one element of input
into the impact assessment, the Commission services have invited EU banks to
submit data that illustrate the expected impact of stylised structural reform
scenarios on the group's balance sheet, profit and loss account and selected
other variables. The data request was part of the public consultation between
16 May 2013 and 11 July 2013 and can be retrieved here: | |
| http://ec.europa.eu/internal_market/consultations/2013/banking-structural-reform/docs/data-template_en.xlsx | |
| As structural reform
targets large and complex too-important-to-fail banking groups, the Commission
services in particular have encouraged data submissions from EU banks with the
highest degree of systemic importance. Respondents have been requested as a
matter of priority to complete the data request as well as to report underlying
assumptions about relevant macroeconomic and other variables. | |
| In that context, banks
have been asked to provide information about balance sheet, profit and loss,
and selected other variables in a number of different scenarios: | |
| -
balance sheet and profit and
loss account information, as well as information about selected other
variables, at year end 2012; | |
| -
simulated group balance
sheet and profit and loss by end 2017, assuming in particular the
implementation of the Bank Recovery and Resolution Directive and the Capital
Requirements Directive IV/Capital Requirements Regulation; and | |
| -
simulated end 2017 balance
sheet and profit and loss account in the stylised structural reform scenarios
specified below and to be implemented by end 2017. | |
| The two structural
reform scenarios differ in the activities to be undertaken within a trading
entity, as well as with respect to the strength of the separation between the
deposit and trading entity. | |
| The two reform
scenarios are stylised and simplified and intend to usefully inform the
assessment of the set of structural reform options being considered by the
Commission services. | |
| Stylised EU
structural reform scenario 1 – main features: | |
| Legal separation of certain trading
activities from deposit taking activities within a banking group.
Separation to be completed by end-2017.
Only the following activities are to be
excluded from the legally separate deposit entity (exhaustive list):
proprietary trading, exposures to venture capital, private equity and
hedge funds, and market making.
The trading entity cannot be a
subsidiary of the deposit entity. The deposit entity and the trading
entity each have to comply with prudential requirements (including
capital, liquidity, leverage and large exposure requirements) on an
individual or subconsolidated level (i.e. in case there are several
trading entities within the same corporate group all those entities can be
consolidated for prudential requirements; similar principle applies in
case there are several deposit entities within the same corporate group). | |
| Stylised EU
structural reform scenario 2 – main features: | |
| Legal separation of certain trading
activities from deposit taking activities within a banking group.
Separation to be completed by end-2017.
Only the following activities are to be
excluded from the legally separate deposit entity (exhaustive list): All investment
banking activity (please specify your definition used).
The trading entity cannot be a
subsidiary of the deposit entity. Completely independent funding and
capitalisation of deposit and trading entity. Lending and asset sales
between the deposit entity and the trading entity need to take place on a
commercial and arm's length basis. The deposit entity and the trading
entity each have to comply with prudential requirements (including
capital, liquidity, leverage and large exposure requirements) on an
individual or subconsolidated level (i.e. in case there are several
trading entities within the same corporate group all those entities can be
consolidated for prudential requirements; similar principle applies in
case there are several deposit entities within the same corporate group). The
deposit entity is not allowed to have exposures to financial institutions
(including to any trading entity within its own corporate group), except
for treasury functions, payments services, and letters of credit. No
waivers should be granted. Independent risk management for deposit entity.
Independent treasury management for deposit entity. Separate financial and
supervisory disclosure requirements should be applied to the deposit
entity and the trading entity. | |
| These scenarios are
stylised, relatively restrictive and prescriptive and do not correspond to
concrete structural reform options and do not prejudge the policy choice to be
made by the European Commission at a later stage. | |
| The selected structural
reform scenarios are restrictive in terms of exhaustively listing the banking
activities that are to be performed by the legally, economically and
operationally separate trading entity (limited flexibility to decide about in
which entities activities can be performed), to ensure maximum comparability of
results across banks. | |
| The specified
structural reform scenarios have been designed as being sufficiently distinct,
so as to allow the Commission services to appreciate the incremental costs of
different structural reform design issues. | |
| High-level
findings inferred from submitted data templates | |
| Very few banking groups submitted data templates.
Only six banking groups submitted templates that are sufficiently complete
so as to allow detailed cross-bank comparisons. All but one of these six
banks have total assets exceeding 1000bn EUR. The outlier bank has total
assets around 250bn EUR. The limited sample of banking groups that
provided information does not seem representative and hence does not allow
to infer firm conclusions.
The estimated impact on balance sheet size varies
a lot across banking groups. Whereas one bank reports a small balance
sheet increase (+1%), most others report single-digit balance sheet
percentage reductions, with one outlier bank that reports an expected
balance sheet decrease of 25%.
The estimated size of the trading entity
ranges widely across banks within a given structural reform scenario. The
trading entity size ranges between 6% and 66% of the group’s total balance
sheet for scenario 1 and between 7% and 71% for scenario 2.
Only three banking groups reported the relative
importance of proprietary trading. The reported share of proprietary
trading in overall trading revenues ranges from a low of 0% to 4% of
total trading revenues, which in turn is only a fraction of total
revenues.
The estimated impact of the proposed separation on
the profit before taxes bank responses can be divided in three
groups. For a first group of banks, the estimated impact amounts to at
most a 10% profit reduction. For a second group of banks, the profit
reduction is estimated to be around 40%. The impact on profit for a third
group (bank) is an outlier, as a loss of 6 to 12 times the annual 2012
profitability is reported. Note: The ICB impact estimate of private costs
is 33% of pre-tax profit of UK banks.
Except for one bank, the pre-tax Return on
Equity (RoE) of the deposit-taking entity (DE) is positive and
surprisingly high, ranging between 8.4% and 17.2%. The pre-tax RoE of the
outlier deposit-taking entity is estimated to be minus 10%. Despite this
negative RoE, the DE rating for the outlier bank is estimated to be
unaffected by the structural reform scenario.
The pre-tax RoE of the trading entity (TE)
is positive for three banking groups and negative for the other three
banking groups. The range hovers between 5.2% and 11% for the first group
and between minus 5.3% and minus 35.6% for the second group.
The rating of the DE is unaffected for the 4
banks that reported rating estimates.
The rating of the TE is estimated to go down
for the four banks that reported rating estimates. Again, results vary a
lot across banks. For the first scenario, the downgrades go from 1 notch
to 5 notches[236].
For the second scenario, the range is 2 notches to 4 notches.
The impact on revenues goes from 0% to minus
6% for the first scenario and from 0% to 16% for the second scenario.
The importance of investment banking activities
other than proprietary trading and market-making is surprisingly small,
ranging between 0% and 10% of the group’s balance sheet. Proprietary
trading and market-making make up for 90% of the balance sheet size of
investment banking.
Impacts on total costs also vary widely across banks. Total costs are estimated to go
up for three banking groups. They are estimated to go down for two other
banks. The first group reports a range of cost increases of 1% to 9%,
whereas the latter group reports decreases of total costs of 2% to 11%.
Funding costs are
estimated to go up with approximately 35% and 20% for two banking groups.
Other banks did not report in a format that allows inferring funding cost
impact.
There are numerous inconsistencies in the
submissions, both within a given submission and across banks. | |
| Annex A12 – Estimating the impact of a banking
sector funding cost increase on GDP | |
| 1.
Introduction and summary | |
| This note
presents the results of an exercise that quantifies the economic costs to
society of an increase in the average funding cost of the EU banking sector,
following bank structural reform. Three shocks of different magnitude to banks’
funding costs are introduced in a dynamic stochastic general equilibrium (DSGE)
model. | |
| At the outset,
it should be stressed that any quantitative modelling intrinsically involves
simplifications and assumptions, which yields results that are uncertain and
imprecise. Given the inherent complexity of modern banking, and given that many
social benefits and costs are dynamic in nature (often related to unobservable
incentives), the results presented in this Annex should be treated cautiously. | |
| With this
caveat in mind, the results show that economic output, as measured by the level
of GDP, would decline in the long run by between 0.04% and 0.1% after applying
the funding cost increases. These effects are conservative estimates in the
sense that the funding cost shocks are assumed to be completely passed through
to customers. | |
| 2.
Model description | |
| The model used in this exercise is a DSGE
model with a banking sector. The model belongs to a branch of applied general
equilibrium theory that is influential in contemporary macroeconomics. The DSGE
methodology attempts to explain aggregate economic phenomena, such as economic
growth, business cycles, and the effects of monetary and fiscal policy, on the
basis of macroeconomic models derived from microeconomic principles. The model
distinguishes between borrowers (entrepreneurs) and savers. Savers divide up
their financial wealth into government bonds, bank equity and deposits. In this
model government bonds pay a risk free rate. The deposit rate is lower than the
risk free rate because of a liquidity premium, i.e. banks charge depositors to
make funds available on request. The rate of return on equity includes a risk
premium, providing investors with a return above the risk free rate. | |
| The banking system transforms savings of
households into loans for entrepreneurs. Decision rules (demand for deposits,
demand for capital, loan rates, etc.) are derived from maximising the value of
the bank – the present value of bank dividends – subject to a capital
requirement constraint. The banks buy labour services from the households,
which are partly fixed and partly flexible in proportion to lending activities.
Furthermore, the bank pays dividends to its shareholders. | |
| The model shows the macroeconomic effects
of permanently increasing (or decreasing) the risk premia for bank capital
and/or increasing (or decreasing) the funding cost for deposits. The banking
sector is represented by one stylised bank with a simple balance sheet, where
total assets consist of loans (L) and liquid assets (government bonds: B).
Total liabilities are the sum of deposits and wholesale funding (D) and bank
equity (). The banking sector faces a capital requirement constraint, which
is formulated in terms of risk weighted assets: | |
| (1) | |
| The concept applied is that of a
consolidated balance sheet for the banking sector, which provides information
about the stock of loans to the non-financial sector, and yields an estimate of
the borrowing costs of non-financial corporations (NFC). | |
| The main transmission channel of increasing
funding costs is via higher lending rates for firms. An increase in funding
cost increases marginal costs for banks. These costs are assumed to be shifted
completely onto loan rates (there is a zero mark-up). In addition there is some
tightening of the collateral constraint, since the value of capital of NFCs
declines, because of the expected decline of dividends. | |
| Higher lending rates and the tightening of
the collateral constraint decrease investment and future consumption, and have
a marginal effect on employment (since real wages adjust in the long run). In
case of an increase in the return on equity (RoE) for banks, domestic
households receive a higher return, which affects consumption positively in the
short run. However, in the medium to long run this effect is dominated by the
increase in the cost of capital. The increase in the deposit rate is modelled
via a reduction in the supply of deposits of private households. Reduced
savings increases consumption, which also dampens the negative macroeconomic
effect in the short run. | |
| 3.
Calibration and scenarios tested | |
| Before applying any type of shock to the
model, the model has to be calibrated to observed data. All parameters
describing the non-banking part of the model are taken from Ratto et al.
(2009). For the EU Banking sector, the following parameters are applied: | |
| §
ratio of tier 1 capital to risk weighted assets:
6%; | |
| §
risk weights for the two asset classes are 55%
for loans and 5% for government bonds, respectively; | |
| §
loan rate: 4.1%; | |
| §
return on equity: 10%; | |
| §
deposit and wholesale rate: 2.5%. | |
| Three different funding cost shocks are
applied to the model. These shocks are based on a collection of information of
private costs to banks. The information stem from a survey, where banks were
asked to estimate the resulting costs of stylised structural reform scenarios,
and model-based estimates of funding cost increases. The latter model estimates
come from the SYMBOL model, initially developed to assess the consequences of
bank failures in the EU (see Annex A10). To this information was also applied a
certain amount of own judgement, in order to reconcile some estimates with
others, as the surveyed banks supplied a rather wide range of cost estimates,
which often were internally inconsistent (see Annex A11). | |
| The first two shocks are realistic, but
still conservative measures of the economic impact of structural reform, as the
model assumes that shocks are entirely passed through to customers, with
maximum impact as a consequence. The first shock involves increasing the
funding cost (the deposit and wholesale funding rates taken together) faced by
banks that may fall under the regulation by 5 basis points. The second shock is
an increase in the funding cost of 12 basis points, which represents an upper
bound, as derived from other analysis in the Impact Assessment on bank
structural reform.. This second scenario reflects the upper bound for the
cumulative effect of introducing the Bank Recovery and Resolution Directive and
implementing structural reform of the banking sector. | |
| For illustrative purposes, the third shock
is an extreme event where banks affected by structural reform faces an increase
in their funding cost of 25 basis points. Obviously, this is not a realistic
scenario. However, it serves to illustrate the linearity of the results within
the ranges of increasing funding costs. | |
| These shocks to funding costs only apply to
those banks that are affected by the reform. It is assumed that banks affected
by structural reform constitute approximately 55% of total banking assets in
the EU. This is an estimate based on a threshold calibration exercise, which is
part of the Commission’s Impact Assessment on bank structural reform. Yet again
this is a conservative estimate, as it implies that the increasing costs apply
also to some banks that basically have no or very little trading activity. Thus
the shocks that are fed to the model are 2.75, 6.6 and 13.75 basis points,
respectively. | |
| 4.
Results | |
| The increase in the funding rate (weighted
average of deposit and wholesale rates) is introduced in the model via a
reduction in the supply of funding. The amount of withdrawn funding is
calibrated to generate the appropriate long-term increase in the funding rate.
Thus, the three shocks to the funding rate are visible in the rightmost columns
in Table 1 (2.75 basis points), Table 2 (6.6 basis points), and Table 3 (13.75
basis points). The increase in funding rate is entirely passed through onto the
banks’ lending rates (the last line in each table). | |
| Table 1: Increase of funding rate: 5 bp (for 55% of bank assets) | |
| Year || 1 || 2 || 3 || 4 || 10 || 50 || Long Run | |
| GDP || -0.02 || -0.02 || -0.02 || -0.03 || -0.04 || -0.09 || -0.10 | |
| Capital stock || 0.00 || -0.02 || -0.03 || -0.04 || -0.09 || -0.21 || -0.24 | |
| Loan stock || -0.04 || -0.10 || -0.11 || -0.11 || -0.14 || -0.23 || -0.25 | |
| Funding rate || -2.60 || -1.69 || 5.04 || 2.67 || 2.45 || 2.70 || 2.75 | |
| Loan rate || -2.43 || -1.53 || 5.19 || 2.83 || 2.61 || 2.84 || 2.89 | |
| Employment || -0.02 || -0.02 || -0.01 || -0.02 || -0.01 || -0.01 || -0.01 | |
| Note: Interest rates are deviations from baseline in basis points. The remaining variables are % deviations from baseline. | |
| The long-run impact of the funding cost
increase is a decline in the long-run level of GDP of about 0.1%, which is
illustrated in the top row of Table 1. The shocks imply a decline in the
capital stock and the loan stock. Employment is also affected negatively, but
only marginally. From the table one can also infer what the result would be if
the shock was lower, which there are indications of. For example, if the shock
is instead 2 basis points, the lowest estimate, the economic impact is
approximately 0.04%. | |
| Table 2: Increase of funding rate: 12 bp (for 55% of bank assets) | |
| Year || 1 || 2 || 3 || 4 || 10 || 50 || Long Run | |
| GDP || -0.04 || -0.04 || -0.05 || -0.06 || -0.10 || -0.22 || -0.24 | |
| Capital stock || -0.01 || -0.04 || -0.06 || -0.10 || -0.22 || -0.51 || -0.57 | |
| Loan stock || -0.10 || -0.24 || -0.27 || -0.26 || -0.34 || -0.55 || -0.59 | |
| Funding rate || -6.23 || -4.05 || 12.09 || 6.41 || 5.88 || 6.48 || 6.60 | |
| Loan rate || -5.83 || -3.67 || 12.47 || 6.79 || 6.26 || 6.83 || 6.95 | |
| Employment || -0.06 || -0.04 || -0.03 || -0.04 || -0.03 || -0.02 || -0.02 | |
| Note: Interest rates are deviations from baseline in basis points. The remaining variables are % deviations from baseline. | |
| The cumulative effect of introducing both
the BRRD and bank structural reform, implying additional private costs, would
amount to a decline in GDP of 0.2%. This result is presented in in the last
cell of the top row in Table 2. The effect on employment remains marginal. The
estimated impact of the cumulative effect of both introducing BRRD and bank
structural reform does not change much as the impact of BRRD seems to dominate
that of bank structural reform. | |
| Table 3: Increase of funding rate: 25 bp (for 55% of bank assets) | |
| Year || 1 || 2 || 3 || 4 || 10 || 50 || Long Run | |
| GDP || -0.08 || -0.08 || -0.10 || -0.13 || -0.22 || -0.45 || -0.50 | |
| Capital stock || -0.02 || -0.08 || -0.13 || -0.20 || -0.45 || -1.06 || -1.19 | |
| Loan stock || -0.22 || -0.50 || -0.57 || -0.54 || -0.71 || -1.14 || -1.23 | |
| Funding rate || -12.98 || -8.44 || 25.18 || 13.36 || 12.26 || 13.50 || 13.75 | |
| Loan rate || -12.14 || -7.64 || 25.97 || 14.15 || 13.04 || 14.22 || 14.47 | |
| Employment || -0.12 || -0.08 || -0.07 || -0.08 || -0.07 || -0.05 || -0.05 | |
| Note: Interest rates are deviations from baseline in basis points. The remaining variables are % deviations from baseline. | |
| Given the initial values and the calibration, the outcome of the
model is to a large extent linear, which is illustrated in Table 3. When the
cumulative shock is five times larger, also the impact on GDP is five times
larger. The information in the tables therefore allow for interpolating the
results of other shocks within the considered range. Beside the decline in
output, both the capital stock and loan stock declines. Also in this more
extreme scenario the effect in employment is very limited. | |
| 5.
Comparison of results | |
| In this section the derived results are
compared with those of the Impact Assessment (IA) published by the UK
government at the introduction to Parliament of the Financial Services (Banking
Reform) Bill. Although the UK proposal is different from the Commission’s, the
UK Impact Assessment may serve as a consistency check, both in terms of the
size of the shocks and the outcome. The information in the UK IA can be
translated to figures that are comparable to those used and derived in this
note. However, this requires making use of additional data sources and making
some more or less restrictive assumptions. | |
| Table 3: Breakdown of private costs of ring-fencing, UK proposal | |
| On-going costs, per year || Low || High | |
| Capital || £1.3bn || £2.6bn | |
| Funding || £70m || £890m | |
| Operational || £150m || £530m | |
| Depositor preference || £200m || £380m | |
| Total on-going costs, per year || £1.7bn || £4.4bn | |
| According to the modelling approach of the
UK government, total private costs for UK banks will range between GBP 1.7-4.4
billion, of which capital costs are in the range of GBP 1.3-2.6 billion, and
wholesale funding costs are in the range of GBP 0.07-0.89 billion. The UK IA
also considers two other on-going costs: operational costs and costs due to
depositor preference, i.e. creditors preferring insured deposits to senior
unsecured debt (see Table 3). | |
| As the balance sheet in the in the DSGE
model is simple and scaled down, all costs other than capital costs are bundled
together to calculate a comparable shock to be applied in the DSGE model. This
bundling of almost all costs and applying them as funding costs in the DSGE
framework is of course a crude simplification, which allow for conceptual
errors in terms of how the different costs affects a bank and are passed on to
customers. Nevertheless, the result is that funding costs would increase in a
range of GBP 0.42-1.8 billion, which translates into a funding cost increase
between EUR 0.49-2.1 billion (with an average exchange rate for 2013 of 0.853
GBP/EUR). | |
| According to the ECB's consolidated banking
statistics, interest expenses were EUR 68.44 billion. Given the
assumptions, these would increase to between EUR 68.9-70.5 billion. Applying
this range of costs to the total amount of deposits and debt certificates
(including bonds), yields a funding cost increase for the domestic banks in the
UK in the order of 1-4 basis points. Adjusting the figures by the weight of the
affected banks (0.55), imply a chock between 0.52-2.24 basis points. With the
DSGE model, this range of shocks yields a decline in GDP of between
0.02%-0.08%. | |
| The Commission’s estimates and the UK
estimates are comparable, both in terms of magnitude of private costs and the
impact on the real economy. The UK IA estimates a reduction in long-run GDP
level of 0.04%-0.16%. Note that the UK makes use of a different model to generate
their results. They use the NiGEM model, developed by the National Institute of
Economic and Social research. NiGEM is an estimated model, which uses a
‘New-Keynesian’ framework. The model is structured around the national income
identity, can accommodate forward looking consumer behaviour, and has many of
the characteristics of a DSGE model. Unlike a pure DSGE model, NiGEM is based
on estimation using historical data. Even though different estimation
techniques and different models have been used, the results are very close to
each other. | |
| Annex A13 – Shadow
banking - Securities finance transactions and transparency | |
| 1.
introduction | |
| The 2008 crisis was global and financial
services were at its heart, revealing inadequacies including regulatory gaps,
ineffective supervision, opaque markets and overly-complex products. The crisis
highlighted the need to improve regulation and monitoring not only in the
traditional banking sector but also in the area of non-bank credit activity,
called shadow banking. The shadow banking system can broadly be described as
“credit intermediation involving entities and activities (fully or partially)
outside the regular banking system”. In practice it includes entities which
raise funding with deposit - like characteristics, perform maturity and/or
liquidity transformation, allow credit risk transfer or use direct or indirect
leverage. | |
| Shadow banking features
high on the international agenda. G20 Leaders have asked the Financial
Stability Board (FSB) to look into shadow banking in order to identify the main
risks and make recommendations. The overarching aim, as reaffirmed on several
occasions by the G20, is to eliminate the dark corners in the financial sector
that have a potential impact on systemic risk or merely result from regulatory
arbitrage and extend regulation and oversight to all systemically important
financial institutions, instruments and markets. | |
| Because of its size and close links to the
regular banking sector, the shadow banking sector poses a systemic risk. The
first factor is size. The latest studies indicate that the aggregate shadow
banking assets are about half the size of the regulated banking system. Despite
the fact that shadow banking assets have decreased slightly since 2008, the
global figure at the end of 2012 was €53 trillion[237]. In terms of geographical distribution, the biggest share is
concentrated in the United States (around €19.3 trillion) and in Europe
(Eurozone with €16.3 trillion and the United Kingdom with around €6.7
trillion). The second factor which increases risks is the high level of
interconnectedness between the shadow banking system and the regulated sector,
particularly the regulated banking system. Any weakness that is mismanaged or
the destabilisation of an important factor in the shadow banking system could
trigger a wave of contagion that would affect the sectors subject to the
highest prudential standards. | |
| The response to the crisis has been
international and coordinated through the G20 and the FSB. The FSB has
suggested that as long as such activities and entities remain subject to a
lower level of regulation and supervision than the rest of the financial
sector, reinforced banking regulation could drive a substantial part of banking
activities beyond the boundaries of traditional banking and towards shadow
banking. For this reason the FSB under the lead of the G20 initiated at the end
of 2011 several work streams aimed at identifying the key risks of the shadow
banking system. These work streams include: (i) the interaction between banks and
shadow banking entities; (ii) the systemic risks of Money Market Funds (MMFs);
(iii) the regulation of other shadow banking entities like hedge funds; (iv)
the evaluation of existing securitisation requirements and; (v) the use of
Securities Financing Transactions (SFTs) like securities lending and repurchase
agreements (repos). | |
| Before the G20 and the FSB looked at the
shadow banking system, the hedge funds were singled out as an area of grave
concern. In April 2009, the G20 called for the hedge funds and their managers
to be registered and properly supervised. Particular attention was given to
their use of leverage and counterparty exposures. This is for this reason that
the Commission proposed as early as April 2009 a directive on Alternative
Investment Fund Managers (AIFM), including managers of hedge funds. The shadow
banking regulatory agenda of the Commission has been set out in a Communication
adopted in September 2013. | |
| The recent financial crisis
has also shown how critical funding liquidity risks can be in shaping the fate
of individual institutions and in transmitting contagion across the financial
markets. The procyclicality of funding liquidity created by private financial
players, especially shadow banking entities, can be disruptive. It helped to
fuel the financial bubble with liquidity generated by several forms of asset
inflation. The rehypothecation of the collateral to support multiple deals, in
particular securities lending and repurchase agreements, allowed for increased
liquidity as well as the build-up of hidden leverage and interconnectedness in
the system. When confidence in the value of assets, safety of counterparties
and investor protection collapsed it created wholesale market runs leading to a
sudden deleveraging and/or public safety nets (central bank facilities, etc.).[238] In this context, trust and funding liquidity evaporated and it
became impossible for even the biggest and strongest banks to access either
short or long-term funding.[239] | |
| The FSB recommendations
on shadow banking of 29 August 2013 have been formally endorsed at the G20
summit in St Petersburg.[240] They cover large areas of the financial system, notably the wide
spread use of securities lending and repurchase agreements, also called
securities financing transactions (SFTs), and of rehypothecation. These
techniques are used by almost all actors in the financial system, be they
banks, securities dealers, insurance companies, pension funds or investment
funds. SFTs use assets belonging to an entity to obtain funding from or to lend
them out to another entity. The main purpose of SFTs is therefore to obtain
additional cash or to achieve additional flexibility in carrying out a
particular investment strategy. The FSB and G20 have concluded that SFTs have
the propensity to increase the built-up of leverage in the financial system as
well as to create contagion channels between different financial sectors. This
international work on shadow banking comes at a time where the banks are being
subject to more stringent rules, including the proposed rules on the structural
separation of banking activities. Confronted with this new legislative
framework, there is no certainty that banks will not shift parts of their
activity into less regulated areas as shadow banking. In order to closely
follow market trends regarding entities whose activities qualify as shadow
banking, in particular in the area of SFTs, it is necessary to implement
transparency requirements that could inform the regulatory authorities about
the next steps that would be required to deal with these issues. In this
regard, the work undertaken by the FSB gives some precision about the
transparency level that is required. | |
| In 2013, the FSB
adopted 11 Recommendations to address the risks inherent to securities lending
and repurchase agreements. This impact assessment will only touch upon the
issues related to the transparency of the SFTs markets and rehypothecation,
i.e. Recommendations 1, 2, 5 and 7. | |
| When assessing the
transparency of the SFTs markets and rehypothecation, three main themes emerge:
(1) the monitoring of the build-up of systemic risks related to SFT
transactions in the financial system; (2) the disclosure of the information on
such transactions to the investors whose assets are employed in these
transactions; and (3) the contractual transparency over rehypothecation
activities. EU regulatory authorities lack the necessary data to better monitor
the use of SFTs and the risks and the vulnerabilities for the stability of the
financial system that they imply. Access to this information will give the
possibility to regulators to better design and apply their macro-prudential
tools. At the same time the investors are not properly informed whether and to
what extent the investment fund, in which they have invested or plan to invest
in, has encumbered or intends to encumber investment assets by means of
engaging in SFTs and other equivalent financing structures that would create
additional risks for the investors. Finally, insufficient contractual
transparency makes clients uncertain about the extent to which their assets can
be rehypothecated, or about the risks posed by rehypothecation. | |
| 2.
Securities financing markets in the EU | |
| The securities
financing markets represent one part of the shadow banking universe. According
to the FSB definition, SFTs are considered as a shadow banking activity
irrespectively of the entity that is performing such a SFT activity. The
following analysis therefore covers all entities that use SFTs. | |
| Economic context | |
| Example of the
securities lending case, Source: International Securities Lending Association
(ISLA) | |
| SFTs consist of any transaction that uses
assets belonging to the counterparty to generate financing means. In practice,
this mostly includes lending or borrowing of securities and commodities,
repurchase (repo) or reverse repurchase
transactions, or buy-sell back or sell-buy back transactions. All these
transactions have similar, even identical, economic effects. The two main
differences between repos and securities lending are their different
transaction structure and their different purpose. In terms of transaction
structure, securities lending occurs when an institutional investor agrees to
lend out its securities to another party in return for a fee and collateral,
while a repo is the sale of securities together with an agreement for the
seller to buy back the securities at a later date. In terms of transaction
purpose, securities lending is being driven significantly by a demand to borrow
securities (for short selling purposes, trade settlements, etc.) whereas repo
is more often driven by a desire to either borrow or lend cash. Market
participants rely heavily on bilateral repos for financing. SFTs can be
conducted on a bilateral basis, using a triparty agent, via an agent lender or
being centrally cleared. | |
| While not being directly associated with a
SFT, other financing structures may produce equivalent effects. Those other
financing structures include, for example, total return swaps (TRS), collateral
swaps or liquidity swaps that are often used interchangeably with classic SFTs
by investment funds. For the purpose of reporting to investors, those other
financing structures will be included in the scope in addition to the SFTs.
With regard to the reporting to competent authorities, the reporting
requirement will be limited to SFTs because derivative contracts are already
covered by European Market Infrastructure Regulation (EMIR)[241] reporting obligations. | |
| The EU repo market
tripled between 2001 and 2011 from EUR 0.9 trillion to EUR 3.1 trillion.[242] The
June 2013 market survey[243] of the International Capital Market Association estimated the value
of the outstanding repo contracts of the participating 65 institutions at EUR 6.1
trillion and the growth of the market over the preceding six months at 8.6%.[244] | |
| The 2013 ECB's Euro
Money Market survey[245] does not provide absolute outstanding levels but provides some
statistics relating to the European repo market denominated in euro. There is a
relatively high level of concentration in the euro repo market as the top 20
banks represent more than 82% of the total repo activity of the 161 credit
institutions surveyed. It is also important to note that 71% of all bilateral euro
repo transactions were cleared by central counterparties, compared to 56% in
2012. | |
| There is no publicly
available data on securities lending transactions in the EU. Several private
data vendors, however, conduct private market surveys on securities lending.
According to International Securities Lending Association, global securities
lending stands at EUR 1.4 trillion. | |
| Financial institutions responded
to collateral scarcities resulting from the shift from unsecured lending by
engaging in more collateral management, including optimising the use of
available collateral to enhance liquidity, e.g., collateral swaps. An important
element in this collateral management is rehypothecation. A Data Explorers
survey (from investment banks) is the only data source available that covers
the total global amount of rehypothecation. It estimates that securities of
EUR 0.4 trillion were subject to rehypothecation in the EU in 2011, while
globally it reached EUR 1.2 trillion in 2011. The IMF estimates that
globally hedge funds provide an additional EUR 0.6 trillion of securities.
This implies a total of EUR 1.8 trillion of collateral available in 2011
(i.e. EUR 0.6 trillion plus EUR 1.2 trillion). Thus, rehypothecation
contributed about EUR 2.8 trillion to globally available collateral
(EUR 4.6 trillion according to IMF estimates) in 2011. The players
facilitating rehypothecation and the beneficiaries of the funding liquidity it
gives are concentrated. The 14 major investment banks (G14) accounted for 86%
of the rehypothecated collateral at the end of 2011 through their shadow
banking activities with MMFs.[246] This
translated into the financing of more than 30% of the financing of the total
liabilities of shadow banking entities between 2007 and 2010.[247] | |
| Regulatory context | |
| The EU rules on capital requirements[248] require supervisory reporting of aggregate data on repo transactions
of credit institutions, but existing requirements are not detailed and frequent
enough for the purposes of monitoring of financial stability. SFTs involving
entities such as investment funds, pension funds and insurance companies are
rarely covered by existing supervisory reporting requirements despite the fact
that they can give rise to financial stability concerns. Although the Markets in Financial Instruments Directive (MiFID)[249] includes a reporting obligation on any transaction in financial
instruments, level 2 implementing measures[250] exempt securities financing transactions from this reporting
requirement (notwithstanding the record-keeping of client orders and
transactions). | |
| The provisions
regarding the reporting to investors on the use of SFTs and other financing
structures are scattered in different places in the Directive on undertakings
for collective investment in transferable securities (UCITS) [251] directive and in the ESMA guidelines on ETFs and other UCITS issues[252]. Neither SFTs nor other financing structures are defined in the
UCITS or Alternative Investment Fund Managers (AIFM)[253] directive but these activities are covered through other
definitions and obligations. Overall there is a lack of harmonisation and
granularity in the existing reporting standards. | |
| The EU’s current
regulatory framework does not take account of the systemic issues posed by
shadow banking, such as the rehypothecation of collateral. The Financial
Collateral Directive[254] lacks clarity on the operational processes that should be followed
where collateral takers decide to reuse securities collateral given using a
security interest. Client asset protection is a key feature of the MiFID.
Currently under revision,[255] it requires the investor’s consent for the intermediary’s use of its
assets, investors can be left unprotected where an intermediary uses a title
transfer to use the investor’s securities. In essence, the legal framework
governing how securities are held and used is currently left to Member States'
law. It is composed of a patchwork of national laws. Nevertheless, each of
these instruments has a different limited personal and material scope.
Together, these measures cover only some of the aspects relevant to how
securities are used by financial markets and leave some important gaps and
inconsistencies in the regulatory framework, in particular in relation to
shadow banking activities. | |
| 3.
Problem definition
Driver 1: lack of comprehensive (frequent
and granular) data on securities financing transactions | |
| SFTs display structural similarities with
banking activities as they can lead to maturity and liquidity transformation
and increased leverage, including short-term financing of longer-term assets.
They are, therefore, considered as shadow banking activities by the FSB. During
the financial crisis, the authorities responsible for the monitoring of
financial stability encountered significant difficulties to anticipate the
emergence of systemic risks due to the lack of timely and comprehensive data on
trends and developments in securities financing markets. Moreover, existing
information gaps and lags prevent regulators from identifying the built-up of
financial stability risks that would prove detrimental in times of a credit or
liquidity crisis. The absence of data also prevents regulators from promptly
taking the measures necessary to mitigate the negative effects of a potential
crisis. Moreover, the lack of frequent and granular data made it impossible to
develop a comprehensive picture across the full range of market participants in
these markets, especially on the interactions of the regulated banking sector
with shadow banking entities. | |
| The FSB recently published a summary of the
available data to regulators on securities lending and repos showing the lack
of frequent and granular data on EU securities financing markets.[256] Moreover, in a paper published by the European Systemic Risk Board
(ESRB), the authors concluded that the information available to EU regulatory
authorities was not sufficient for the purpose of monitoring the systemic risks
that may arise from SFTs.[257] Existing industry data or data collected in other publicly
available surveys displays weaknesses in relation to the level of granularity,
coverage of instruments and of institutions and their geographic coverage across
Member States. This makes it particularly difficult to compare and use the data
from different surveys for prudential purposes. | |
| The lack of transparency is most acute with
respect to bilateral transactions. In these areas no frequent and granular market
data is readily available. Data on securities lending is very limited or not
available at all, while information on key indicators for monitoring of the
financial stability risks such as haircut levels, remaining maturity of
collateral, reuse of collateral, is not typically available. | |
| Driver 2: SFTs create conflicts of interests between
the fund managers and the investors | |
| With a volume of assets
under management around EUR 9 trillion, investment funds are heavily
engaged in SFTs and other financing structures in Europe. The majority of the
European investment funds, representing around 70% of the assets under
management, operate under the rules of the UCITS Directive while all other
funds operate under the AIFMD. Generally, investors choose an investment fund
according to its publicly stated investment strategy. This strategy comprises
the asset classes in which the fund intends to invest but also the investment
techniques that the fund intends to employ. SFTs are currently not presented as
being an integral part of an investment strategy. Asset managers argue that SFT
are not part of their core strategy and, at best, play an ancillary role. SFTs
may, however, have significant impacts on the performance and the risk profile
of the fund as they lead to expose the funds to additional risks. | |
| A common feature of all
SFT techniques is that they involve exchanging assets belonging to the
investment fund with an external counterparty. While sharing similar
structures, these techniques are not necessarily used for the same purpose. | |
| 1. Securities lending involves a fund lending its investment assets
against a "lending fee". The lending proceeds can be used to enhance
the return of the fund or to decrease the management fees. Securities borrowing
is used by investment funds mainly to cover short positions (mostly relevant
for AIFs). Liquidity or collateral swaps often take the same form as classic
securities lending transactions. | |
| 2. Repos are used by investment funds to generate cash. This cash is
then used to finance additional investments of the fund. Repos are used to
increase the leverage of the fund. Reverse repos are used by investment funds
to lend cash on a secured basis mostly to credit institutions. | |
| 3. Other financing structures include for example TRS. With a TRS an
investment fund collects the investor's cash and passes it on to a TRS
counterparty, usually an investment bank. Although not explicitly mentioned in
the FSB recommendations, TRS create the same type of risks as securities
lending and repo. TRS are used by managers because they offer exposures to
strategies that would be difficult or too costly to implement otherwise. | |
| SFTs are used because
they offer managers economic interest or management flexibility. Their use is
entirely subject to the manager's discretion which is driven by a motivation
that might not necessarily be aligned with the interests of the investors. This
could raise principal-agent problems. This agency dilemma may incentivise managers
to act to increase their own profit, before and above considerations linked to
the interests of their investors. | |
| Conflict of interest
may appear in the context of security lending transactions where the fund
manager lends investment assets of the fund for a fee and receives collateral
as a guarantee in case of default of the borrower. It is common practice for the
fund manager to retain part of the fee. This practice creates a conflict
between the interests of the manager and the investors, because as more assets
of the fund are lent out or more of the collateral received as guarantee is of
bad quality, the higher the lending fees that the manager can expect. On the
other hand, high levels of securities lending and collateral of inferior
quality increases investors' exposure to risk. | |
| This conflict may be
worsened when the manager and its counterparty managing the securities lending
program, the agent lender, belong to the same corporate group. In that case,
the fund manager may have little ability to negotiate favourable terms for the
interests of the fund investors, as it will be confronted with a parent or
sister entity that has controlling power over the management company as well
(i.e. a banking entity). TRS also involve possible conflict of interests when
they are concluded on an intra-group basis. A conflict exists because the
banking counterparty has an interest in posting collateral of lower quality as
a way to remove these assets from its balance sheet in order to avoid
regulatory requirements. | |
| Conflicts of interests
are inherent between funds’ managers and funds’ investors but are more likely
to occur in the relative opacity that surrounds the use of SFTs. Especially
fund investors are insufficiently informed about the existence of this
financing tool or the extent of assets that are encumbered by SFT transactions.
The relevant sectorial legislation, UCITS and AIFM directives, do not treat
SFTs alike traditional investments of the fund. But like the primary
investments of the funds, SFTs change the risk profile of the fund and will
often change the fund's investment profile. These changes constitute material
information that is needed to assess the risk and reward profile of the fund.
However, this information is not properly disclosed to investors or at least
not with the sufficient degree of granularity. Fund investors, even the
institutional investors like the insurance groups or the pension funds, have
therefore little means of assessing whether these transactions are in their
interests or not. | |
| Driver 3:
Rehypothecation creates risks for clients and for engaging counterparties | |
| For the purpose of this report,
“rehypothecation” is defined as any pre-default use of assets collateral by the
collateral taker for their own purposes. Rehypothecation is used in bilateral
transactions between commercial market participants (i.e. dynamic
rehypothecation) and between intermediaries and their clients (i.e. static
rehypothecation). When the intermediary or the counterparty exercises its
rehypothecation right, the ownership right is replaced with a contractual right
to the return of equivalent securities. This is not protected as MiFID
only protects a client's ownership rights. Thus, rehypothecation works until
bankruptcy; if an intermediary defaults, a client with a contractual claim is
an unsecured creditor, whose assets are tied to the insolvency estate and they
have to line up with other unsecured creditors. | |
| Static rehypothecation has declined since
Lehman’s collapse as clients demanded segregation of their securities from the
ones owned by their intermediaries or limited the amount of securities that
intermediaries could take as collateral. Data from
August to November 2008 shows a sudden drop in rehypothecable assets at Morgan
Stanley (fall of 69 %), Merrill Lynch (51 %) and Goldman Sachs (30 %).[258] However, anecdotal evidence indicates a
trend reversing its decline as confidence returns that governments will not
allow another major intermediary to fail. | |
| There are also drivers incentivising
dynamic rehypothecation of collateral received from counterparties. In a survey,
76% of respondents agreed that entering or expanding rehypothecation is a key
lever to increase trading revenues related to collateral utilisation in the
context of collateral scarcity.[259] But too much rehypothecation (whether static or dynamic) has the
potential to threaten financial stability.
Rehypothecation allows securities collateral to be used to create multiple
obligations that interconnect different parties. The resulting obligations
amount to a multiple of the value of the securities, creating concerns as the
chains are opaque and hidden from participants and regulators. Maturity and
liquidity mismatches allow for hidden leverage and risks to build that increase
as the chain lengthens and more deals are secured using the same collateral.[260] In contrast, overall available collateral has declined post-Lehman
and the length of the collateral chains has also shortened.[261] | |
| The opacity and legal certainty as to a
legal position can undermine confidence in counterparties and magnify a
financial crisis. These problems are compounded by the fragmentation and
barriers posed by diverging legal frameworks in the internal market.
Rehypothecation can deprive clients of their investment and prevent counterparties
from exercising rights attached to securities. This is even truer in an
internal market context as clients may be unaware of the consequences of
rehypothecation. | |
| Problem 1: Regulatory authorities are
unable to effectively monitor the use of SFTs | |
| Regulatory authorities
have experienced difficulties in monitoring, in a timely and granular manner,
the developments in securities financing markets and the relevant risks. These
markets are complex, evolve rapidly and involve a variety of participants.
Participants range from regulated credit institutions to insurance companies,
broker-dealers, asset managers and pension administrators. The recent financial
crisis showed that securities financing markets are vulnerable to bank-like
runs and fire sales of the underlying collateral, especially when the value of
the assets is decreasing (e.g. 2008). Moreover, the assumption that securities
financing is always robust even in stressed market conditions proved to be
flawed as this led to the formation of interconnections among markets and
market participants and the propagation of contagion. | |
| Since SFTs are
structured in a variety of ways, it can be difficult to identify the real risks
individual market participants incur or pose to financial stability. According
to the FSB, the lack of appropriate market transparency left regulatory
authorities repeatedly dealing with relatively late-stage market developments
that sparked the transmission of systemic risk during the financial crisis.
Authorities had a limited overview of the maturity, liquidity and credit risk
transformation taking place through SFTs. It was very difficult for them to
detect the accumulation of risks and anticipate the consequences of the failure
of a systemically important player such as Lehman Brothers International. | |
| In general, SFTs
provide funding and thus liquidity to financial markets. Consequently, some of
the inherent risks of repos and securities lending transactions are similar to
the risks of bank intermediation. As many shadow banking entities actively
participate in SFTs markets, while this activity is not apparent to regulatory
authorities, SFTs can contribute to the build-up of leverage and lead to
significant systemic risks. For example, SFTs can cause significant maturity
and liquidity transformation to take place outside the regulated banking
system. This happens when a non-bank is financing long-term assets with
short-term SFTs or collateralising less liquid assets in order to obtain liquid
funding. In stressed market conditions, the risks related to maturity and
liquidity transformation can lead to the default of shadow banking entities,
which in turn can negatively impact the banking sector. | |
| In the run-up to the
crisis, leverage in securities financing markets was increased because of the
low levels of collateralisation (i.e. no or low haircut requirements) combined
with often inadequate valuation of the underlying collateral.[262] However, after the outbreak of the crisis, market participants
started to require higher amounts of collateral given the falling prices of the
collateralised assets and funding was withdrawn from the market. Once the value
of collateral decreases, SFTs that rely on this collateral may no longer be
sustainable and may need to be unwound quickly. Thus, SFTs led to a brusque
deleveraging and put additional pressure on leveraged credit institutions
relying on SFTs markets. SFTs can further amplify systemic risk through the
interconnectedness between financial institutions, especially between banks and
shadow banks. | |
| The dynamics of SFTs
markets can be impacted by significant risks of fire sales i.e. selling of the
collateral received by the borrower following its default. Moreover, fire sales
have a pro-cyclical effect on market prices in case of distressed market
conditions as they further exacerbate the downward trend. Many of these risks
can significantly impact asset quality, counterparty credit risk and the
availability of funding in securities financing markets, thus impacting the
activities of the regulated banking sectors. | |
| Problem 2: SFTs are used at the detriment
of the investor | |
| In an investment fund,
investors expect to be exposed to traditional market risk linked to the
investment of the fund. The gains or losses that investors realize are expected
to be generated by the investment policy that is pursued in accordance with the
stated investment strategy of the fund as communicated to and agreed with the
investors. SFTs, however, expose the investors to counterparty risk, leverage
and liquidity risk that are not part of the stated investment strategy of the
fund. | |
| Should the counterparty
to a SFT default, the fund is fully exposed to the loss, e.g. the collateral
posted with that counterparty or the securities loaned to that counterparty. For
example, when a substantial portion of the assets of a fund have been lent out
to a single counterparty, the default of this counterparty might put in peril
the viability of the fund. It is not uncommon that funds rely on a single counterparty
when managing their entire securities lending program. In this case, the
default of that counterparty may entail severe losses for investors. | |
| In the case that the cash
investments by a fund manager subsequent to a repo transaction cause losses,
the fund investor will bear the losses – which will manifest themselves in a lower
performance of the fund. In addition, as SFTs encumber the liquidity of the
fund, investors might not always be able to redeem their investments as promised
in the funds redemption policies. Fund managers may be forced to suspend
redemptions for the period necessary to unwind the SFT transaction. It has been
demonstrated that some funds may encumber up to 100% of their Net Asset Value
in such transactions[263], thus undermining their liquidity. According to a study on major providers
of exchange traded funds (ETF, a type of "listed" investment fund),
25% of ETFs can have more than 50% of their assets loaned out and 3% had, in
2011, on average more than 90% of their assets on loan. | |
| Securities lending generates
additional revenues for the fund through the fee that is earned. These revenues
are not always distributed back to fund investors and may be used at the sole
discretion of the fund manager. According to the above study realized on
European ETFs, the portion of revenues returned to the fund could range from
45% to 70% of gross revenue, with the fund manager and the securities lending
agent retaining the balance. Only a few fund managers return 100% of the net
revenue. The agent lenders are charging fees amounting to 10% to 40% of the
gross revenue. When the fund performs securities lending activities, the
investor bears 100% of the risks related to these activities but receives only
a fraction of the return that is generated. | |
| Problem 3: Rehypothecation shifts the
legal and economic risks in the market | |
| Collateral scarcity and the need
for funding liquidity is encouraging rehypothecation of assets instead of
simply keeping collateral as insurance against a default. Although the
increased use of rehypothecation eases this scarcity, it shifts the legal and
economic risks in an already complex financial system from regulated sectors to
shadow banking by involving non-financial institutions through repos and
securities lending. These risks centre on the difficulty of identifying who is
exposed to whom. The failures of Lehman Brothers and Bear Stearns also revealed
the risk of runs by investors on large intermediaries due to asset protection
concerns about the safety of their property. | |
| This increased reliance on
rehypothecation of collateral can contribute to systemic risk, since in times
of market stress it motivates counterparties to withdraw their assets if they
fear the insolvency of their counterparty or intermediary - events that
significantly contributed to the failures of Lehman and Bear Stearns[264].
This is inter alia since there is the lack of contractual transparency of
rehypothecation activities. When assets are rehypothecated, the collateral
provider's ownership rights are weakened so that they have only a claim for
equivalent securities to be returned by the collateral taker. The failure of a
major intermediary caused by a run can then set off a domino effect across the
financial system where highly interconnected counterparties are unable to
mitigate their exposures to each other or are unable to access the securities
they need to secure funding because they are trapped in the insolvent estates
of failed intermediaries. Mounting distrust between investors also causes
sudden deleveraging as the liquidity given by churn disappears. | |
| Rehypothecation can be seen as a developing
threat that will become a major problem again if it remains unaddressed.
Despite the dangers demonstrated by Lehman and MF Global, short-term incentives
and procylicality are increasing again, heightening the risk that it could
trigger another crisis. The extension of funding liquidity that it gives to the
market is dependent on confidence and susceptible to sudden deleveraging with
consequences for the real economy. | |
| 4. Analysis of subsidiarity | |
| Based on the
nature of the problems outlined in the above analysis, several major
justifications that meet the principle of subsidiarity for action at the EU
level become apparent. The majority of SFTs as well as rehypothecation
activities are performed on a cross-border basis between entities that often do
not have their seats in the same jurisdiction and involve assets and currencies
issued in different jurisdictions. Acting at the European level is the minimum
to cover SFTs to the greatest extent possible and to allow regulatory
authorities at national and EU level to have a comprehensive overview of the
SFTs markets across the entire EU. The effectiveness of remedies implemented in
an autonomous and uncoordinated way by individual Member States would likely be
very low as such remedies would be able to capture just a portion of the
market. Furthermore, given the systemic impact of the problems, uncoordinated
action may even prove counterproductive because of the risk of data
fragmentation and incoherence. Only aggregated data at the European level can
give the necessary macroeconomic picture that is required to monitor the use of
SFTs. | |
| As regards investment
funds, the European fund industry has an important cross-border dimension. The
share of cross-border assets for the European investment funds industry as a
whole (UCITS and non-UCITS AuM) has risen from 21% in 2001 to 45% in 2012[265]. This means that around one of two investors buy a fund that is not
domiciled in their country of residence. It is therefore important that the
investor protection standards are applied evenly across the EU in order to
ensure that all European investors benefit from the needed transparency over
the use of SFTs.. | |
| 5.
objectives | |
| The general objectives
are to: | |
| (1) Ensure financial
stability in the internal market by preventing the build-up of systemic risks; | |
| (2) Increase the
protection of investors and clients. | |
| Reaching these general
objectives requires the realisation of the following more specific policy
objectives: | |
| (1) Ensure that the
systemic risks of the SFT markets are adequately monitored; | |
| (2) Ensure that SFTs
profit to investors first; | |
| (3) Limit the potential
risks for clients and counterparties linked to rehypothecation. | |
| The specific objectives
listed above require the attainment of the following operational objective: | |
| (1) Make frequent and granular
information on SFT markets available to regulatory authorities; | |
| (2) Increase the
transparency toward the fund investors over the use of SFTs and other financing
structures; | |
| (3) Reduce the uncertainty
about the extent to which assets have been rehypothecated. | |
| 6. Policy options | |
| In order to meet the
first operational objective, the Commission’s services have analysed different
policy options, such as relying on existing initiatives, improving the scope
and frequency of existing market surveys, enhancing regulatory reporting and
requiring a SFT reporting to a trade repository. | |
| In order to meet the second operational objective, the Commission’s
services have analysed policy options related to the implementation of
disclosure requirements in various periodical reports that UCITS and AIFs have
to produce as well as in the pre-contractual documents such as the fund
prospectus. | |
| In order to meet the
third operational objective, the Commission’s services have analysed four
policy options, ranging from no action at EU level, to contractual transparency
and to the introduction of a rehypothecation cap. | |
| 7.
Stakeholder
consultation | |
| The FSB conducted a
public consultation[266] in November 2012 on relevant problems in SFT markets, inter alia,
the lack of transparency. There was broad support for more transparency in the
securities lending and repo markets, while many respondents suggested taking
into account existing reporting requirements and other available market data.
The contributions received in response to the Commission's public consultation
on shadow banking and the European Parliament's own-initiative-report also
highlight the importance of appropriate measures in this area.[267] | |
| A public consultation
on different UCITS issues was conducted in 2012 and stakeholders were notably
asked about the need to increase the transparency requirements. Many industry
stakeholders felt that for UCITS funds the transparency issues are adequately
addressed by the ESMA guidelines. Many however, also stated that a codification
of such transparency rules would facilitate their harmonized implementation. | |
| 8.
analysis of impact of different policy options | |
| Operational
objective 1: options aimed at reporting frequent and granular information to
regulatory authorities | |
| Option 1.1 Rely on
existing initiatives at national level or from the industry side (no action) | |
| This option relies on
existing initiatives as well as possible actions at national or industry level.
Although some initiatives such as ICMA’s semi-annual survey on EU repo market,
the ECB’s annual euro money market survey or the survey on credit terms and
conditions in euro-denominated securities financing markets by the Committee on
the Global Financial System and the ESCB, have led to improved SFT
transparency, there are still important gaps in the reported indicators and
data continuity. These gaps have been identified by the FSB and ESRB, both of
which call for a more comprehensive data collection on SFTs. | |
| Indeed, the current
initiatives are not broad enough in their coverage to allow for effective
monitoring of the systemic risk linked to SFTs: ICMA's survey covers around 61
institutions in 15 European countries, the ECB's survey mainly covers
transactions by a constant panel of 104 banks in euro denominated interbank
repos. Because of their semi-annual or annual frequency, existing surveys lack
continuous data and, in certain circumstances, the data may represent an
inaccurate or even misleading source of information (e.g. outdated data,
"window-dressing" discrepancies). Moreover, participation in the
surveys is voluntary and there are data protection issues with certain
indicators (e.g. counterparty identity) which prevent their reporting. Given
these critical gaps in the data and as seen during the recent crisis,
regulators' ability to understand the risks and react in stressed market
conditions is significantly undermined. | |
| Option 1.2 Improve
the scope and frequency of existing market surveys | |
| On the benefits side,
this option would permit to close, at least partially, some of the gaps in the
scope of the existing surveys, thus slightly increasing the transparency
compared to Option 1.1. It may also increase the standardisation and
streamlining of the processes used by market participants as more actors and
transactions will be covered. | |
| Using market surveys,
however, makes it difficult to ensure that all relevant participants report the
data needed, thus not achieving a sufficient level of transparency of the
market activity. As market surveys are essentially periodic, they do not
provide a continuous flow of information and increasing their frequency will
ultimately increase the reporting costs for participating firms. Although the
market surveys could be adapted from one period to another to include new
indicators, the successive adaptations will further raise reporting costs and
affect comparability of data. Finally, the use of improved market surveys will
still allow for some "window dressing" and will not provide
regulatory authorities with up-to-date data. Therefore, market survey cannot be
used for frequent and timely monitoring purposes. | |
| Option 1.3 Enhance
regulatory reporting | |
| Regulatory reporting is
a key tool to monitor regulated entities' activities and assess the level of
risks linked to SFTs (see also section 3 on regulatory context). This option
has a number of benefits compared to Option 1.1 and Option 1.2. It will solve
some of the existing shortcomings related to the lack of continuous data, the
data protection issues and the voluntary nature of market surveys since a
frequent standardised reporting would be required by law. This option, however,
will only cover supervised entities and the extent of its scope will mostly
depend on the ability of regulatory authorities to obtain information from
non-supervised entities. If not all market participants are captured, the
reporting coverage will be incomplete. In any case, the market coverage would
be higher than with market surveys. This means that the overall level of
transparency would be significantly improved compared to Options 1.1 and 1.2. | |
| There are, however, a
number of disadvantages as this option will lead to the fragmentation of
reported information among regulatory authorities. This problem would be
particularly acute for market regulators and systemic risk regulators, but could
also prove significant for prudential regulators of groups of financial
entities active in multiple jurisdictions. In addition, regulatory authorities
will need to increase their resources to deal with the reported information
which would mean a cost increase for the authorities concerned. Moreover,
regulated firms will also face increased reporting costs due to the required
granularity and higher frequency of the data reporting but these costs are
expected to decrease over time because of on-going automation and
standardisation of reporting processes and templates. | |
| Option 1.4 Require
SFTs reporting to trade repositories | |
| The reporting to trade
repositories (TRs) will lead to a substantial increase in the transparency of
securities financing markets. Since the information will be collected in a
central database, this will facilitate regulators' access to the data and avoid
the need to compile individual information from different regulators. It would
allow for complete and timely information to be reported (e.g. principal
amount, currency, type and value of collateral, the repo rate or lending fee,
counterparty, haircut, value date, maturity date), therefore making it possible
for regulators to perform a well-timed comprehensive monitoring of the market
developments, which is not the case for Options 1.1, 1.2 and 1.3. This option
will completely close the current data gaps and the reporting obligation will
cover all market participants, regulated or unregulated. The periodic
publication of aggregate data by TRs can be an additional benefit as it will
improve the overall data available to investors but also for research projects. | |
| There could be one-off
investment costs of creating SFTs trade repositories which could be owned and
run either by private entities (e.g. existing TRs) or public bodies. These costs
could be, however, minimised by using existing structures such as registered
TRs, matching facilities, tri-party agents, central counterparties. In terms of
operating costs, market participants will incur the cost of handling the SFTs
reporting processes to the TRs as well as the fees to the TRs for services
provided. This option will therefore incur higher total costs than the ones
under Options 1.1 and 1.2 but costs can be reduced to a certain extent by leveraging
experience and facilities created through the existing obligation to report
derivative instruments to TRs under EMIR. The experience from derivatives
reporting shows that the fees might not be particularly high and mainly depend
on the biggest firms which will report large numbers of transactions to TRs,
thus allowing for economies of scale. It is expected that the Member States
with the biggest SFTs markets will be more affected by these measures but they
will benefit, as well as the entire Union, from greater monitoring of the
systemic risks linked to SFTs markets. This option will however allow for less
flexibility to modify the reporting content and it will incur higher costs than
in options 1.1 and 1.2. | |
| The overall costs of
this measure can be mitigated by allowing smaller market participants to
delegate the reporting to their counterparties or third parties. In most cases
the delegation will be to bigger institutions with whom small market
participants usually have SFTs, and who are better placed (e.g. scale
economies) to bear the reporting costs. In order to allow for an accurate
reporting, a certain level of standardisation will also be needed, which can be
provided by level 2 measures, building on existing initiatives and studies (e.g.
EMIR, FSB). | |
| Option 1.5 Require
reporting to trade repositories or, if that is not possible, directly to
regulators | |
| This option takes into
account the possibility that a trade repository may not exist or, in case it
does exist, that it may either not be willing or not be able to accept the
information reported by the counterparties. This means that, if it is
impossible to report SFTs to a trade repository, then the counterparties should
report them directly to the relevant regulator. | |
| The cost-benefit
analysis for this option is largely identical to the one for the previous
option on requiring SFTs reporting to TRs. There will, however, be additional
costs for regulators (e.g. ESMA, national competent authorities) to handle the
information reported but, at the same time, market participants would not have to
pay fees to the services of the TRs. The key additional benefit of this option
is that it ensures the effective reporting of SFTs in any event, thus
guaranteeing that regulators acquire a comprehensive picture of SFTs markets. | |
| Summary | |
| The preferred policy
option that has been chosen is to request that all SFTs are reported to a trade
repository, or, if that is not possible, directly to regulators. This option is
the most efficient in order to allow early detection of risks building up in
the SFT market as it allows gathering data with a higher level of granularity
and frequency. | |
| This option is
therefore the most indicated to answer to the objective of this regulation,
i.e. ensuring financial stability by preventing the build-up of systemic risks
in SFT markets. | |
| Each option is rated between "---" (very negative), ≈
(neutral) and "+++" (very positive) based on the analysis in the
previous sections. The benefits are, however, not quantified in monetary terms,
as this is not possible on an ex ante basis. The costs should be understood in
a broad sense, not only as compliance costs but also as all the other negative
impacts on stakeholders and on the market. This is why we have assessed the
options based on the respective ratio of costs to benefits in relative terms.
The assessment highlights the policy options which are best placed to reach the
related objectives. | |
| Policy options || Impact on stakeholders || Effectiveness || Efficiency | |
| 1.1 No action || 0 || 0 || 0 | |
| 1.2 Improve the scope and frequency of existing market surveys || (+) Some reporting gaps of existing surveys could be closed, providing regulatory authorities with more market information (+) Market participants would not be subjected to reporting obligations || (-) No continuous flow of information. (--) Sufficient coverage (in terms of number/significance of market participants) cannot be guaranteed (-) Scope for 'window dressing'. (-) Risk of insufficient standardisation || (--) Regulatory authorities will not avail of comprehensive up-to-date data matching their requirements for frequent and timely monitoring | |
| 1.3 Enhance regulatory reporting || (++) Regulatory authorities would obtain continuous data from a wider pool of market participants (-) Increased costs for regulatory authorities (-) (Only) regulated entities have to provide information and bear the reporting costs. || (++) Frequent and standardised data flow (-) Coverage limited to supervised entities. (-) Fragmentation of information among regulatory authorities. || (+) Improved data availability counterbalanced by limitations of coverage of entities, fragmentation of data among authorities and cost increases for authorities and regulated firms. | |
| 1.4 Require SFTs reporting to trade repositories || (+++) Regulatory authorities obtain complete and timely market information (--) Market participants have to bear reporting costs. (+) Investors and other stakeholders benefit from the periodic publication of aggregate data || (+++) Complete closure of current data gaps (+) Easy access for regulators || (++) Regulators are enabled to perform well-timed comprehensive market monitoring; there are possibilities to minimise investment costs and reporting costs for small market participants | |
| 1.5 Require reporting to trade repositories or, if that is not possible, directly to regulators || (+++) Impact as above in 1.4, but (-) where reporting to trade repositories would not be possible, additional costs for regulators from handling the information reported directly to them. || (+++) As above in 1.4, additionally: (+++) Effective reporting ensured, where reporting to trade repository is not possible || (+++) As above in 1.4., with the additional key benefit that effective reporting is ensured under all circumstances. | |
| Operational
objective 2: options aimed at increasing the transparency toward fund investors | |
| Option 2.1 Rely on existing transparency
requirements[268] | |
| Under this option, the
initiative would be left to National Competent Authorities (NCA) of the Member
States and to the European Securities and Markets Authority (ESMA) to create
transparency in the SFT area. NCAs under the umbrella of ESMA have already
taken action in this field with the entry into force of guidelines on UCITS
funds. Those guidelines require the manager to publish in the UCITS annual
report information on the exposures; identity of counterparties as well as type
and amount of collateral for SFTs. In addition managers are required to publish
the revenues and the costs related to the use of securities lending and repos.
These reporting obligations come on top of what is required by the UCITS
directive, notably by the requirements contained in the annexes of the
directive. | |
| The reporting
requirements toward investors are much less developed in the AIFMD context. The
directive itself contains few specifications on SFTs whereas no additional
guidelines have been developed up to date. Under the AIFMD the competent
authorities have access to a larger amount of information on SFTs than
investors. | |
| Impact on
investors: The existing UCITS requirements give
some general information to the investors but are not granular enough to be
able to give a detailed picture. For example the investor has no information on
the amount of securities subject to SFTs as a proportion of the fund’s Assets
under Management (AuM). As such investors are not able to assess the degree of
involvement of the fund in this activity and therefore cannot judge the degree
of risk that this fund entails. Other information is missing such as
concentration data on the collateral or data on the re-use and re-hypothecation
of the collateral. The revenue and costs of those transactions are disclosed
indistinctively as a gross amount; it is therefore impossible to analyse the
breakdown for each type of activity and the source of the costs. The
comparability between different investment funds is therefore not optimal. | |
| This issue is further
reinforced by the absence of SFT reporting for AIFs. The AIFM directive
contains several data that fund managers should disclose to their investors but
almost none of them cover the use of SFTs. There is a risk that national
legislations diverge in that respect and thus that investor protection
standards diverge between Member States. | |
| Impact on
managers: The absence of an EU coordinated
approach entails the risks that some Member States decide to implement SFT
reporting requirements individually and thus in a diverging manner. Fund
managers operating cross-border would then need to apply different rules which
would potentially increase their reporting costs. More generally ESMA
guidelines do not benefit from the same enforcement quality as primary EU
legislation because Member States have the option not to apply ESMA guidelines. | |
| The respondents to the UCITS consultation supported the initiative
taken by ESMA to increase the transparency of SFTs. The majority of them, being
from the industry side or the public side, considers that the ESMA guidelines
are in this regard sufficient to address the issue of transparency. Other
respondents consider that some legal codification (e.g. through a legal
initiative or technical standards) would be necessary in order to ensure a
harmonized implementation in the EU. | |
| Option 2.2
Incorporate SFTs and equivalent financing structures reporting into existing ex-post
documentation, such as periodical reports required under the UCITS directive or
the AIFMD | |
| According to the UCITS
Directive, UCITS funds have to produce annual reports containing different
financial statements as well as information on the different investments
undertaken by the fund. UCITS funds must also produce half-yearly reports
containing information on assets and liabilities and more generally on the
composition of its portfolio. According to the AIFM Directive, information on
AIFs should be disclosed to investors at least on an annual basis or more
frequently according to the fund rules. The existing UCITS and AIF reports
already do provide some information on the use of SFTs and could be easily used
to incorporate also more detailed regular reporting on the use of SFTs. The
data to be reported would correspond to the list proposed by the FSB, such as
global data, concentration data, counterparty disclosure or policy on
acceptable types of collateral. To increase the awareness of the investor to
the revenue that is generated by the SFT and equivalent activity, the reports
will have to include detailed information on the costs and returns. In order to
ensure complete information of the investors, these information requirements
should cover financing structures equivalent to SFTs. | |
| Impact on
investors: Ex-post documentation gives insight
to the investors on the transactions that the fund has been involved in over
the previous reporting period. It is a means for the investors to check the
performance of the fund and other indicators regarding the risks or costs. More
generally, it gives the possibility to verify that the fund's investment
strategy has evolved as announced in the prospectus. Including more detailed
data on SFTs, presented in a structured way will enable investors to gain a
more comprehensive understanding of these transactions and in particular their
implications on the fund risk and reward profile. This will enable the
investors to understand whether these transactions create a value added to them
and will facilitate the comparison with other similar investment funds.
Investors will also be able to identify the proportion of SFT revenue that is
returned to the fund and assess the amount of costs related to this activity.
In practice it is to be expected that the institutional investors will most
probably be interested to have access to this information whereas doubts exist
regarding the capabilities of retail investors to grasp the significance of
this information. This information could for example be used by institutional
investors such as pension funds or insurance companies as part of their due diligence
activity when selecting investment funds. These investors could then screen and
compare the different investment fund targets at the light of new criteria
linked to the SFT activity. | |
| Impact on managers: SFTs are currently labelled by fund managers as an ancillary
activity. SFT are not revealed in detailed mostly to avoid disclosing their
inherent risks (default of a SFT counterparty, insufficient collateral) but
also the pecuniary benefit that these transactions entail for the manager. By
introducing enhanced reporting requirements, SFT would become more visible and
would de facto be assimilated to the fund's investment strategy. Managers will
have to incur some costs for computing this information and passing it on to
the investors. Some stakeholders that responded to the FSB consultation[269] warned that the
additional disclosure will increase the reporting costs which ultimately will
increase the fees that investors pay. The costs should not however be
overestimated since the additional data will be reported through existing UCITS
and AIF reports. In addition part of those data already has to be disclosed
under existing rules applying to UCITS and AIFs. | |
| For the funds that are
not active in SFTs, the enhanced reporting requirements will have no impacts,
whereas the reporting costs will generally increase with the degree of use of
SFTs. However, funds that use SFTs very actively usually do so in a standardised
manner – in the case of securities lending with agent lenders – for whom
reporting is a relatively straightforward task; accordingly recourse to agent
lenders will decrease the cost of providing this information. The disclosure of
revenue and costs attached to the SFT activity may have an influence on the
manager's remuneration. The transparency to investors might increase the
pressure on the manager to rebate a larger part of the revenue from SFTs to the
investors. | |
| Generally, the industry stakeholders that responded to the FSB
consultation and to the Commission consultation on UCITS issues supported the
goal of increased disclosure to fund investors. Some stakeholders expressed
that transparency standard of SFTs should be harmonised upwards in order to
inform investors in an efficient, standardised and comparable way. Within the
UCITS context, many stakeholders expressed that there would be merit in making
the ESMA guideline requirements mandatory to facilitate their harmonized
implementation. | |
| The FSB consultation respondents questioned the usefulness of
detailed disclosure on SFTs as they argued that such detailed information may
rather confuse than inform retail investors. It should however be recalled that
UCITS funds are mostly purchased by institutional investors. It is estimated
that around 90% of the UCITS funds AuM are held by institutional investors.
Those professional investors have the capability to understand the impacts
(such as on the counterparty risk or the liquidity risk) of using SFTs and as
indicated previously this new information will be useful in selecting a fund. | |
| In the case of UCITS funds, they did not see the need of such
detailed information as SFTs cannot be used to increase fund leverage due to
regulatory limitations. Even though the UCITS directive and the ESMA guidelines
pose certain limits to the leverage of UCITS funds, there are other major risks
created by these measures – in particular counterparty risk - that make
disclosure of such measures necessary. | |
| Finally the argument that disclosing SFT information risks providing
confidential information to competitors about the positions of the fund has
little merit since investment funds are already obliged to disclose on a
regular basis all investments and positions they take directly in the market. | |
| Option 2.3 Implement
SFT and equivalent financing structures reporting through ex-ante documentation,
in the prospectus or equivalent AIF report according to the article 23 of the
AIFM directive | |
| Every investment fund,
being a UCITS fund or an AIF, is required to produce a prospectus setting out
the fund rules and the rules of incorporation. The fund rules usually contain
all the information related to the investment strategy that the fund intends to
pursue. Those fund rules represent the “contractual obligation” of the fund
manager towards the investor. Once the fund is set-up according to those rules,
the manager is not allowed to deviate from them. The supervisory authorities,
with the help of the depositary of the fund, are responsible to control that
managers are acting according to the predefined rules. Under this option, managers
would be required to also include the use of SFT as part of the investment
strategy they intend to pursue. This could include for example information on
the total amount of assets that can be on loan at any point in time, the
reasons and goals behind the use of SFTs, the policy of the manager regarding
the valuation and management of collateral that is exchanged as part of an SFT,
including its re-use or re-investment, the policy regarding the quality and
identity of the counterparties and how the revenues and the costs related to
those transactions will be shared. | |
| Impact on
investors: Investors would have knowledge,
prior to their investment, on whether SFTs form part of the investment strategy
pursued by a fund. They will be able to measure the expected risk and reward
profile linked to this activity. Their ability to compare the investment
proposition of different investment funds will increase. In addition, investors
will receive increased assurance that managers will not use to a greater extent
than announced in the fund rules. In the case that managers lose money because
their SFT transactions exceed the pre-announced limits, investors would be able
to invoke the manager's liability for breach of contract. Enhanced disclosure
of SFT will also mitigate potential conflict of interests between the fund
manager and the fund investors because investors will be reluctant to invest in
funds where their interests are neglected. | |
| Impact on
managers: Stating in the fund rules the planned
activity related to SFTs will restrict the manager’s flexibility in using those
techniques. Managers will be bound by the predefined strategy enacted in the
fund rules. For example they could be limited in their use of repo which could
in turn have an effect on the degree of leverage that managers are permitted to
use. In practice if the manager wants to change the rules on the use of SFTs,
the manager will be first obliged to seek the agreement of the investors.
Therefore the manager will no longer have the entire discretion over the use of
SFTs. Since the prospectus or other equivalent pre-contractual documents have
to be produced only once at the creation of the fund, the introduction of SFT
information will not increase the reporting costs. The costs of setting up a
prospectus could be slightly increased but this should be seen in conjunction
with all the other information that has to figure in the document. As such the
cost impacts will be marginal. | |
| Generally, the industry stakeholders felt that fund prospectus
should inform the investor in the most objective, transparent and impartial
way. A major industry association also suggested that a standard template for
securities lending disclosures should be developed for UCITS to incorporate
into the prospectus and with a requirement that anything outside of these
parameters should be disclosed separately. | |
| Option 2.4 Implement
specific reporting requirements for retail investors | |
| Under the Packaged
Retail Investment Products (PRIPS) initiative[270], fund managers will
have to produce a short document aimed at retail investors only. Irrespective
of being a structured product, insurance product or an investment fund,
investors will have the same information about the products. The information
should be presented in a clear, simple and comparable manner so that all retail
investors could understand it. Under this option the Key Information Document
(KID) for investment funds would contain additional information on the use of
SFTs. | |
| Impact on
investors: Retail investors would have access
to the SFT information through a pre-contractual document that is easy to
access and to read. This would raise their awareness that SFTs exist and that
they increase the riskiness of the fund. It would however be challenging to
present the main risk and reward profile linked to SFTs in a KID that is
supposed not to be longer than 2-3 pages and that should already include all
the other information related to the fund. The information would need to be
reported in a very concise way that would not help the retail investor to
understand it. Moreover it could end up being misleading should the information
be reported in a too short manner. In addition there is a risk that the core
objective of the PRIPS initiative to make all packaged investment products
comparable is not reached because SFT reporting would concern investment funds
only and not structured products or life insurance investment products. | |
| Impact on
managers: to the extent that managers already
have to produce a KID, this should not create major impacts. Because the KID is
equivalent to a pre-contractual document such as the prospectus, the impacts on
the manager’s flexibility would be the same as under option 2.3. | |
| The option to introduce SFT disclosure in the KID was not directly
tested in the different consultations but some stakeholders expressed doubts as
to the usefulness of SFT information for retail investors. The interest of
retail investors to know the details of the SFT activity performed by the
investment funds is also put into question. It is therefore doubtful that a KID
contained SFT information would be of any added value. | |
| Summary | |
| Policy options || Impact on stakeholders || Effectiveness || Efficiency | |
| 2.1 No action || 0 || 0 || 0 | |
| 2.2 Implement SFT reporting through ex-post documentation || (+) investors benefit from full transparency (-) managers must incur disclosing costs || (+) transparency increases the protection of the investor (+) coherence with FSB || (++) increased transparency at little cost for the manager | |
| 2.3 Implement SFT reporting through ex-ante documentation || (+) investors benefit from pre-contractual disclosure (--) managers become fully accountable over the use of SFTs || (+) investors benefit from contractual protection in the case of misuse of SFTs (+) coherence with FSB || (+) increased protection at the price of making SFT a normal activity for the manager | |
| 2.4 Implement specific reporting requirements for retail investors || (+) retail investors benefit from preeminent SFT information (-) retail investors might lack interest and understanding (≈) little impact in terms of cost for the manager || (-) risk of unclear SFT information (-) risk of undermining comparability of the KID || (--) risk of confusion not compensated by increased benefit for retail investors | |
| Option 1 cannot be
retained as it would not address the problem of conflict of interest and
unequal treatment of investors. Investors will continue to have less
information than the manager, to have no influence on the fund’s activity and
to be neglected in revenue sharing arrangements. | |
| Option 2 has the merit to
disclose all the SFT activity over the last reporting period so that investors
can follow it. Such information will increase their awareness of the use of
SFTs. Under option 3, investors have pre-contractual information on the use of
SFT so that they can choose each fund according to its stating strategy.
Options 2 and 3 are not superior or inferior to each other but are
complementary. Option 2 is important for on-going transparency whereas option 3
is important for pre-contractual transparency. As such both options should be
retained. | |
| Option 4 has the merit
to recognize that retail investors need a particular treatment in the access to
the information. But the KID is not the right place to address this concern
because it risks undermining the objective to make the KID simple and
comparable between all packaged investment products. Moreover it is doubtful
that retail investors will have any interest or understanding for this new
information. As such this option cannot be retained. | |
| In order to ensure that
investors have sufficient information over the use of SFTs, it is therefore
necessary to require disclosure before the investors invest in the fund as well
as after the SFTs have been used. The use of SFT, its extent and the eligible
counterparties should be identified in both the periodical reports and in the
fund's prospectus or equivalent AIF report according to the article 23 of the
AIFMD. These information requirements should apply to financing structures
equivalent to SFTs in order to ensure complete information of the investors. | |
| Operational
objective 3: option aimed at reducing the uncertainty about the extent to which assets have been
rehypothecated | |
| Option 3.1 No action | |
| Under this option no
specific rules on rehypothecation would be introduced. In this case, the
systemic risks related to the uncertainty about the extent to which assets have
been rehypothecated would not be fully addressed throughout the EU and the
contractual and operational transparency of such activities would remain low,
effectively preventing counterparties from properly managing their risk
exposure. This implies that when the same securities are being rehypothecated
several times, the failure of a counterparty could lead to a race to secure the
collateral by multiple parties, as happened in the Lehman and Bear Stearns
collapses. This option would not achieve minimum harmonisation of
rehypothecation rules within the Union which could allow for better
transparency towards clients and engaged counterparties in their cross-border
activities. | |
| Option 3.2 Oblige
contractual transparency on rehypothecation | |
| This option consists of specific
transparency requirements to be met by contractual agreements on
rehypothecation as well as requiring the prior express consent to
rehypothecation by the counterparty providing collateral. The FSB has developed
a similar policy recommendation on sufficient disclosure to clients in relation
to rehypothecation of assets.[271]
All Member States also support the need for more transparent rehypothecation.[272] | |
| This would fully meet the specific
objective 3 by requiring the prior express consent of the providing
counterparty to the rehypothecation of the financial instruments it has
provided as collateral, ensuring that it is fully aware of the potential risks
involved, in particular in the event of default of the receiving counterparty.
Furthermore, according to this option, prior to the actual rehypothecation the
financial instruments received as collateral have to be transferred to an
account opened in the name of the receiving counterparty, which would also help
prevent a future crisis scenario, where investors are uncertain about their
rights, thus contributing to financial stability. Such rules are consistent
with existing market practice in major securities markets in the EU (e.g.
rehypothecation undertaken by prime brokers based in the UK). | |
| The rule concerning the providing counterparty's express consent to
rehypothecation would be along the lines of Article 19, MiFID Implementing
Directive 2006/73/EC. This approach would be broader than MiFID as it would apply to all counterparties engaging in
rehypothecation. It would also cover the providing counterparty who has only a
mere contractual right to have equivalent securities returned after
rehypothecation ends (MiFID protects only clients' ownership rights). Currently
an investment firm may book the securities as its own on its records and, in
such a case, they would not be covered by the MiFID client asset protection
rules (e.g. rules that impose segregation between the client's and the firm's
assets and require that the investment firm uses securities only with the
client's express consent). In the MiFID review, the Commission proposed to
address this by banning title transfer collateral arrangements with retail clients
for the purpose of securing or covering clients' present or future, actual,
contingent or prospective obligation.[273]
The Alternative Investment Management Association, which represents global
hedge funds community, agrees with a prior consent rule as they want to be able
to authorise counterparties to rehypothecate their assets in some well-defined
circumstances.[274] | |
| In terms of
effectiveness, the proposed option would also ensure
that counterparties are enabled to fully manage their exposure. By clarifying
that express consent is needed for rehypothecation to take place, the proposed
option would prevent non-authorised rehypothecation of assets. The requirement
that financial instruments received as collateral have to be transferred to an
account opened in the name of the receiving counterparty prior to rehypothecation
would supplement the Financial Collateral Directive and
is analogous to the FSB Recommendation 7. This would
not only rebalance the position of collateral providers, but would reduce
systemic risk by preventing excessive rehypothecation and make the rehypothecation
chain transparent, thus contributing to the general objective to ensure
financial stability. | |
| Option 3.3 Introduce
a rehypothecation cap | |
| A cap on the level of rehypothecation would
constitute a clear direct restriction on rehypothecation. Such a cap could be introduced
along the lines of the cap in the US[275]
where a limit on the maximum leverage and the amount of collateral that could
be rehypothecated could be introduced, e.g., intermediaries could only be
allowed to: (1) lend 50% of the purchase price of securities to be deposited as
collateral with the respective intermediary; and (2) to rehypothecate clients’
securities they hold as collateral up to 140% of the value of the client's liabilities
towards the intermediary. | |
| This would
prevent excessive levels of rehypothecation by setting it at a constant level
and, thus, reduce the uncertainty about the extent to which assets have been
rehypothecated . A transparent rehypothecation cap that is constant would, in
addition, allow authorities and regulators to monitor the level of endogenous
liquidity that is generated by market practices. It would also provide a level
playing field within the EU, thus improving the functioning of the Single Market,
and globally, notably with the US. The alignment with the US 140% rule would
close the regulatory gap between the USA and the EU that leaves market
participants the opportunity for arbitrage. For example, when Lehman Brothers
went bankrupt many US hedge funds found themselves with significant exposure to
Lehman Brother International Europe as their prime brokerage agreements were
structured to permit client-asset transfer to the prime brokerage's UK
subsidiary. | |
| In terms of fundamental rights, this option could have a
negative impact on the right to property (Article 17 Charter of
Fundamental Rights), as the rehypothecation cap would also cover collateral
provided under title transfer arrangements. In this situation, the collateral
taker becomes the securities owner for the duration of repo/securities lending
transaction and as such the collateral taker is entitled to dispose of its
ownership right, which the rehypothecation cap would limit. The Alternative
Investment Management Association considers that it would be inappropriate to
introduce harmonised rules which set a limit on rehypothecation. [276]
However, individual rights would have to be considered against the cumulative
impact of the collective behaviour of market participants if a majority engages
in rehypothecation, leading to a build-up of hidden leverage and generating
chains of contagion in the system that can threaten the overall economy. In
these circumstances, it may be justified to impose limits. | |
| This option also has a potential negative macro-economic impact.
Despite the fact that a constant maximum would prevent rehypothecation from
being pro-cyclical and prevent future liquidity bubbles being created by this
market practice, it could lead to a reduction in an important source of
liquidity and funding for financial intermediaries. The reduction of the
liquidity available in the EU financial system in terms of collateral available
from 2007 to 2011 was the result of two different dynamics: (1) a reduction in
high quality collateral due to the EU debt crisis; and (2) a reduction of the
velocity of collateral i.e. the number of times the same collateral has been
reused in the system. A rehypothecation cap could negatively impact the repo
and securities lending markets, which are an important tool for funding,
collateral management and secured lending and could adversely affect economic
growth. Finding a sustainable velocity rate wold require better data on levels
of rehypothecation in the market. In the current absence of this data, retaining
this option would lead to an arbitrary cap being chosen and could impact the
markets and economy disproportionately. Therefore this option should not
be retained at present. | |
| Option 3.4 Introduce
a duty for intermediaries to offer a contractual rehypothecation cap | |
| This option consists of
allowing rehypothecation for assets taken as collateral for the value of the
client's or counterparties actual obligation plus a reasonable haircut
contractually agreed by the parties. This option would not align EU rules with those of the US but it might
give the parties the ability to negotiate a haircut equivalent to the 40% one
used in the US. By prescribing that the parties could not overrule the
obligation to set a cap by contract, transparency around rehypothecation and thus
client asset protection would be enhanced. As discussions with stakeholders have
shown, such contractual rehypothecation arrangements are likely to be
ineffective in reducing the uncertainty of rehypothecation as a contractual
rehypothecation cap is common market practice and usually oscillates between
100% and 150% of client's indebtedness. This option would therefore have a
very limited impact. | |
| Summary | |
| The proposed policy
option is option 3.2, i.e. specific transparency requirements to be met by contractual
agreements on rehypothecation, prior express consent by the counterparty
providing collateral and a requirement to transfer financial instruments
received as collateral to an account opened in the name of the receiving
counterparty. | |
| This approach is the
most efficient and proportionate in order to make counterparties fully aware of
the potential risk exposure of their collateralised assets, to enable them to
fully manage risk exposure and make efficient use of their assets. This option
is therefore the most appropriate to answer to the objective of this
regulation. | |
| Policy options || Impact on stakeholders || Effectiveness || Efficiency | |
| 3.1 No action || 0 || 0 || 0 | |
| 3.2 Oblige contractual transparency on rehypothecation || (++) Collateral providers are aware of their exposure in case of rehypothecation (++) Counterparties benefit from greater transparency || (+) Consent rule helps prevent non-authorised rehypothecation (+) Transparency enables counterparties to fully manage their risks (+) Coherence with FSB and Financial Collateral Directive || (++) Enhanced protection of collateral provided and limitation of opaque collateral chains. | |
| 3.3 Introduce a rehypothecation cap || (-) Intermediaries' scope for providing collateralised loans and for rehypothecating collateral obtained is limited || (+) A constant cap would effectively limit rehypothecation (+) The regulatory gap with the US would be closed and a level playing field would be provided. (-) The introduction of a cap limits fundamental rights (property rights) (--) The cap could adversely affect macro-economic liquidity and funding, if not set at the right level. || (-) In the absence of reliable data, at present the benefits are outweighed by possible risks to economic growth. | |
| Option 3.4 Introduce a duty for intermediaries to offer a contractual rehypothecation cap || (+) The parties are enabled to negotiate a haircut on collateral || (≈) Effect depends on result of negotiations. || (≈) Very limited impact | |
| 9.
The retained policy options and their impacts | |
| The retained policy options | |
| In order to increase the transparency over
the use of SFTs, a combination of different measures is necessary. | |
| In order to enhance the supervisory
monitoring over the use of SFTs, each counterparty will have to report SFTs to
a trade repository (option 1.5). The use of SFTs raises also questions linked
to investor protection standards. Investors are often unaware of the use that
is made of these techniques and even less of the risks that are created. In
order to increase the awareness of the investors in investment funds, the fund
reporting will have to be enhanced: at the level of the periodic reporting and
at the level of the pre-contractual documents (options 2.2 and 2.3). To
complete the policy toolkit, it is also necessary to implement new rules on rehypothecation.
These new rules should ensure that all counterparties providing collateral have
given their prior express consent to rehypothecation of the financial
instruments concerned and that these financial instruments are transferred to
an account opened in the name of the receiving counterparty before
rehypothecation can take place (option 3). | |
| All retained options taken together will
ensure that the shadow banking activity of using SFTs is properly supervised
and regulated. The SFT practice will not be prohibited nor limited by specific
restrictions but be more transparent. As such the retained options are not
expected to create structural impacts on the SFT market. The retained options
will increase the reporting costs for the counterparties but this increase will
be outweighed by the benefits of having greater transparency for the competent
authorities, clients, investors and society at large. | |
| Impact on SMEs | |
| The requirement to report SFTs to trade
repositories is not expected to have any impact on SMEs as they do not
participate in SFT markets. The indirect costs related to additional reporting
costs for financial companies would be negligible. | |
| The strengthening of the provisions to
better deal with the risks of investment funds will increase investor protection
standards for all investors, including SMEs. SMEs, as retail investors and
other corporates of larger size, may use investment funds to realize certain
placements. Enhancing the transparency requirements could help SMEs to select
investment funds that minimize their use of SFTs and therefore their overall
risk. As such the risks that SMEs face in investing in investment funds could
decrease. | |
| SME-clients of financial intermediaries
will benefit from the rules on express consent and increased transparency to be
met by rehypothecation agreements, which increase the protection of the
financial instruments they may provide as collateral. | |
| Social impact | |
| To the extent that the proposed policies
will help contain the effects of future financial crises on the real economy,
they will also help reduce the social costs of those crises (e.g.
unemployment). | |
| Regarding the impacts on the asset
management sector’s employment, should the assets under management be
maintained at current levels, no further impact would be expected. | |
| Environmental impact | |
| Nothing would suggest that the proposed
policy will have any direct or indirect impacts on environmental issues. | |
| Impact on Member States | |
| The reporting of SFTs
to trade repositories is expected to be similar to the existing reporting
framework for trade repositories for OTC derivatives under EMIR. This would
limit the impact to Member States, national competent authorities and ESMA. | |
| The creation of new rules
will require the national competent authorities (NCA) of the Member States to
check their implementation. As some of those rules are already applied through
the ESMA guidelines, this should not require any additional substantial work
regarding the UCITS funds. Additional supervision work will however be needed
as regards the AIFs but no material impact is expected since those funds are
already under close scrutiny through the application of the AIFM Directive and
its reporting requirements. | |
| Some additional burdens
might impact ESMA that could be required to harmonize the supervision process.
ESMA will also have to be involved in the usual complaint resolution that
arises in the application of single market law. Regarding the opinion of Member
States on possible issues on compliance with any new requirement, no specific
views have yet been expressed. | |
| The rehypothecation
requirements would not significantly impact Member States. National competent
authorities would be required to enforce these rules at national level. | |
| Impact on third countries | |
| No impacts on third countries are expected
for the obligation to report SFTs to trade repository. Only entities based in
the EU would be subject to this obligation. | |
| The new reporting requirements in the asset
management sector will have to be implemented by managers domiciled in third countries
when they market or manage AIFs in the EU. The AIFM directive has introduced
the same reporting requirements to all AIFs that are marketed in the EU
territory so the third country managers have to respect the EU rules when
marketing non-EU AIFs in the EU. This principle will be the same as regards the
new SFT reporting requirements. Because UCITS funds are domiciled and managed
in the EU, no impact is expected for third countries. | |
| The rehypothecation requirements would
cover also counterparties established in third countries, when they
rehypothecate collateral provided by an EU entity. Therefore, third country
counterparties would have to respect these rules. | |
| 10. Monitoring and Evaluation | |
| Ex-post evaluation of
all new legislative measures is a priority for the Commission. Evaluations are
planned about 4 years after the implementation deadline of each measure. The
forthcoming legislation will also be subject to a complete evaluation in order
to assess, among other things, how effective and efficient it has been in terms
of achieving the objectives presented in this report and to decide whether new
measures or amendments are needed. | |
| The following
indicators can be used to monitor the first and third specific objectives on
increased transparency of SFTs towards regulatory authorities and reduced
uncertainty on rehypothecation: [1] size of different segments of SFT markets,
level of interconnectedness and market concentration, average maturity of SFTs
and leverage; and [2] size of rehypothecation activities and collateral
velocity. It is important to note that data on rehypothecation encompasses SFTs
and other collateral-based activities such as collateral provision for
derivative contracts. | |
| In terms of indicators
and sources of information that could be used to monitor the second objective
of increasing fund’s transparency, data collected by the NCAs as part of the
authorisation process and their ongoing supervision task can be used. It is
also possible to access directly the different periodical reports and prospectuses
on internet. As such a sample of different funds can be assembled to perform a
detailed monitoring exercise. This analysis could assess how the funds are
communicating to their investors and how important is their use of SFTs. | |
| As regards the international
dimension of the policy measures, the FSB plans to conduct a peer review of the
implementation of their recommendations in the different jurisdictions. The
European Commission will closely monitor this review in order to ensure that
the recommendations have been evenly applied by all G20 Member States. | |
| 11.
Additional information | |
| Overview of existing reporting
requirements | |
| The below table
provides a general overview of the different reporting obligations that exist
in the financial legislation on SFTs and equivalent measures. | |
| || Reporting to competent authorities || Reporting to investors || Reporting to trade repositories | |
| CRR Credit institutions || Scope: SFTs. Data elements and frequency: aggregate data and annual or semi-annual or quarterly frequency. || || | |
| MIFID Investment firms || Scope: any transaction in financial instruments, except SFTs. Data elements and frequency: highest level of granularity and frequency. || || | |
| EMIR Counterparty of a transaction. || || || Scope: any OTC derivative transaction, including total return swaps. Data elements and frequency: highest level of granularity and frequency. | |
| UCITS Mutual funds || Equivalent as investor reporting except for the use of derivatives where the types, risks and applicable limits must be reported || Annual and semi-annual reports Scope: general scope including broadly derivatives and other techniques such as SFT, no granular disclosure Data elements (included in ESMA guidelines): exposure, identity of counterparties, collateral, revenue Prospectus Scope: same as above Data elements (included in ESMA guidelines): intention to use them, revenue agreement, risk description || | |
| AIFMD Alternative investment funds || Scope: covers partially some SFTs and some other financing transactions Data elements: information on sources of leverage, including names of counterparties, value of collateral or reuse of assets Data frequency: depends on the size and varies from quarterly to annually || Annual report Scope: securities lending Data elements: exposure, revenue Prospectus Scope: all assets and techniques Data elements: collateral and reuse arrangement, risk description || | |
| Detailed overview of existing and
proposed fund reporting requirements | |
| UCITS directive | |
| The provisions
regarding the reporting to investors over the use of SFTs and other financing
structures are scattered in different places in the UCITS directive and in the
ESMA guidelines on ETFs and other UCITS issues. | |
| Neither SFTs nor TRS
are defined in the UCITS directive. What generally covers securities lending
and repos is the broad concept of Efficient Portfolio Management (EPM)
technique. EPM techniques are defined according to their objectives: reduction
of risk, reduction of costs or generation of additional income (Art. 11
Eligible Asset Directive). This implies that the scope of EPM techniques is
flexible and depends on the interpretation that every manager makes of the
concept. In practice it is however commonly admitted that securities lending
and repos form an integral part of the EPM techniques. Practices that are
economically equivalent to securities lending or repos, the other financing
structures, can be considered as well as EPM techniques. This includes for
example the liquidity swap (change the liquidity profile of the fund) or the
collateral swap (exchange of fund’s assets). | |
| UCITS funds may also
invest in all kind of Financial Derivative Instruments (FDI) that have
equivalent characteristics as SFTs. These instruments have in common that they
are not used for the primary purpose of investing the assets of the funds but
for pursuing some other objectives. For example in the case of Total Return
Swap (TRS) the objective is to get exposure to strategies that would be
difficult or too costly to implement. For that reason certain FDI could also
fall under the scope of “other financing structures”. | |
| The new reporting
requirements that are proposed are indicated in italic in the below table. | |
| Periodic report || Propesctus | |
| Exiting requirements UCITS Directive, Annex I Schedule B, Point VII: Details, by category of transaction within the meaning of Article 51 carried out by the UCITS during the reference period, of the resulting amount of commitments. ESMA guidelines: · the exposure obtained through EPM · the identity of the counterparty(ies) · the type and amount of collateral · the revenues together with the direct and indirect operational costs and fees incurred. Proposed add-ons Specification of the details that have to be reported. This will include the information contained in ESMA guidelines plus all the following information: · global data: amount of securities on loan and total amount of assets engaged in each type of SFT · concentration data: top 10 counterparties for each type of SFT · aggregate transaction data: type and quality of collateral, maturity tenor, currency of the collateral, country of domicile, settlement and clearing (tri-party, central counterparty, bilateral) · data on re-use: share of collateral that is re-used, cash collateral re-investments, information on any restrictions · safekeeping methods: number of custodians, legal chain (segregated accounts or pooled accounts) · data on returns and costs: breakdown between the fund manager, the investors and the agent lender In addition these provisions will cover equally all transactions that have the same economic profile, namely the SFTs and the other financing structures such as the TRS, the collateral or the liquidity swaps. || Exiting requirements UCITS Directive, Annex I Schedule A, Point 1.15: Indication of any techniques and instruments or borrowing powers which may be used ESMA guidelines: · Information of investors over the intention to use EPM, including a description of the risks (counterparty risk, conflict of interest) and the impacts on the UCITS performance · Disclosure of the policy regarding the costs/fees that may be deducted from the revenues and the identities of the entities to which the costs/fees are paid · information on the underlying strategy and composition of the investment portfolio or index in the case of TRS Proposed add-ons Specification of the details that have to be introduced in the prospectus. The prospectus is a pre-contractual document that is binding to the manager. Therefore it gives confidence to the investors that the fund will respect the pre-defined investment limits. In that regard the idea is to treat SFTs and other equivalent structures as a normal investment activity in the prospectus: · General description of the SFTs and the rationale for their use · Reporting on the max proportion of the portfolio that can be subject to such techniques and the types of assets that can be subject to it · Criteria used to select counterparties · Policy on collateral valuation and safekeeping · Description of the incurred risks, including risks linked to collateral management, operational, liquidity, counterparty custody, legal risks · Revenue sharing agreement between fund manager, investors and third parties | |
| AIFM directive | |
| As under UCITS, neither
SFTs nor other financing structures are defined, directly or indirectly, in the
AIFM directive. General provisions are set out in the main directive and in the
delegated regulation. AIFs are otherwise subject to national rules. | |
| Periodic report || Propesctus | |
| Exiting requirements AIFM delegated regulation, Art. 104 · Amounts due to counterparties for collateral on return of securities loaned · Fee income from securities loaned Proposed add-ons Same information as UCITS || Exiting requirements AIFM Directive, Art. 23 Types of assets, techniques, associated risks, applicable investment restrictions, sources of leverage, collateral and asset reuse arrangement Proposed add-ons Same information as UCITS | |
| FSB recommendations | |
| || FSB Recommendations || EU response | |
| 1 || Authorities should collect more granular data on securities lending and repo exposures amongst large international financial institutions with high urgency. Such efforts should to the maximum possible extent leverage existing international initiatives such as the FSB Data Gaps Initiative, taking into account the enhancements suggested in this document. || Creation of a Trade Repository | |
| 2 || Trade-level (flow) data and regular snapshots of outstanding balances (position/stock data) for repo markets should be collected. Regular snapshots of outstanding balances should also be collected for securities lending markets and further work should be carried out on the practicality and meaningfulness of collecting trade-level data. Such data should be collected frequently and with a high level of granularity, and should also capitalise on opportunities to leverage existing data collection infrastructure that resides in clearing agents, central securities depositories (CSDs) and/or central counterparties (CCPs). National/regional authorities should decide the most appropriate way to collect such data, depending on their market structure, and building on existing data collection processes and market infrastructure where appropriate. Trade repositories are likely to be an effective way to collect comprehensive repo and securities lending market data. Regulatory reporting may also be a viable alternative approach. || Creation of a Trade Repository | |
| 3 || The total national/regional data for both repos and securities lending on a monthly basis should be aggregated by the FSB which will provide global trends of securities financing markets (e.g. market size, collateral composition, haircuts, tenors). The FSB should set standards and processes for data collection and aggregation at the global level to ensure consistent data collection by national/regional authorities and to minimise double-counting at the global level. || To be implemented by the FSB | |
| 4 || The Enhanced Disclosure Task Force (EDTF) should work to improve public disclosure for financial institutions’ securities lending, repo and wider collateral management activities, taking into consideration the items noted above. || To be followed by the EDTF | |
| 5 || Authorities should review reporting requirements for fund managers to end-investors against the FSB’s proposal, and consider whether any gaps need to be addressed. || To be implemented now within the investment fund frameworks set out in the UCITS and AIFM Directives | |
| 6 || Regulatory authorities for non-bank entities that engage in securities lending (including securities lenders and their agents) should implement regulatory regimes meeting the minimum standards for cash collateral reinvestment in their jurisdictions to limit liquidity risks arising from such activities. || To be followed later following more assessment | |
| 7 || Authorities should ensure that regulations governing re-hypothecation of client assets address the following principles: • Financial intermediaries should provide sufficient disclosure to clients in relation to re-hypothecation of assets so that clients can understand their exposures in the event of a failure of the intermediary; • In jurisdictions where client assets may be re-hypothecated for the purpose of financing client long positions and covering short positions, they should not be re-hypothecated for the purpose of financing the own-account activities of the intermediary; and • Only entities subject to adequate regulation of liquidity risk should be allowed to engage in the re-hypothecation of client assets. || Contractual transparency to be implemented now. The other provisions to be followed later following more assessment | |
| 8 || An appropriate expert group on client asset protection should examine possible harmonisation of client asset rules with respect to re-hypothecation, taking account of the systemic risk implications of the legal, operational, and economic character of re-hypothecation. || Expert group to be set up | |
| 9 || Authorities should adopt minimum regulatory standards for collateral valuation and management for all securities lending and repo market participants. || To be followed later following more assessment | |
| 10 || Authorities should evaluate, with a view to mitigating systemic risks, the costs and benefits of proposals to introduce CCPs in their inter-dealer repo markets where CCPs do not exist. Where CCPs exist, authorities should consider the pros and cons of broadening participation, in particular of important funding providers in the repo market. || To be followed later following more assessment | |
| 11 || Changes to bankruptcy law treatment and development of Repo Resolution Authorities (RRAs) may be viable theoretical options but should not be prioritised for further work at this stage due to significant difficulties in implementation. || To be considered at a later stage | |
| Annex 14: Glossary of terms | |
| ABS - Asset Backed
Security - Asset
backed securities are securities backed by a pool of receivables. Investors
generally only bear the risk arising from these receivables and are generally
insulated from the credit risk of the respective (former) owner of the assets
(originator/seller). The receivables of the underlying portfolio that is
securitised generate interest and principal payments. These payments as well as
potential losses that may occur in case the underlying obligors of the
securitised assets do not serve their obligations, are distributed to investors
according to certain rules (« the structure »). Hence, the investors
in ABS have to focus on both the underlying risk of the securitised portfolio
and the rules that determine which consequences investors have to face in case
a certain event occurs. Typically, the securitised assets are referenced by
various notes with different risk profiles, and hence, ratings. The fact that
different notes have different risk profiles, though they all reference the
same underlying portfolio, is based on the respective aforementioned
transaction structure. This in principle can enable investors to satisfy their
individual risk appetite and needs. ABS allows for a broad band of flexibility
in terms of asset classes being securitised and structures being applied. | |
| BU - Banking Union
- The Banking Union in the broad sense includes a single legal and regulatory
framework for all EU banks, a single bank supervisor, a single bank recovery
and resolution mechanism (authority and fund), including provisions to bail in
creditors efficiently and effectively when needed, and a single deposit guarantee
scheme. The justification for a banking union in a monetary union are financial
stability, efficiency of financial intermediation, and the effective and
uniform transmission of monetary policy throughout all member states. Banking
Union implies that the creditworthiness of a national sovereign be decoupled
from the creditworthiness of the banks in its jurisdiction. It is designed to
break the link between ailing banks and indebted governments. The goal is to avoid
the strain which is put on public finances when banks need rescuing, and, at
the same time, to reduce banks’ exposure to increasing risks in public debt.
Banking Union is based on a single rulebook for financial regulation, common to
all 28 members of the Single Market. | |
| BCBS –
The Basel Committee on Banking Supervision is the primary global standard-setter for
the prudential regulation of banks and provides a forum for cooperation on
banking supervisory matters. It is a committee of banking supervisory
authorities that was established by the central bank governors
of the Group of Ten countries in 1974. It provides a forum for
regular cooperation on banking supervisory matters. | |
| BRRD - Bank Recovery and Resolution Directive - is a Commission's proposal for
a Directive on crisis prevention, management and resolution that assigns to the
EBA the task to develop a wide range of Binding Technical Standards, Guidelines
and reports on key areas of recovery and resolution, with the aim of ensuring
effective and consistent procedures across the European Union, in particular
with respect to cross-border financial institutions. | |
| CRD IV/CRR - Capital Requirements - EU rules on capital requirements
for credit institutions and investment firms putting in place a comprehensive
and risk-sensitive framework and to foster enhanced risk management amongst
financial institutions. | |
| Collateral - Collateral
is an asset or
third party commitment that is used by the collateral provider to secure an
obligation to the collateral taker. Collateral arrangements may take different
legal forms. Collateral may be obtained using the method of title transfer or
pledge. It may be forfeited in the event of a default. It includes all sorts of
legal arrangements giving additional security to a creditor, e.g. pledge, lien,
repo. | |
| Collateral management - granting, verifying, and giving advice on
collateral transactions in | |
| order to reduce credit
risk in unsecured financial transactions. | |
| Competent authority - Any organization that has the legally
delegated or invested authority, | |
| capacity, or power to
perform a designated function. In the context of structural reform, it refers
to the body which is in charge of bank supervision. | |
| Default - An event stipulated in an
agreement as constituting a default. Generally, such events relate to a failure
to complete a transfer of funds or securities in accordance with the terms and
rules of the contract in question. A failure to pay or deliver on the due date,
a breach of agreement and the opening of insolvency proceedings may all
constitute such events. | |
| Directive - A directive is a legislative act
of the European Union, which requires Member States to achieve a particular
result without dictating the means of achieving that result. A Directive
therefore needs to be transposed into national law contrary to regulation that
have direct applicability. | |
| DFA - Dodd Frank
Act - The
Dodd–Frank Wall Street Reform and Consumer Protection Act became law in the
United States in 2010, introducing reforms to financial Regulation. | |
| EBA – European Banking Authority
- The European Banking Authority is an independent EU Authority which works to
ensure effective and consistent prudential regulation and supervision across
the European banking sector. See ESA | |
| ECB - European
Central Bank is
the central bank for the euro and administers the monetary policy of the
Eurozone, which consists
of 18 EU member states. It is one of the world's
most important central banks and is one of the seven institutions of the European Union (EU) listed
in the Treaty on the Functioning of the European Union (TFEU). The
capital stock of the bank is owned by the central banks of all 28 EU member
states. | |
| EIOPA – European Insurance and Occupational Pensions
Authority is part
of the European System of Financial Supervision consisting of three European
Supervisory Authorities (ESA) and the European Systemic Risk Board (ESRB). It
is an independent advisory body to the European Parliament, the Council of the
EU and the European Commission. EIOPA’s core responsibilities are to support
the stability of the financial system, transparency of markets and financial
products as well as the protection of insurance policyholders, pension scheme
members and beneficiaries. See ESA. | |
| EESC – European
Economic and Social Committee is a consultative EU Committee
established in 1958. It is a consultative assembly composed of employers (employers' organisations), employees (trade unions) and
representatives of various other interests. | |
| ESAs – European
Supervisory Authorities - European Securities and
Markets Authority (ESMA); European Banking Agency (EBA); and European Insurance
and Occupational Pensions Authority (EIOPA) - created in January 2011 with a
mandate to contribute to financial stability and improve the functioning of the
internal market by creating an integrated supervisory framework. | |
| ESMA - European
Securities and Markets Authority - Successor body of CESR, continuing work in the securities and
markets area as an independent agency and also with the other two former level
three committees. See ESA. | |
| ESRB - European
Systemic Risk Board -
European Systemic Risk Board was set up in response to the de Larosière group's
proposals, in the wake of the financial crisis. This independent body has
responsibility for the macro-prudential oversight of the EU. | |
| Financial
instrument - A
financial instrument is an asset or evidence of the ownership of an asset, or a
contractual agreement between two parties to receive or deliver another
financial instrument. | |
| FSB - Financial
Stability Board -
Established to coordinate at the international level the work of national
financial authorities and international standard setting bodies and to develop
and promote the implementation of effective regulatory, supervisory and other
financial sector policies. It brings together national authorities responsible
for financial stability in significant international financial centres,
international financial institutions, sector-specific international groupings
of regulators and supervisors, and committees of central bank experts. | |
| G8 – The countries of Canada,
France, Germany, Italy, Japan, Russia, the United Kingdom, and the United
States. | |
| G20 – The Group of Twenty Finance
Ministers and Central Bank Governors. The G-20 is made up of the finance
ministers and central bank governors of 19 countries: Argentina, Australia,
Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico,
Russia, Saudi Arabia, South Africa, Republic of Korea, Turkey, United Kingdom,
United States of America. The European Union, who is represented by the
rotating Council presidency and the European Central Bank, is the 20th member
of the G-20. | |
| Government
intervention –
can take place through amongst others taxation (subsidisation), regulation, or
the setting up of institutions. Basic justifications for government
intervention are (i) to correct market failures, e.g. those due to positive or
negative externalities, asymmetric information, and coordination failures; (ii)
to guard against abuse of market power, thus keeping markets competitive (e.g.
competition policy); (iii) to redistribute income, through taxes and subsidies;
(iv) to keep the system honest by creating and enforcing rules of the game
(e.g. Libor); and (v) to protect taxpayer interests when public money is spent
or put at risk. | |
| Hedging - Hedging is the practice of
offsetting an entity's exposure by taking another opposite position, in order
to minimise unwanted risk. This can also be done by offsetting positions in
different instruments and markets. | |
| HFT - High
frequency trading -
High frequency trading is a type of electronic trading that is often characterised
by holding positions very briefly in order to profit from short term
opportunities. High frequency traders use algorithmic trading to conduct their
business. | |
| IFRS –International Financial
Reporting Standards are designed as a common global language for business
affairs so that company accounts are understandable and comparable across
international boundaries. They are a consequence of growing international
shareholding and trade and are particularly important for companies that have
dealings in several countries. | |
| Leverage - The “leverage ratio” is defined
in Article 4(86) on the CRR IV proposal as the relative size of an
institution's assets, off-balance sheet obligations and contingent obligations
to pay or to deliver or to provide collateral, including obligations from
received funding, made commitments, derivatives or repurchase agreements, but
excluding obligations which can only be enforced during the liquidation of an
institution, compared to that institution’s own funds. | |
| Liquidity – | |
| Liquidity
defies a simple definition. Market liquidity is generally referred to as
the ability to buy or sell an asset at short notice with little impact on its
price. Funding liquidity describes the ability to raise cash either by
borrowing or via the sale of an asset (which again depends on market
liquidity). Market liquidity is a complex concept that is used to qualify
market and instruments traded on these markets. It aims at reflecting how easy
or difficult it is to buy or sell an asset, usually without affecting the price
significantly. Market liquidity is a function of both volume and volatility.
Market liquidity is positively correlated to volume and negatively correlated
to volatility. A stock is said to be liquid if an investor can move a high
volume in or out of the market without materially moving the price of that
stock. If the stock price moves in response to investment or disinvestments,
the stock becomes more volatile. Financial institutions provide funding
liquidity through, for example, interbank lending, and they provide market
liquidity to securities markets, for instance through market-making activity.
The conditions under which these intermediaries can fund their balance sheets,
in turn, depend on the willingness of other market participants to provide
funding or market liquidity. Thus, liquidity is to a large degree endogenous. A
funding shortage (illiquidity) arises when it is prohibitively expensive to (i)
borrow more funds (low funding liquidity) and/or (ii) sell assets (low
market liquidity). Funding liquidity may dry up due to maturity mismatch, high
margins/haircut, roll-over risk, redemption risk, etc. Market liquidity may be
low due to fire sale discounts or depressed sales prices. Funding illiquidity
and market illiquidity interact in times of crisis and explain why liquidity
can suddenly evaporate (cause a funding shortage). The two liquidity concepts
do not exist in a vacuum. They are influenced by the level of confidence and
risk appetite in the financial system, and by the financial soundness of other
financial firms. | |
| Long Position - A “long position” refers to the buying of
a security with an expectation that the security will rise in value. | |
| Market efficiency - Market efficiency refers to the
extent to which prices in a market fully reflect all information available to
investors. If a market is efficient, then no investors should have more
information than any other investor, and they should not be able to
systematically predict price changes better than other investors. | |
| Market failures – refer to economic situations
when the market (made up of private actors and when left on their own without
government intervention) does not provide a good or service efficiently even
though economic benefits outweigh economic costs. This happens when the private
benefits (or costs) are not equal to the public benefits (or costs). Market
failure is an economic concept, not a political one. Market failures justify state
intervention. The main types of market failures are (i) externalities/spill-overs:
Positive (R&D, training) or negative (environmental pollution, bank
failures); (ii) imperfect/asymmetric information (SME financing, financial
market freezes, etc.); (iii) coordination failures (standard setting, subsidy
races, depositor runs); (iv) abuse of dominant positions; and (v) public good
provisioning (defence, legal system, etc.). | |
| Market
fragmentation -
Market fragmentation typically refers to the fact that rules and/or market
conditions vary across countries and/or markets for similar services. It is the
opposite of market integration. | |
| Market integrity - Market integrity is the fair
and safe operation of markets, without misleading information or inside trades,
so that investors can have confidence and be sufficiently protected. | |
| Market maker - A market maker is a firm that
will buy and sell a particular security on a regular and continuous basis by
posting or executing orders at publicly quoted bid-ask prices. | |
| Market making - Market making is the purchase and sale of financial instruments (government
bonds, corporate bonds, equities, derivatives, etc.) for own account at prices
defined by the market maker, on the basis of a commitment to provide market
liquidity on a regular and on-going basis. | |
| MiFID - Markets in Financial Instruments Directive is a EU law that provides harmonised regulation for investment
services across the 31 member states of the European Economic Area (the 28 Member States of the European Union plus
Iceland, Norway and Liechtenstein). The main objectives of the Directive are to
increase competition and consumer protection in investment services. As of the
effective date, 1 November 2007, it replaced the Investment Services Directive. | |
| MTF - Multilateral Trading Facility is an electronic system which
facilitates the exchange of securities between counterparties. The securities
may include derivatives and instruments which do not have a main market, as
well as traditional securities. | |
| Negative
externalities - A
negative externality in economics and finance is usually a cost incurred by a
party that is outside of the decision or transaction of another party. For
example, pollution and traffic jams are externalities of a person’s private
decision to drive a car to work. Negative externalities are an important type
of market failure which justify government intervention (e.g. taxation). | |
| OECD – Organisation
for Economic Co-operation and Development is an international economic organisation of 34 countries founded in
1961 to stimulate economic progress and world trade. It is a forum of countries
committed to democracy and the market economy,
providing a platform to compare policy experiences, seek answers to common
problems, identify good practices and co-ordinate domestic and international
policies of its members. | |
| OTC - Over the
Counter - Over
the counter, or OTC, trading is a method of trading that does not take place on
an organised venue such as a regulated market or an MTF. It can take various
shapes from bilateral trading to trading done via more organised arrangements
(such as systematic internalisers and broker networks). | |
| Principle of
proportionality -
Similarly to the principle of subsidiarity, the principle of proportionality
regulates the exercise of powers by the European Union. It seeks to set actions
taken by the institutions of the Union within specified bounds. Under this
rule, the involvement of the institutions must be limited to what is necessary
to achieve the objectives of the Treaties. In other words, the content and form
of the action must be in keeping with the aim pursued. The principle of
proportionality is laid down in Article 5 of the Treaty on European Union. The
criteria for applying it is set out in the Protocol (No 2) on the application
of the principles of subsidiarity and proportionality annexed to the Treaties. | |
| PE - Private equity is an
asset class consisting of equity instruments provided to firms that are not
publicly traded on an exchange. Private equity is about buying stakes in
businesses, transforming business and then realising the value created by
selling or floating the business. | |
| Procyclicality - A condition of positive
correlation between the value of a good, a service or an economic indicator and
the state of the economy. The value of the good, service or indicator tends to
move in the same direction as the economy, growing when the economy grows and
declining when the economy declines. The term is generally used to refer to the
mutually reinforcing mechanisms through which the financial system can amplify
business fluctuations and possibly cause or exacerbate financial instability.
These 'positive feedback' mechanisms are particularly disruptive and apparent
during an economic downturn. | |
| Proprietary trading
- Proprietary
trading is the purchase and sale of financial instruments for own account with
the intent to profit from subsequent price changes. | |
| Regulation - A regulation is a form of
legislation that has direct legal effect on being passed in the European Union. | |
| Regulatory
arbitrage -
Regulatory arbitrage is exploiting differences in the regulatory situation in
different jurisdictions or markets in order to make a profit. | |
| Regulated
market - Regulated
market is a multilateral system which brings together or facilitates the
bringing together of multiple third-party buying and selling interests in
financial instruments in a way that results in a contract. Examples are
traditional stock exchanges such as the Frankfurt and London Stock Exchanges. | |
| Rehypothecation - Any pre-default use of
financial collateral by the collateral taker for its own purposes. | |
| Repo/Repurchase
agreement - A
'repurchase agreement' is economically similar to a secured loan, with the
'repo buyer' (effectively the money lender) receiving securities as collateral
to protect him against the default by the 'repo seller' (effectively, the
borrower of money). Legally, a 'repo,' can be defined as a collateral
arrangement in which the 'repo seller' transfers ownership of securities sold
to the 'repo buyer' for an amount of cash (the purchase price) at moment T,
while the 'repo buyer' agrees to sell and transfer equivalent securities at a
future moment T+x for a certain amount of money, including an interest
component (the repurchase price). | |
| Risk premium - The risk premium is the return
that investors require above the amount that a similar but otherwise
'risk-free' asset promises. A risk-free asset is a theoretical asset that would
never default. So the risk premium is the amount that an investor wants to be
paid for taking credit and/or market risk. | |
| Sanction - A penalty, either
administrative or criminal, imposed as punishment. | |
| SFT - Securities
financing transactions -
This is the general terms for financing transactions backed by securities
collateral such as repo, securities lending or any transaction having an
equivalent economic effect and posing similar risks, in particular buy/sell
back transactions. | |
| Securities
lending/Securities lending agreement - In securities lending, the economic
purpose is to temporarily obtain a specific security for certain purposes, e.g.
to facilitate settlement of a trade or to facilitate delivery of a short sale.
Legally, a ‘securities lending agreement’, can be defined as a transaction in
which the 'securities borrower' borrows specific assets from 'securities
lender' in exchange for a fee and collateral at moment T. The parties agree to
return the lent securities and the collateral on maturity. | |
| Securitisation - Asset
backed securities are securities backed by a pool of receivables. Investors
only bear the risk arising from these receivables and are generally insulated
from the credit risk of the respective (former) owner of the assets
(originator/seller). The receivables of the underlying portfolio that is
securitised generate interest and principal payments. See ABS. | |
| SIFIs - Systemically important
financial institution is a bank,
insurance company, or
other financial institution whose failure might trigger a financial
crisis. | |
| Single rulebook - The single rulebook is the
concept of a single set of rules for all Member States of the union so that
there is no possibility of regulatory arbitrage between the different markets. | |
| SMEs - Small and
medium sized enterprises -
On 6 May 2003 the Commission adopted Recommendation 2003/361/EC regarding the
Small and medium sized enterprise definition. While 'micro' sized enterprises
have fewer than 10 employees, small have less than 50, and medium have less
than 250. | |
| Shadow banking
system - Defined
by the FSB as 'the system of credit intermediation that involves entities and
activities outside the regular banking system' or, in short, 'non-bank credit
intermediation'. Experience from the financial crisis demonstrates that
capacity for some non-bank entities and transactions to operate on a large
scale in ways create bank-like risks to financial stability (long-term credit
extension based on short-term funding and leverage). | |
| Short Position - refers to the selling of a security with
an expectation that the security will fall in value. | |
| SSM - Single
Supervisory Mechanism is a mechanism through which, per
the European
Commission's proposal, the European Central Bank (ECB) shall assume ultimate
responsibility for specific supervisory tasks related to the financial
stability of the biggest and most important Eurozone based banks. | |
| SRM - Single Resolution Mechanism
has been designed
to complement the Single Supervisory Mechanism (SSM) which, once operational in
late 2014, will see the European Central Bank (ECB) directly supervise banks in
the euro area and in other Member States which decide to join the Banking
Union. SRM would ensure that – not withstanding stronger supervision - if a
bank subject to the SSM faced serious difficulties, its resolution could be
managed efficiently with minimal costs to taxpayers and the real economy. | |
| Subsidiarisation – Subsidiarisation in the context of structural reform requires the trading entity and
the deposit entity to maintain self-standing reserves of capital and of loss-absorbing
debt, as well as to comply with other prudential and legal requirements on an
individual, sub-consolidated or consolidated basis. Subsidiarisation provides a
degree of independence and to some extent also insulates the deposit entity
from shocks and losses. | |
| Systemic failure - A systemic failure refers
either to the failure of a whole market or market segment, or the failure of a
significant entity that could cause a large number of failures as a result. | |
| TEC – Treaty of the European
Community | |
| TFEU – Treaty on the functioning of
the European Union | |
| Trade
repository - Means
a legal person that centrally collects and maintains the records of certain
transactions. | |
| Trading venue - A Trading venue is an official venue where
securities are exchanged; it includes MTFs and regulated markets (e.g. typical
stock exchanges). | |
| UCITS – The
Undertakings for Collective Investment in Transferable Securities, Directive 2001/107/EC and 2001/108/EC (UCITS)
are a set of European Union Directives that aim to allow collective investment schemes to operate freely throughout the
EU on the basis of a single authorisation from one member state. In practice many EU member
nations have imposed additional regulatory requirements that have impeded free
operation with the effect of protecting local asset managers. | |
| Underwriting
- Securities
underwriting is a typical investment banking activity in which banks raise
investment capital from investors on behalf of corporations and governments
that are issuing securities (both equity and debt securities) in
return for a fee. It is a way of selling newly issued securities, such as
stocks or bonds, to investors. | |
| Venture capital - Venture
capital (VC) is that part of private equity that entails finance provided to
early-stage, high-potential and possibly, high-growth start-up companies. This
commonly covers the seed to expansion stages of investment. | |
| Volatility - Volatility refers to the change
in value of an instrument in a period of time. This includes rises and falls in
value, and shows how far away from the current price the value could change,
usually expressed as a percentage. | |
| Volcker
Rule – The "Volcker
Rule" refers to Section 619 of the Dodd-Frank Wall Street Reform and
Consumer Protection Act. See Dodd Frank Act. | |
| [1] In 2011 the Basel Committee on Banking
Supervision supplemented the trading book framework with an incremental risk
capital charge, which includes default risk as well as migration risk, for
unsecuritised credit products. http://www.bis.org/publ/bcbs158.htm | |
| [2] http://ec.europa.eu/internal_market/bank/docs/high-level_expert_group/report_en.pdf | |
| [3] See e.g. remarks from Wayne Bayres –
Secretary General of the Basel Committee in Banking Supervision “Regulatory
reforms – incentives matter” to the Bank of Portugal conference on the 24
October 2012. | |
| [4] There is clearly not a one to one correspondence between
commercial/trading activities and declared split of RWAs between credit and
market risk. Not only market risk can also be originated by activities
considered as commercial banking (i.e. assets held at fair value) and credit
risk can also be generated by trading activities, but there seem to be no
clear-cut definition of commercial banking activities and trading activities in
the literature or in policy practice | |
| [5] The analysis is conducted on a sample of
255 banks located in the EU and across years 2006 to 2011. Data are sourced
from the SNL commercial database http://www.snl.com. See next section for
details. | |
| [6] The measurement of aggregate profits is
subject to a high degree of uncertainty, (see e.g. “Measuring and analysing
profit developments in the Euro area” http://www.ecb.europa.eu/pub/pdf/other/pp63-73_mb200401en.pdf
- ECB). We are here however not interested in exact measures in absolute terms
as we are more concerned with measuring levels of income per unit of capital in
order to measure incentivation effects. | |
| [7] These 255 banks are available in the SNL
database (http://www.snl.com), have a total assets data point available in 2011
and are located in EU27 countries. 183 banks are effectively used to estimate
the preferred model. The reduction of the sample is only due to missing data. | |
| [8] The exercise was repeated also on a sample
including all EEA EFTA countries (i.e. plus Norway, Iceland, Lichtenstein) EU27
and all EFTA countries (i.e. EEA EFTA plus Switzerland). Results were
substantially unvaried. See the following section for additional details. | |
| [9] At the time of the first drafting of this
report Croatia still had to join the EU, bringing membership to 28 states. The
current analysis refers to the 27 members of the EU as of January 2012. 14
financial institutions are available in SNL for Croatia; all of them are
small-sized: their respective total assets are under 30 bn EUR. Some of these
banks are local subsidiary of European financial institutions (Raiffeisenbank
Austria for example). None of these would have been proposed as candidates for
structural reform. | |
| [10] http://www.ecb.int/stats/money/consolidated/html/index.en.html contains EU consolidated banking data for 2011 divided between
Domestic credit institutions, with a sum of total assets of 35’901 bn EUR, and
Foreign-controlled subsidiaries and branches, with a sum of total assets of
8’916 bn EUR. | |
| [11] In their report “Trading activities and
bank structural separation: possible definitions and calibration of exemption thresholds”
Commission Services have proposed different definitions in order to identify
institutions conducting different trading activities, such as market making and
proprietary trading. The sample analysed in this report is selected based on
definition 3, focusing on market and counterparty risk, see page 10 of the
cited report for a more in-depth discussion. Although the sample of selected
banks varies according to the definitions used for selection purposes,
definitions 2, 3 and 4 of that report would all involve the same allocation of
trading assets and liabilities for selected banks, so that a single analysis
can be considered to cover all these three cases. | |
| [12] It should be noted that two banks from the
candidates’ sample are identified as outliers when calculating results, and
they are thus dropped from the sample effectively used in section 5. | |
| [13] It should be noted that income statement
data are less populated than balance sheet data used in the panel regression,
thus the sample used for the calculation and presentation of results might
differ from the sample used in the regression analysis. | |
| [14]
http://www.eba.europa.eu/capitalexercise/2011-EU-Capital-Exercise.aspx | |
| [15] Only an extremely
limited number of banks publish RWAs/MCRs for the banking and trading books.
However, the definition of banking and trading book might not coincide with the
definitions of trading and commercial banking activities here investigated. | |
| [16] See e.g. S. Avramova and Le lesle, V., (2012), “Revisiting
Risk-Weighted Assets: Why Do RWAs Differ Across Countries and What Can Be Done
About It?”, IMF working papers, WP/12/90, International Monetary Fund,
Washington (DC). | |
| [17] See Appendix A for more details on the econometric analysis
development. | |
| [18] In fact, predicted RWAs based on these
coefficients are re-normalized to sum to total RWAs declared by banks (i.e.
estimated RWAs are in fact used to attribute to each activity line a share of
RWAs as declared by banks). A series of corrections based on expected effects
of changes of rules and definitions when moving to Basel III or alternative
regulatory scenarios are also considered in the final allocation. See Annex F
for details. | |
| [19] Alternative breakdowns were also tested, in particular other
liability side items and net values of assets and liabilities. See (Reference
to be inserted) for additional details of categories’ definitions. | |
| [20] The exercise was also repeated including
all European Economic Area countries: all coefficients remain identical except
for the coefficient on Securities Held to Maturity, which halves and becomes
even less significant. | |
| [21] This variable has a coefficient of 0.20 before the introduction of
Basel 2.5 regulation changes in 2011. | |
| [22] This coefficient is basically indistinguishable from zero, given
its extremely low statistical significance. | |
| [23] The stars denote statistical confidence according to the usual
10%/5%/1% scale | |
| [24] The number of cases used in the regression is lower than the full
sample due to the fact that not all variables are available for all banks in
the sample and all years. | |
| [25] Different regulatory scenarios will imply
different corrections to the predicted RWAs and the final value of the MCRs.
See Annex A5 for details. | |
| [26] During preparation of the report, an alternative assumption related
to the alternate allocation of assets held at fair value or AFS was also
considered. Intermediate calculations referring to additional definitions
considering this element are available upon request. | |
| [27] This is done by calculating the share of
predicted RWAs of each activity on total predicted RWAs and multiplying it by
total RWAs reported in the balance sheet. | |
| [28] The European Banking Authority conducted a Quantitative Impact
Study (QIS) to estimate the impact of new requirements to raise quality and
level of capital base. Results presented in Annex A5 that shows that the RWAs
would increase. For the purposes of this document, as precise data on
fulfillment of criteria 2 and 3 are not available, group 1 banks are those with
a capital in excess of 3bn. The increase in RWAs is calculated separately for
trading activities and for commercial banking activities. This methodology for
the correction of RWAs is consistent with the treatment of RWAs applied in the
JRC cost benefit analysis via the SYMBOL model. QIS corrections by country as
available in 2011 are used a factor of correction of RWA independently of the
years (i.e. the same correction is applied from 2006 to 2011). | |
| [29] While RWAs are
increased in Basel III scenarios, MCRs are decreased in Basel II scenarios, to
represent the fact that part of what is declared and allowed as capital will
not be considered as such under the more stringent future rules. | |
| [30] Alternative definitions have been tested
for the allocation of income. Results can be provided by the authors. | |
| [31] This departure from the use of earnings
before taxes is mainly due to the fact that under alternatives definitions of
trading activities, which were tested in other versions of this work | |
| [32] For interest revenues not referring
to loans, this is equivalent to an assumption that the interest rate revenue
per unit of commercial or trading assets are equivalent: the hypothesis of
equal returns has been confirmed via statistical tests conducted on the part of
the sample for which more detailed data is available. For interest expenses
this is equivalent to assuming that all activities would face the same funding
cost: this assumption is not based on results from data, but constant funding
costs across activities could be justified on the grounds that all activities
within the same institution would be facing the same funding WACC. A set of
regression models was tested to obtain a more detailed split of operational
expenses across activity lines, without satisfactory results. | |
| [33] Results where operational expenses are not included are available
from the authors. | |
| [34] Graphs are based on all available observations in the entire
6-years period; thus the same bank can be considered several times in the
construction of the plot. | |
| [35] The definitions of outliers employed here is the original introduced
by Tukey: 1.5 times the inter-quartile range above or below the 3rd and 1st
quartile, respectively. | |
| [36] It should be noted that, as some banks have a “whole bank” density
which is 1 or very close to it (as per their balance sheet), the RWA density
for the commercial activities will come out as larger than one if the density
for the trading activities will be lower than the density for the “whole bank”.
These points are excluded from the graph. | |
| [37] Three banks are
excluded from the sample from this point of the document due to their results
being outliers by several orders of magnitudes with respect to the rest of the
data. | |
| [38] In a previous
version of the study, additional scenarios based on changes in the risk weights
coefficients for all years (i.e. counterfactuals for B2 weights post-2010 or
for B2.5/B3 weights pre-2011) were also included. Given the fact that the new
regressions do not highlight a large effect from the changes in the sample
considered, and the complication of several interacting scenarios and
definitions, this has not been included in the current analysis. | |
| [39] The main difference with MCR is therefore
that, while MCR is calculated using the exact capital adequacy ratio, this
proxy of equity will take into account any eventual surplus capital and will be
set always to be equal to or larger than the estimated MCR. | |
| [40] In 2011 the Basel Committee on Banking
Supervision supplemented the trading book framework with an incremental risk
capital charge, which includes default risk as well as migration risk, for
unsecuritised credit products. http://www.bis.org/publ/bcbs158.htm | |
| [41] www.snl.com | |
| [42] The main advantage of this definition of income is that it allows to
consider unrealized gains and losses in available for sale activities at the
same time as corresponding gains and losses in activities accounted for at fair
value. | |
| [43] Alternative definitions of trading
activities including one or both of these classes were also tested, results are
available from the authors | |
| [44] These hypotheses have been confirmed via statistical tests
conducted on the part of the sample for which more detailed data is available.
The assumption of proportional sharing of funding costs is instead not borne by
the data, but could be justified on the grounds that all activities within the
same institution would be facing the same funding WACC. | |
| [45] This implies that when a value is missing,
the repartition is applied to a upper level of the income hierarchy. In this
case if at least one value between ‘Interest Earned on Customer Loans’ (1.1.a1)
and ‘Interest Earned on Trading Assets’ (1.1.a2) is missing, α will be
applied to the ‘Interest income’ (1.1.a) | |
| [46] Other operating income = Equity accounted results + dividends from
equity instruments + rental revenue + lease and rental revenue + other
non-interest income | |
| [47] Appendix D provides
a set of figures for all banks in the original sample. | |
| [48] A. Pagano, J. Cariboni, M. Marchesi, N. Ndacyayisenga, M.
Petracco-Giudici, H. Joensson; (201) “Trading activities and functional
structural separation: possible definitions and calibration of a de minimis
exemption rule”, JRC (European Commission Internal). | |
| [49] In this exercise, Group1 banks are those
banks whose Tier Capital is over 3 bn EUR. Group 1 RWA will be increased by
+21.2%, Group 2 by +6.9%. | |
| [50] In this exercise, Group1 banks are those
banks whose Tier Capital is over 3 bn EUR. Group 1 RWA will be increased by
+21.2%, Group 2 by +6.9%. | |
| [51] Due to data issues (excess missingness,
outlier behaviour, excess variation), LLänsförsäkringar, ING Bank, Belfius
Banque, ESF Group data are not considered. Some other banks are also partially
considered (Dexia, Lloyds Group, Rentenbank, Caixa Económica Montepio Geral,
Cajas Rurales Unidas, HSH Nordbank, SNS REAAL). | |
| [52] http://www.eba.europa.eu/documents/10180/87706/EBA-BS-2012-037-FINAL--Results-Basel-III-Monitoring-.pdf/778804a5-8e3e-4073-83df-afd1be0b626e | |
| [53] See footnote 5 for complete reference. | |
| [54] These effects are not to be confused with those linked to the
stricter definition of the quality of capital introduced by Basel 3.The change
in the RWA due to the change in the definition of capital measures: (i) the
effects of lower RWA for exposures that are included in RWA under Basel 2 but
receive a deduction treatment under Basel 3; (ii) the increase in RWA applied
to securitisation exposures deducted under the Basel 2 that are risk-weighted
at 1250% under Basel 3; (iii) the increase in RWA for exposures that fall below
the 10% and 15% limits for CET1 deduction. | |
| [55] It should be noted
that total ROA referring to the income and total assets items used in this
paper, which differ from the after-tax profit reported by the firm, can be
obtained as where , refer to the Trading Activity and Commercial Banking
Activity. | |
| [56] Many of the leading UK banks have told the UK Parliamentary
Commission on Banking Standards that they do not engage in proprietary trading
at all. The same message was given by NL banks to the Members of the Commission
on the structure of Dutch banks. The French and the German structural reform proposals
propose to subsidiarise proprietary trading (see Annex A1 for more details).
Their cost-benefit analysis findings have not been made public, but BNP Paribas
corporate-banking and investment-banking revenues are estimated to be impacted
by the government plans by less than 2%. An internal Febelfin survey provides
evidence that proprietary trading amounts to 2% of trading revenues for Belgian
banks in 2012 (down from 13%, 11% and 8% in 2009, 2010, and 2011 respectively).
In turn, trading revenues are estimated to amount to 9% of overall revenues in
2012 (first semester). | |
| [57] Jérôme Kerviel at Société Générale, Nick Leeson at Barings
Bank, Kweku Adoboli at UBS are only some of the traders that caused multiple
billion trading related losses, some of which effectively bringing down their employer
banks. | |
| [58] Very
few banks submitted quantitative evidence in the public consultation. None of
them reported that proprietary trading accounted for more than 4% of trading
revenues, which in turn is only a fraction of total revenues. | |
| [59] The treasury function of a bank needs to engage in trades to
manage excess liquidity or hedge the risk from for example selling fixed-rate
mortgages while being funded with floating rate borrowing. Over time the
treasury functions in some banks have become more aggressive traders with
strategies that could be seen as resembling proprietary trading. In some cases,
Treasury operations no longer merely manage the natural dynamics of the balance
sheet arising from customer activity, but increasingly perform a set of trading
activities in themselves and become pure profit centres. | |
| [60] A Febelfin 2013 commissioned survey suggests that market making
(excluding short term ALM transactions) accounts for 66% of Belgian bank
trading revenues in 2012 (first semester), whereas market making (including
short term ALM transactions) would account for 56% of all trading revenues for
all Western European banks. Few banks submitted quantitative evidence during
the public consultation about the importance of their market making activities,
but those that did reported that market making accounted for 25% to 100% of
their trading revenues. | |
| [61] There are two types of market makers. Voluntary Market Makers
(VMM) and Designated Market Makers (DMM). VMM act on their own initiative and
earn no compensation, but the profit they make by charging the bid-ask spread.
DMM are appointed and have contractual obligations to maintain two way prices
and volumes for a specified period of the trading day. DMM are contractually required
to give customers the best bid or ask price for each market order transaction.
This ensures a fair and reasonable two-sided market. In
return for fulfilling these obligations, DMM are often offered a range of
potential benefits by exchanges, including reduced trading fees, monthly
stipends and a share of net trading revenue. DMM exist in most stock exchanges
of the major industrialised countries. The presence of DMM varies across
markets. The market for foreign exchange and for some classes of derivatives
rely mainly on VMM. Other markets, such as equity markets give rise to both VMM
and DMM. For some rarely traded instruments, DMM are the main actors. Most
transactions done in OTC markets are with a MM. Designated market makers
provide these benefits also in bad times and therefore dampen negative cyclical
effects. Without designated market makers liquidity would dry up each time
there is a market downturn. Of course, their ability to assume this role is
limited, given that they expose their balance sheet to losses. Losses can put
all intermediaries in distress, and given that several designated market makers
are universal banks in Europe the losses on designated market making activity
can put the traditional banking activities at risk such as the provision of
payment system services or of loans to non-financial corporates. | |
| [62] Market makers often have signed on to a
voluntary code of conduct, which already considers manipulative practices by
banks with each other or with customers to be “unacceptable trading behaviour”.
However, the multiple financial scandals in the years since signing these
voluntary agreements cast doubt on their effectiveness. | |
| [63] Zingales (2012): “With the repeal of Glass-Steagall, investment
banks exploded in size and so did their market power. As a result, the new
financial instruments (such as credit default swaps) developed in an opaque
over-the-counter market populated by a few powerful dealers, rather than in a
well regulated and transparent public market. The separation between investment
and commercial banking also helps make the financial system more resilient.
After the 1987 stock market crash, the economy was unaffected because
commercial banks were untouched by plummeting equity prices. During the 1990-91
banking crisis, securities markets helped alleviate the credit crunch because
they were unaffected by the banking crisis. By contrast, in 2008 the banking
crisis and the stock market crisis infected each other, pulling down the entire
economy.” | |
| [64] For example, benefits of market liquidity should become smaller
with the degree of market liquidity. The additional benefits of the extra
liquidity derived from high-frequency trading must be of negligible (or
negative) value compared to the benefits from having a market which is
reasonably liquid on a day-by-day basis. Moreover, ever greater market
liquidity may give rise to destabilising momentum effects, such as cycles of
undervaluation and overvaluation. In addition, voluntary market making may not
occur when it is most needed, i.e. during troubled market conditions. Even
dedicated market makers are typically only allowed to post quotes during 90% of
the trading period and of course they may decide to breach their contractual
obligations if they deem that fulfilling them would threaten their solvency. | |
| [65] Zingales (2012): “The third reason why
I came to support Glass-Steagall was because I realised it was not simply a
coincidence that we witnessed a prospering of securities markets and the
blossoming of new ones (options and futures markets) while Glass-Steagall was
in place, but since its repeal have seen a demise of public equity markets and
an explosion of opaque over-the-counter ones. To function properly markets
need a large number of independent traders. The separation between commercial
and investment banking deprived investment banks of access to cheap funds (in
the form of deposits), forcing them to limit their size and the size of their
bets. These limitations increased the number of market participants, making
markets more liquid. With the repeal of Glass-Steagall, investment banks
exploded in size and so did their market power. As a result, the new financial
instruments (such as credit default swaps) developed in an opaque
over-the-counter market populated by a few powerful dealers, rather than in a
well regulated and transparent public market.” | |
| [66] When facilitating client business a bank is likely to try and
hedge most of its risks. Hence, genuine market making should entail limited
market risk. However, the actual exposure to risk may vary across time
depending on the liquidity of the instruments, on changes in market volatility
and on significant variation in the sizes of positions that market making
clients may wish to acquire or liquidate. Moreover, there may be a mismatch
between the position and the hedge (basis risk) and the hedge will need to be
rebalanced over time as market moves alter risk profiles. Furthermore, market
makers are still exposed to high counterparty risk and the concrete functioning
of market making can vary in relation to different financial instruments and
market models. | |
| [67] Ellis et al. (2000) and Kang and Liu (2007) | |
| [68] Kroszner and Rajan (1994), Kroszner (1998), Hebb and Fraser
(2003) and Stiglitz (2010) | |
| [69] Kroszner and Rajan (1994), Puri (1994), Benston (1990), Hebb
and Fraser (2002), Hebb and Fraser (2003) | |
| [70] Hartzell, Kallberg, Liu (2008) and Kovner (2010). | |
| [71] Diamond (1991), Rajan (1992), Saunders and Walter (1994), and Stein
(2002), for example. | |
| [72] Kroszner and Rajan (1994), Kanatas and Qi (2002), Drucker and
Puri (2005). | |
| [73] Mortgage securities are created when these loans are packaged, or
“pooled,” by issuers or servicers for sale to investors. As the underlying
mortgage loans are paid off by the homeowners, the investors receive payments
of interest and principal. | |
| [74] In a simple CDO, the underlying pool consists of bonds; whereas in
a synthetic CDO the underlying pool consists of Credit default Swaps. | |
| [75] Here the underlying pool consists of commercial loans. | |
| [76] Note that several measures have been
taken after the crisis with respect to securitisation, such as CRD IV
requirements on risk retentions and due diligence duties, CRA III regulation
and transparency obligation to be introduced in MIFID 2. However, the concerns
of TBTF and TITF remain. | |
| [77] Popov and Smets (2013) analyse the role of direct intermediation
through financial markets with the indirect intermediation through levered
banks. They argue that less deep financial markets in the EU relative to those
of the US are, to a large extent, responsible for the smaller increase in
productivity and slower pace of industrial innovation. They also compare the
liquidity spirals, asset fire sales, and interbank market freezes of the recent
financial crisis with the much more orderly burst of the dot-com bubble. They
argue that the credit boom of the 2000s was driven by debt finance, while the
dot-com bubble was mostly driven by an expansion in equity ownership, and
equity is not held in levered portfolios. | |
| [78] A Frontier Economics report (2013)
estimates that the market value of patents granted to private equity backed
firms in 12 large European countries between 2007 and 2011 is 1.5 times the
total amount of private equity investment during that period. Also they find
that the value added of financing in private equity can be significantly more
effective in promoting innovation (measured by the number of patents granted)
than non-private equity finance. Mollica and Zingales (2007) show that the causality
runs from private equity (in particular venture capital) to innovation and not
the other way around (that is private equity selecting more innovative firms).
However, Gilligan and Wright (2012) consider that the evidence is ambiguous on
whether private equity performance outweighs alternative forms of investments
such as quoted shares. They explain that while industry studies shows better
performance of private equity funds, once controlling for risk and correcting
for sample bias evidence shows that average fund performance is very close to
the S&P 500 (from slight over-performance to 3% per annum
underperformance). | |
| [79] Not all investment banking activities
are transaction-oriented activities. Not all commercial banking activities are
relationship-oriented activities. | |
| [80] The classic motivation (Diamond and Dybvig, 1983) for banks to
offer deposits derives from the existence of random liquidity shocks faced by
depositors and the need for depositors to be insured against these liquidity
shocks. The law of large numbers implies that aggregating over these
idiosyncratic liquidity shocks leads to exploitable diversification benefits. | |
| [81] What subsidiarisation means in practice is breaking up
complex financial institutions, including branches that cross borders – into
distinct subsidiaries. This is often called “ring-fencing,” a term that makes
clear that the goal of subsidiarisation is to define robust boundaries between
different corporate operations to keep the "sheep on one side and the wolves
on the other." | |
| [82] See as explained on
http://www.ifrs.org. | |
| [83] Directive 2013/34/EU of the European Parliament and of the Council
on the annual financial statements, consolidated financial statements and
related reports of certain types of undertakings, amending Directive 2006/43/EC
of the European Parliament and of the Council and repealing Council Directives
78/660/EEC and 83/349/EEC, OJ L 182, of 26 June 2013, page 19. In this context, it is also relevant to
mention the specific Directive that applies to banks and other financial
institutions in combination with the Accounting Directives, namely: Council
Directive 86/635/EEC on the annual accounts and consolidated accounts of banks
and other financial institutions, OJ L 372, of 31 December 1986, page 1. | |
| [84] See Article 7 of Regulation (EC) No 1606/2002 of
the European Parliament and of the Council on the application of international
accounting standards, OJ L 243 of 19 July 2002, page 1 ("IFRS
Regulation"). | |
| [85] See Article 8 of the IFRS Regulation. | |
| [86] See the Directive of the European Parliament and
of the Council on the access to the activity of credit institutions and the
prudential supervision of credit institutions and investment firms and amending
Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (the
"CRDIV"), OJ L176, of 27 June 2013, page 338. | |
| [87] Directive 2009/111/EC of the European Parliament and of
the Council amending Directives 2006/48/EC, 2006/49/EC and 2007/64/EC as
regards banks affiliated to central institutions, certain own funds items,
large exposures, supervisory arrangements, and crisis management, OJ L 302, of
16 September 2009, page 97. | |
| [88] For purposes of this Annex, "insured
deposits" are defined as deposits repayable by the guarantee scheme under
national law. | |
| [89] An Investment firm is any legal person whose regular
occupation or business is the provision of one or more investment services to
third parties and/or the performance of one or more investment activities on a
professional basis. Investment services and activities are listed in Annex I to
the Directive 2004/39/EC of the European Parliament and of the Council on
markets in financial instruments amending Council Directives 85/611/EEC and
93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council
and repealing Council Directive 93/22/EEC, OJ L 145, of 30 April 2004, page 1, ("MiFID"). | |
| [90] However, this credit institution authorization could
not cover receiving insured deposits. | |
| [91] For a more in-depth description of on-going structural
reform projects both within the EU and outside, see Annex A1 of this
Impact Assessment. | |
| [92] Directive 2011/35/EU of the
European Parliament and of the Council concerning mergers of public limited
liability companies, OJ L 110, of 5 April 2011, page 1; the Sixth Council
Directive 82/891/EEC based on Article 54(3) of the Treaty, concerning the
division of public limited liability companies, OJ L 378, of 31 December 1982,
p. 47; and Directive 2005/56/EC of the European Parliament and of the Council
on cross-border mergers of limited liability companies, OJ L310 of 26 October
2005, page 1. | |
| [93] Directive
2012/30/EU of the European Parliament and of the Council on coordination of
safeguards which, for the protection of the interests of members and others,
are required by Member States of companies within the meaning of the second
paragraph of Article 54 of the Treaty on the Functioning of the European Union,
in respect of the formation of public limited liability companies and the
maintenance and alteration of their capital, with a view to making such
safeguards equivalent, OJ L 315, of 25 October 2012, page 374. | |
| [94] Directive 2011/35/EU of the
European Parliament and of the Council concerning mergers of public limited
liability companies, OJ L 110, of 5 April 2011, page 1; the Sixth Council
Directive 82/891/EEC based on Article 54(3) of the Treaty, concerning the
division of public limited liability companies, OJ L 378, of 31 December 1982,
p. 47; and Directive 2005/56/EC of the European Parliament and of the Council
on cross-border mergers of limited liability companies, OJ L310 of 26 October
2005, page 1. | |
| [95] See as explained in the
European Commission's Green Paper on Shadow Banking, COM(2012) 102 final,
Brussels 19 March 2012. | |
| [96] Those objectives are: reducing
moral hazard (excessive risk taking); facilitate resolvability; facilitate
management, supervision; reducing conflicts of interest; reducing resource and
capital misallocation; and reducing efficiencies. | |
| [97] The Directive establishing a framework for the recovery
and resolution of credit institutions and investment firms (the
"BRRD") is formally not yet in force. However, for purposes of this
Annex it has been assumed that it will be in force prior to the implementation
of any separation measure required by financial institutions. It will therefore
be included in the notion of "existing legislation" as used in this
Annex. | |
| [98] "Management body" is defined in the CRDIV and
means the body or bodies of an institution, appointed in accordance with
national law, which is empowered to set the institution's strategy, objectives
and overall direction, and which oversees and monitors management
decision-making. This shall include persons who effectively direct the business
of the institution. | |
| [99] See Article 91 of the CRDIV. | |
| [100] Regulation (EU) No 575/2013 of the European Parliament
and of the Council on prudential requirements for credit institutions and
investment firms and amending Regulation (EU) No 648/2012 (the
"CRR"), OJ L 176, of 26 June 2013, page 1. Note that all Investment
firms as defined in Article 4(1) of MiFID are subject to CRR prudential
requirements as laid down in the CRDIV and the CRR. Investment firms which are
not authorised to provide ancillary services or which provide only certain
services and activities or which are not permitted to hold money or securities
belonging to their clients are subject to specific prudential requirements
which are specified in the CRR and the CRDIV. | |
| [101] More specifically, credit institutions and investment
firms (with some exceptions) are not allowed to incur an exposure to any of
their counterparties exceeding 25% of their eligible capital. Importantly,
where Member States adopt national laws requiring structural measures to be
taken within a banking group, intragroup exposures, where these exposures
consist of exposures to an entity that does not belong to the same subgroup,
competent authorities may apply a limit on a sub-consolidated basis which is
set at a level below 25% but not lower than 15% until 30 June 2015 after which
the limit may go as low as to 10% but not further. See Article 395(6) of
the CRR. | |
| [102] This general rules is set out in Articles 6, 11 and 412
of the CRR. | |
| [103] See Articles 131 and 133 of the CRDIV. | |
| [104] See Articles 37 to 50 of the Directive of the
European Parliament and of the Council establishing a framework for the
recovery and resolution of credit institutions and investment firms and
amending Council Directives 77/91/EEC and 82/891/EC, Directives 2001/24/EC,
2004/25/EC, 2005/56/EC, 2007/36/EC and 2011/35/EC and Regulation (EU) No
1093/2010 (the "BRRD"). Subject to certain specific conditions,
resolution authorities may choose to apply the minimum requirement of own funds
and liabilities on a consolidated basis to groups which are subject to
consolidated supervision. | |
| [105] See Article 104 of the CRDIV. | |
| [106] Governance arrangements have to
include a clear organizational structure with well-defined, transparent and
consistent lines of responsibility, effective processes to identify, manage,
monitor and report the risks that financial institutions are or might be
exposed to, adequate internal control mechanisms, and remuneration policies and
practices that are consistent with and promote sound and effective risk
management. This translates into a requirement for the management body to
approve and implement an effective risk management strategy. See Article
88 the CRDIV | |
| [107] See Articles 92 to 96
of the CRDIV on remuneration policies. | |
| [108] The term "significant subsidiary" of an EU
parent institution is not defined in the CRR. | |
| [109] See Article 13 of the
CRR. | |
| [110] See Article 7 of the BRRD. | |
| [111] See Article 11 of the BRRD. | |
| [112] See Articles 7 and 8 [and 10??] of the CRR
regarding the derogation to the application of prudential requirements on an
individual basis with regard to own funds, large exposures, leverage, liquidity
and public disclosure. | |
| [113] Article
11(5) of the CRR already provides that competent
authorities may require structurally separated institutions to comply with the
large exposure obligations on a sub-consolidated basis. | |
| [114] Articles 16 to 22 of the BRRD provide the conditions and
procedures for intra-group financial support. Currently Member States shall
ensure that parents and subsidiaries may enter into agreements to help each
other. Approval of such an agreement is subject to certain conditions (Article
19). | |
| [115] See Article 11 of BRRD that
provides that group resolution plans shall identify how the group resolution
actions could be financed and, where appropriate, set out principles for
sharing responsibility for that financing between sources of funding in
different Member States. | |
| [116] "Intra-group exposures" consist of exposures
of a group entity or a subgroup of entities to another group entity or subgroup
of group entities. Those intragroup exposures may arise from assets or
off-balance sheet items attracting a capital requirement for credit or
counterparty credit risk. Limiting intra-group exposures aims at reducing the
concentration risk associated with the default of a group entity. | |
| [117] Whether a transaction is undertaken on an arm’s length
basis is in principle judged according to all the circumstances of each
particular transaction. The test to apply could be to consider whether a
prudent person acting with due regard to their own commercial interests would
have made such a transaction. Note, however, that Article 248(2) of the CRR
provides that the EBA shall, in accordance with Article 16 of Regulation (EU)
No 1093/2010, issue guidelines on what constitutes arm's length conditions. | |
| [118] Articles 16 to 22 of the BRRD provide the conditions and
procedures for intra-group financial support. Currently Member States shall
ensure that parents and subsidiaries may enter into agreements to help each
other. Approval of such an agreement is subject to certain conditions (Article
19). As previously mentioned, in principle, an agreement to provide financial
support may only be concluded if the supervisory authority considers none of
the parties in breach of the rules on capital or liquidity, or is at risk of
insolvency. However, it makes sense to specifically set out in legislation that
for the deposit entity such agreements can by their nature jeopardize the
liquidity or solvency of the deposit entity or create a threat to financial
stability and therefore cannot be concluded. | |
| [119] See Article 11 of the BRRD that
provides that group resolution plans shall identify how the group resolution
actions could be finance and, where appropriate, set out principles for sharing
responsibility for that financing between sources of funding in different
Member States. | |
| [120] This would have to be coordinated with the Commission's
assessment of the appropriateness and the impact of imposing limits on
exposures to shadow banking entities which carry out banking activities outside
a regulated framework that need to be finalized by 31 December 2015. (See Article
395 of the CRR.) | |
| [121] The Commission Staff Working document from June
2 2010, SEC (2010) 669: "Corporate Governance in Financial
Institutions: Lessons to be drawn from the current financial crisis, best
practices." Accompanying document to the Green Paper: "Corporate
governance in financial institutions and remuneration policies;"
COM(2010) 284 final. | |
| [122] Current CRDIV rules provide that members of the
management body have to possess "sufficient knowledge, skills and
experiences" to perform their duties. The overall composition of the
management board shall also reflect an adequately broad range of experiences. The
number of directorships is limited so that board members of significant institutions
cannot hold more than one executive directorship and two non-executive
directorships or four non-executive directorships. Executive or non-executive
directorships within the same group are counted as one. | |
| [123] If this rule is selected the term "sufficient"
would have to be defined. The definition of "sufficient" is to some
extent contextual and will depend on the strength of the fence and the overall
objectives of the rule. This rule will not necessarily marry well with other
rules and might even become redundant; for example in combination with b. | |
| [124] Any of a and b would require provisions on sanctions in
case of non-compliance. I.e., Member States would have to ensure effective
penalties in case of non-compliance. | |
| [125] Those objectives are: reducing
moral hazard (excessive risk taking); facilitate resolvability; facilitate
management, supervision; reducing conflicts of interest; reducing resource and
capital misallocation; and reducing efficiencies. | |
| [126] Derogations to individual
requirements could not be allowed which most likely will require some type of
amendment to current rules. | |
| [127] The
degree of control will depend on the management style of the parent company's
executives and the share ownership structure. | |
| [128] The deposit entity may engage in certain activities that
are not separated but involve a certain degree of trading; for example,
underwriting which may necessitate some ancillary market making. | |
| [129] For sake of clarity intra-group lending and borrowing is
not included in the definition of debt and can therefore take place. | |
| [130] With regard to ownership
restrictions, see footnote 56. | |
| [131] http://ec.europa.eu/internal_market/bank/docs/high-level_expert_group/report_en.pdf | |
| [132]
http://ec.europa.eu/internal_market/consultations/2012/hleg-banking/replies-summary_en.pdf | |
| [133]
http://ec.europa.eu/internal_market/financial-markets/derivatives/index_en.htm | |
| [134]
http://ec.europa.eu/internal_market/bank/regcapital/new_proposals_en.htm | |
| [135]
http://ec.europa.eu/taxation_customs/taxation/other_taxes/financial_sector/ | |
| [136] http://www.snl.com/. See Annex I
for additional information on the sample. | |
| [137] The use of annual reports published by individual banks is not
retained since balance sheet items published in annual reports do not always
use the same classification of financial instruments. | |
| [138] 244
banks are part of EU 27 and 1 bank of Norway (DNB ASA) has been added in order
to cover the EBA sample. | |
| [139] No small banks are available in SNL, which means that these banks
cannot be used for the calibration and consequently not been proposed for
structural separation. | |
| [140] Source ECB MFI Balance Sheets (GB, DK, LV, PL, SE + Eurozone
countries) | |
| [141] The only exception is Nykredit Realkredit, whose average 2006-2011
total assets amounts to roughly 170 bn EUR. | |
| [142] http://www.eba.europa.eu/capitalexercise/2011-EU-Capital-Exercise.aspx | |
| [143] Switching to a 3-year moving average has shown not to considerably
change results (see Annex III). | |
| [144] All graphs and tables are based on SNL data
and JRC elaborations | |
| [145] http://ec.europa.eu/internal_market/consultations/2012/banking_sector_en.htm | |
| [146] See also Opinion of the European Banking Authority on the
recommendations of the High-level Expert Group on reforming the structure of
the EU banking sector, where on page 4 one can read “the EBA suggests that
available for sale components of liquidity portfolios are excluded from the
first threshold calculation”. http://www.eba.europa.eu/cebs/media/Publications/Other%20Publications/Opinions/EBA-BS-2012-219--opinion-on-HLG-Liikanen-report---2-.pdf | |
| [147] AFS composition can be volatile. For instance for Lloyds in 2011
the share of government securities (good for liquidity constraint) in AFS is
roughly 70% while in 2010 it was 30% (more ABS and corporate securities.
Source: Lloyds annual report). This split is not available for most of the
banks in the sample. | |
| [148] Large volumes of securities and derivatives held for trading also
signal the presence of market risk due to trading activities. | |
| [149] The Commission Services are also considering the option of
separating underwriting, as this activity is highly linked to market making.
However, due to lack of time and data (limited in number of operations are
available) underwriting could not be investigated. | |
| [150] Also U.K. authorities recognizes the: "significant challenge of
defining proprietary trading clearly and distinguishing it from other forms of
trading activity [...] The difficulty that most of us witnesses is trying to
distinguish pure proprietary trading from market-making" (see 3rd Report
-Proprietary trading: http://www.publications.parliament.uk/pa/jt201213/jtselect/jtpcbs/138/138.pdf). | |
| [151] Technical details on the clustering technique adopted are presented
in Annex VI see http://www.eio.uva.es/inves/grupos/representaciones/trTCLUST.pdf
for further references. | |
| [152] In Annex III we will briefly discuss the stability over the years
of the thresholds, considering four moving averages over a three years span:
2006-2008, 2007-2009, 2008-2010 and 2009-2011. In general we do not see many
differences except for the 2008-2010 average. | |
| [153] We made this choice since these thresholds might become part of
legislation. | |
| [154] For instance, banks such as Allied Irish, Bankia and Monte dei
Paschi are part of this group. | |
| [155] As an example, the changes of thresholds from definition 1 to
definition 2 can be obtained as follows. Definition 2 excludes AFS, whose
average in the sample is 15 bn EUR. Therefore the amount threshold is
shifted down from 80 bn EUR to 65 bn EUR. On the other hand, the share of AFS
over total assets accounts on average for around 8%, hence the threshold for
the share dimension moves from 20% down to 12%. | |
| [156] The graph refer to the average shares 2006-2011 and is based on the
subset of banks in the sample for which information on deposits is available (approximately
180 banks). For all selected banks the information on deposits is available. | |
| [157] Covered deposit are obtained from customer deposit applying an
estimated correction factor equal to 0.54, averaging over EU27 data from ECB
and from EU Deposit Guarantee Schemes. | |
| [158] Financial Stability Board list of SIFI as of 2012. http://www.financialstabilityboard.org/publications/r_121031ac.pdf | |
| [159] Note that
the number of banks may slightly varies across the years and across the
definitions | |
| [160] Fixing the
threshold to 80 b€ would allow to select banks such as Lloyds and Intesa
Sanpaolo respecting the clusters structure, due to the large gap existing
between 50 b€ and 100b €. | |
| [161]
www.SNL.com | |
| [162] Source ECB
MFI Balance Sheets EU27 | |
| [163] For each bank
we consider the z-score of its absolute and relative trading activities. The
z-score is a standardized measure which allows comparing variables with
different scales. For each rescaled point we compute its geometric distance
from the two rescaled thresholds. | |
| [164] We assume that these thresholds are valid for all our five time
frames, and we track the 10% of the banks having the smallest distances over
these five average periods. | |
| [165] To estimate the effect of EMIR, we assume a
similar netting reduction of Derivatives Assets as the ones reported on the
balance sheet of US commercial banks. The Office of the Comptroller of the
Currency (OCC) reported in “OCC’s Quarterly Report on Bank Trading and
Derivatives Activities” legally enforceable netting agreements allowed US
(commercial) banks to reduce the gross positive fair value of derivatives by
around 90%. Using precaution, we estimate that 80% of the derivatives assets
will netted out of the balance sheet. Of these netted derivatives, 80% will be
cleared through Clearing House due to EMIR. Combining both figure, 80% * 80% =
64% will be centrally cleared. Around 35% (100%-64%) are expected to remain on
the balance sheet. For the FTT initiative we assume that there will be no
impact on the securities and a moderate impact on the volumes of derivatives. | |
| Source: Financial
Stability Paper http://www.bankofengland.co.uk/publications/Pages/fsr/fs_paper18.aspx | |
| [166] Sensitivity of results to the choice of the parameters reducing the
derivative size is discussed in section IV.2 of this annex. | |
| [167] The distance is the same as the one computed in Annex IV and it is
computed on the average period 2006-2011. With respect to the analysis
presented in Annex IV, the banks close to the thresholds are kept into two
distinct classes in order to assess if there exist differences among them in
terms of structural indicators or if instead they have very similar behaviour. | |
| [168] The number of banks in OUT Borderline is by choice the same number
of banks in IN Borderline’ | |
| [169] For example, the empirical strategy of the initial papers imposed the
estimation of parametric cost functions (which are restrictive) and required
constructing samples of banks with similar production techniques in order to
yield sound estimates. Wheelock
and Wilson (2011) improve on the estimation method by using non-parametric
model of bank costs which does not require such sampling assumptions. An
issue that is harder to address is that the sample size of very large banks is small and the statistical techniques employed are most accurate for average
companies in the industry (see De Young, 2010). Therefore inference for large banks may not be very
reliable. | |
| [170] Furthermore, from a
systemic perspective, they do not address whether the benefits of large size
outweigh the potential costs in terms of systemic risk that larger firms may
impose. | |
| [171] See also Davies and
Tracey (forthcoming). | |
| [172] Speech given by Andrew Haldane at the Association of Corporate
Treasurers, Leeds, Credit is Trust, 14 September 2009, pp 10-11 | |
| [173] Note that this relates not only to activities but also to geographical
diversification. For example, international operations might provide bank
managers with more possibilities to trade against the bank's interest (see
Myers and Rajan (1998)). | |
| [174] Smith and Stulz (1985) show that the
hedging of interest rate risk can increase firm value by lowering the expected
transactions cost of bankruptcy | |
| [175] A financial institution is classified as a conglomerate if its
business include at least of the following activities: i) banking, ii)
insurance and iii) securities. | |
| [176] See http://www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//TEXT+REPORT+A7-2013-0231+0+DOC+XML+V0//EN. | |
| [177] See http://www.europarl.europa.eu/news/en/pressroom/content/20130318IPR06668/html/Time-for-a-wholesale-restructuring-of-banking. | |
| [178] The SYMBOL model (SYstemic Model of Banking Originated Losses) has been
jointly developed by the JRC, DG MARKT, and academic experts of banking
regulation. For technical details see: De Lisa R, Zedda S., Vallascas F.,
Campolongo F., Marchesi M. (2011), Modelling Deposit Insurance Scheme Losses in
a Basel 2 Framework, Journal of Financial Services Research, 40(3),
123-141. Using bank balance sheet data as input, the SYMBOL model operates in
two steps: 1) estimation of an average default probability for the assets of
any individual bank, by means of the features of the Basel FIRB (Foundation
Internal Ratings Based) loss distribution function. 2) Monte Carlo simulation
of the distribution of aggregate losses on the basis of individual banks' asset
default probabilities. See also Appendix C at the end of this report and
Appendix 4 to Annex XIII of the Impact Assessment of the Bank Recovery and
Resolution Directive:http://ec.europa.eu/internal_market/bank/docs/crisis-management/2012_eu_framework/impact_assessment_final_en.pdf. | |
| [179] See e.g. section 3 for further details on simulation methodology
and section 4 for additional details on the estimation of the size and
capitalisation of separated entities. | |
| [180] In their report “Trading activities and bank structural separation:
possible definitions and calibration of exemption thresholds” Commission
Services have proposed different definitions in order to identify different
trading activities, such as market making and proprietary trading. The sample analysed
in this report is selected based on definition 3, focusing on market and
counterparty risk, see section 2 for additional discussion, see Appendix A
for a complete list. It should be noted that not all candidate banks would
necessarily be separated: the choice of simulating separation for the whole
sample seems however the best possible choice in the absence of further
details. | |
| [181] This implies that banks are capitalised in line with CRD IV
requirements and losses are absorbed by holders of bail-inable debt upon
default or undercapitalization. A conservative choice has however been made
regarding the amount of bail-inable liabilities effectively used before
intervention of a public backstop, in line with the minimum levels required in
the draft bank recovery and resolution framework being discussed in trilogue at
the time this study was conducted. See section 3.3 for details. | |
| [182] If the structural reform also contributes to facilitating bail-in,
part of the benefits found when evaluating the impact of Bank Recovery and
Resolution Framework would be attributable to structural reform. | |
| [183] As the large and complex banks might play an important role in providing
credit to the economy and market liquidity, broader and indirect costs and
benefits need to be considered in an overall impact assessment as well. These
costs include effects on market liquidity, interest rates, asset prices and
macroeconomic competition effects. A starting situation with highly indebted
and leveraged banks, households, and governments may exacerbate any of these
effects as high indebtedness together with lower asset prices and higher risk
premia could lead to balance sheet effects. Many of the costs and benefits are
extremely hard to quantify either because of their nature (e.g. enhanced
resolvability and supervision of banks through transparency), or because of
non-negligible cross-linkages and interactions across costs, risks and benefits
and behavioural responses (e.g. changing risk taking incentives, new market
players entering). | |
| [184] Definition 3 focuses on market and counterparty risk by not
considering available for sale securities and including gross volumes of
securities and derivatives held for trading (see page 10 of the cited report
for a more in-depth discussion). Although the sample of selected banks varies
according to the definitions used for selection purposes, definitions 2, 3 and
4 of that report would all involve the same split of trading assets and
liabilities for selected banks, so that a single analysis can be considered to
cover all these three cases. See also footnote 292. | |
| [185] Due to the limited aggregate assets of these small banks (0.25% of
the total sample) simulation results are not materially affected by their
exclusion. | |
| [186] The balance sheet data available in Bankscope are not detailed
enough to split the banks into the TE and the DTB, for instance Bankscope does
not distinguish between derivative for trading and for hedging purposes. | |
| [187] For additional details, see page 10 of the mentioned report. The
exact procedure for estimating the final balance sheet composition and
capitalization of the separated entities in illustrated in section 4. | |
| [188] See section 4 for additional details. | |
| [189] Separation along these lines could be difficult because e.g. legal
obstacles to allocating certain assets or liabilities and/or because assets and
liabilities could need to be divided in ways which do not allow the accounting
identity to be respected in the two separate entities. For example, the amount
of deposits could exceed the assets allocated to the DTB. | |
| [190]De Lisa, R., Zedda, S., Vallascas, F., Campolongo, F., and Marchesi,
M. Modeling Deposit Insurance Scheme Losses a Basel II Framework.
Journal of Financial Services Research 40, 3 (2011). | |
| [191] See Appendix C for an explanation of the SYMBOL methodology and the
calculation of the implied obligor PD. | |
| [192] The base SYMBOL methodology is more concerned with default (i.e.
credit) risk than with market risk, to which the TE is more exposed: see Appendix
D for additional details on using SYMBOL to simulate losses for the TE. | |
| [193] The choice of a 99% confidence implies an increase in the riskiness
of trading entities, while the choice of ignoring the difference between the
holding horizon of trading securities (10 days) and the simulation horizon (1
year) implies a decrease. A precise quantification of the impact of these two
drivers was not possible. | |
| [194] Excess losses are those losses not absorbed by regulatory capital.
In addition to these excess losses, banks recapitalisation funding needs to
meet Basel 3 8% minimum capital requirements are taken into account. This
assumes that all banks considered in the sample represent systemic financial
stability relevance. | |
| [195] The relevance of contagion through the interbank channel is
significantly reduced if bail-in in the context of the Bank Resolution and
Recovery Framework is fully effective. For simulating contagion through the
bail-in channel, outcomes would be extremely dependent on assumptions about the
liability and exposure split due to the sensitivity of the contagion mechanism
to the shape of the network matrix and uncertainty about future holdings of
bail-inable securities. | |
| [196] The estimated shares of banks activity inside the EU is reported in
Appendix D for the largest banks representing 83% of the sample’s total assets. | |
| [197] The advantage of taking as a baseline the gross losses of the
separately simulated portfolios rather than simulating the undivided bank, is
that the gross losses in the scenarios before and after separation are the
result of a single set of simulations and are therefore less subject to
statistical artefacts and implicit correlation settings. A simulation in which
the undivided bank would be simulated as having one portfolio would implicitly
assume a correlation of 1 between the losses in a financial crisis of the DTB
portfolio and the TE portfolio (as they are run as one), rather than 0.5 when
they are run separately. This makes the tail of the undivided bank much fatter
than that of the separately run bank with pooled capital and LAC and it would
thus not provide an adequate baseline. | |
| [198] Total loss absorbing capacity is assumed to be equal to 8% Total
Assets. This minimum requirement is in line with the minimum amount of private
bail-in necessary to trigger intervention of a Resolution Fund in the position
on the BRRD of the Council of June 2013 (http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/137627.pdf).
Given that the introduction of a credible bail-in regime would trigger
dynamical responses of banks and markets which cannot be fully modelled here, a
conservative simplifying assumption is made that all liabilities which could
become eligible for bail-in in excess of this limit will be covered by
collateral or other guarantees. If more funds will be available for bail-in,
losses on public finances and expected losses on bail-inable first bonds might
be further reduced with respect to the results presented in the following. | |
| [199] See Appendix C for details of these definitions. | |
| [200] See Appendix E for details of this calibration | |
| [201] These behavioural responses are calibrated on the basis of the FIRB
formula (which is also the basis for SYMBOL simulations). The percentile to
which capital covers losses at the universal bank is approximated to be the
average of that of the DTB (99.9) and the TE (99), weighted with the relative
shares of RWA. This is about 99.72. | |
| [202] See section 5.2. | |
| [203] It should be noted that not all changes in the distribution of
losses necessarily produce a benefit, as losses for some stakeholders might
increase following separation (generating a cost), and that not all changes in
the cost of capital necessarily produce a cost, as total weighted average cost
of capital for some entities might decrease following separation (generating a
benefit). It should also be noted that these results are not strictly additive,
as variations in losses will translate into variations in the cost of exposed
liabilities if we allow risk premia to be influenced by changes in expected
losses. | |
| [204] Strictly speaking, aggregate benefits are given by the overall
reduction in gross and excess losses across all banks due to the behavioural
response following structural separation. Lower losses and lower bail-in
reduces the risk of contagion and facilitates resolution. Aggregate costs are
measured as the overall reduction in revenues of the TE due to the reduced
(risk weighted) assets. | |
| [205] See footnote 292. | |
| [206] This variable has a
coefficient of 0.17 before the introduction of Basel 2.5 regulation
changes in 2011. | |
| [207] Following the report “Analysis of possible incentives towards
trading activities implied by the structure of banks’ minimum capital
requirements” the liability side of derivatives is included in the
analysis. DTL are Derivative Liabilities Held for Trading and DHL are
Derivatives Liabilities Held for Hedging Purposes (DHA). | |
| [208] The coefficient obtained from the regression is 0.25, but its
t-statistic is so low that it has been set to zero for the purposes of
calculating RWAs. See the report cited in the previous note, section 3 and appendix
A, for additional details on this procedure. | |
| [209] First, estimated RWA are calculated for the TE and the DTB based on
these coefficients. These RWAs are then re-normalized to sum to the RWA of the
original undivided bank. | |
| [210] http://www.eba.europa.eu/documents/10180/87706/EBA-BS-2012-037-FINAL--Results-Basel-III-Monitoring-.pdf/778804a5-8e3e-4073-83df-afd1be0b626e | |
| [211] See footnote 5 for complete reference. | |
| [212] These effects are not to be confused with those linked to the
stricter definition of the quality of capital introduced by Basel 3.The change
in the RWA due to the change in the definition of capital measures: (i) the
effects of lower RWA for exposures that are included in RWA under Basel 2 but
receive a deduction treatment under Basel 3; (ii) the increase in RWA applied
to securitisation exposures deducted under the Basel 2 that are risk-weighted
at 1250% under Basel 3; (iii) the increase in RWA for exposures that fall below
the 10% and 15% limits for CET1 deduction. | |
| [213] The costs of the recapitalisation of banks to Minimum Capital
requirements is considered as all the banks of the sample are assumed to be
systemic in case of distress. | |
| [214] The costs of the recapitalisation of banks to Minimum Capital
requirements is considered as all the banks of the sample are assumed to be
systemic in case of distress. | |
| [215] For the behavioural response with increased capital in the TE,
gross losses for the trading portfolio are the same as in the baseline
scenario, but there is a lower recapitalisation need to the MCR due to the
higher initial capital. | |
| [216] In case of efficient capital markets there would not be a social
benefit in shifting losses from bail-in bonds to equity. However, as markets
are not efficient and spill-over effects and risks of contagion in case of
resolution and bail-in of bondholders are likely to remain substantially higher
than those of losses on equity. | |
| [217] See footnote 21. | |
| [218] This should also be considered part of the behavioural response, as
banks may try to keep risk constant for bail-in able bonds holders, as well as
for equity holders, as capital is increased towards the 8% TA LAC requirement. | |
| [219] Under a full applicability of the Modigliani-Miller theorem WACC
(for the whole banking system) would not change if the risks on the asset side
would not change. The allocation of losses across the banking system should equivalently
not affect the total funding costs of the banking sector (as long as there is
no shift of losses from the private to the public sector, and no change in the
total asset portfolio). The increase in funding costs of the TE and the
reduction in costs for the DTB should cancel out at unchanged balance sheets. Modigliani, F.; Miller, M., 1958, "The Cost of
Capital, Corporation Finance and the Theory of Investment". American
Economic Review 48, n. 3 | |
| [220] Effect (v) does not impact funding costs but is considered in the
overall cost assessment. | |
| [221] Costs (i) and (ii) have a direct impact on the TE and DTB WACC.
Effects (iii) and (iv) imply a benefit/costs to the banks creditors in case of
a financial crisis. The change in the riskiness of the banks’ capital and BiB
can affect the WACC if markets anticipate it. | |
| [222] Weighted averages are calculated based on
relative share of total assets in the final situation. I.e. the weights are 69%
and 31% for behavioural responses 1 and 2 and 79% and 21% for behavioural response
3, as resulting from Table 3. | |
| [223] These estimates of funding costs are broadly consistent with those
presented in the UK Government’s impact assessment (IA) for the Financial
Services (Banking Reform) Bill. Based on estimates provided by the major UK banks
of the likely effect on their funding costs the UK Government uses for the
purposes of the IA a range of minus 10 to 0bps for the changes in cost of
subordinated, long-term unsecured and short-term unsecured debt in the
ring-fenced banks and a range of 0 to 75bps for non-ring-fenced banks. Note
that these estimates only apply to 30-35% of overall funding costs, so to
compare to WACC impact that should be adjusted accordingly. Moreover, the UK IA
does not assume bail-in to be effective in the baseline. This implies that the
reduction in funding costs for the DTB is smaller (as it still benefits from
implicit subsidies), and the high end of the increase in funding costs for the
TE is likely to reflect loss of implicit subsidy. Also the UK IA does not analyse
any behavioural responses to the balance sheets. http://www.official-documents.gov.uk/document/cm85/8545/8545.pdf
(p31-56). | |
| [224] Bain (2013) reports that the 10 largest EU
banks had a return on RWA in 2009-2012 of 1.3%. Ranging across years between
0.9% and 1.7% on average. Bain estimates a return of 1.6% to 1.8% is required
to cover the costs of capital. Taking a range between 0.9% and 1.8%, the
reduction in revenues due to the reduction in RWA in the behavioural response 2
(reduced RWA) can be estimated to be 6-13 bn per year by multiplying the
reduction in RWA by the return on RWA. This lower revenue would reduce the
margin in case of BR2 by 9 to 18 bps. This may overestimate the actual effect
on the profit margin as the marginal return on RWA is likely to be lower than
the average return on RWA. Bain (2013) “European Banking Striking the right
balance between risk and return” at http://www.bain.com/publications/articles/european-banking-bain-report.aspx | |
| [225] The risk premiums
on senior unsecured debt and on subordinated debt reflect estimates for the
average for EU large banking group. The underlying data is taken from the EBA
Weekly Overview of Liquidity and Funding (WOLF), April 2013. The risk premium
on equity is based on the weighted average of the ROE over the period 1999-2011
for France, Germany, UK, Spain, Netherlands, Spain, Belgium and Italy which is
7%. Regulatory requirements reducing leverage tend to also reduce ROE. Source:
Federal Reserve Economic Data: http://research.stlouisfed.org/fred2,
Bank's Return On Equity, Percent, Annual, Not Seasonally Adjusted and AMECO
data for GDP at current prices. | |
| [226]The minimum LAC of 8% TA is assumed to be achieved by emitting
subordinate debt (in addition to equity). This allows calculations with a clear
hierarchy of bail-in losses, such that the subordinate debt absorbs all bail-in
losses The calculation is conducted as if new capital was replacing residual
bail-in capacity, and then by bringing back residual bail-in capacity to the
desired level by substituting subordinated debt for senior unsecured debt (see
next section): no real substitution of capital for bail-in capacity is
considered: This allows to best isolate the two effects and prevents double
counting. | |
| [227]De Lisa, R., Zedda, S., Vallascas, F., Campolongo, F., and Marchesi,
M. Modeling Deposit Insurance Scheme Losses a Basel II Framework.
Journal of Financial Services Research 40, 3 (2011). | |
| [228]In the current version of SYMBOL banks’ losses are obtained by Monte
Carlo sampling from a correlated multivariate normal distribution via Choleski
decomposition. | |
| [229] Vasicek O. A. “Loan portfolio value”, Risk, December 2002, http://www.risk.net/data/Pay_per_view/risk/technical/2002/1202_loan.pdf. | |
| [230] The common factor which drives the "internal value" of firms
would also be driving their "market value" in case they were traded.
Under the implicit assumption that all trading risk can be represented as risk
on traded credits and bonds, the base mechanism of SYMBOL can be used to
simulate a loss distribution based on both default and value risk. It should be noted that, while the standard
representation of the Vasicek model does not explicitly model cash flows and
operates on a pure net-present value (NPV) logic, their introduction would
simply result in a change of the definitions of losses and a shift of the
distribution leaving results unchanged. Similar models with additional risk factors or
variations of the correlation structure have been proposed several times in the
literature: Grundke (2004) proposes an integration of interest rate risk
introducing a Vasicek term structure model; Kupiec (2007) introduces credit
migration risk associated with different term structures by credit quality,
based on the Vasicek interest rate term structure model and Johnston (2008)
proposes an extension to pure equity investments considering dividend cash
flows and a CAPM-style correlation structure. Grundke, Peter, 2004, “Integrating Interest Rate Risk
in Credit Portfolio Models.” Journal of Risk Finance, vol 5, no. 2;
Kupiec, Paul, 2007, “An Integrated Structural Model for Portfolio Market and
Credit Risk.” in Berlin Conference on the Interaction of Market and Credit
Risk; Johnston, Mark, 2009, “Extending the Basel II Approach to Estimate
Capital Requirements for Equity Investments.” Journal of Banking and Finance,
vol. 33, no. 6. | |
| [231] Stahl, Gerhard, 1997, Three cheers. Risk Magazine, Vol. 10,
pages 67–69 | |
| [232] Meaning no
corrections except those for the switch to Basel III. See section 4 for
additional details. | |
| [233] A high correlation of losses across banks implies fatter tails of
the loss distribution. | |
| [234] The three SYMBOL-simulated crises can, according to the SYMBOL
model, be exceeded but with a very low probability: between 0.1% (99.9% simulation)
and 0.01% (99.99% simulation). Under the first simulation there is 0.1% chance
that the crisis will be bigger than estimated and the resolution framework will
not be able to cope with it. In the second and third case the chances are 0.05%
and 0.01% respectively. However, these probabilities are very much dependent on
the SYMBOL model specifications and in particular of the accuracy of the
probabilities in the Basel FIRB formula. Rather than relying on these
probabilities of occurrence of a systemic crisis, the aggregate outcomes of the
three considered simulations can be compared to the state aid used during the
recent crisis. | |
| [235] State aid for 2008-2011 comes from DG COMP state aid official
reports (439.0 billion €):
http://ec.europa.eu/competition/state_aid/studies_reports/expenditure.html,
Table: State
aid approved (2008 – Oct 2012) and state aid used (2008 – 2011) in the context
of the financial and economic crisis to the financial sector (2008 - 2011), in
billion Euro. | |
| As DG COMP figures are yet not
available for 2012, state aid for 2012 is based on DG MARKT elaborations derived
from DG ECFIN survey with Member States' via the Economic and Financial
Committee. | |
| Note that used state-aid measurement
is subject to two kinds of biases: all recapitalization support is included as
expenditure (while a part may be considered a financial transaction if it is in
exchange of valuable bank shares), and losses in any given year might be
unrecognized. | |
| [236] A “notch” is a step in the list of credit ratings, such as going
from AA+ to AA in the S&P and Fitch rating scale or from Aa1 to Aa2 in the
Moody’s rating scale. | |
| [237] Global Shadow Banking Monitoring Report 2013, 14 November 2013, FSB | |
| [238] E.g. EU banks were estimated to have had a shortfall of stable
funding of EUR 2.89 trillion in 2010. | |
| [239] Final report of the High-level Expert Group on structural bank
reforms chaired by E. Liikanen, 2.10.2012. | |
| [240] http://en.g20russia.ru/load/782795034. | |
| [241] Regulation (EU) 648/2012 of 4.7.2012. | |
| [242] Journal of Financial
Market Infrastructure, Autumn 2012 | |
| [243] http://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/short-term-markets/Repo-Markets/repo/latest/ | |
| [244] This number, however, includes double counting of transactions
between the participating institutions and may not represent the real size of
the market. | |
| [245]http://www.ecb.europa.eu/pub/pdf/other/euromoneymarketsurvey201311en.pdf?e34259b291b21d9dee4bc45bcc611b95 | |
| [246] Credit Swiss, UBS, Goldman Sachs, Morgan Stanley Deutsche Bank,
Barclays, Bank of America ML, HSBC and Citi. Source: JP Morgan Cazenove, Global
Equity Research, 28.5.2012. JP Morgan figures are not disclosed. | |
| [247] JP Morgan Cazenove, Global Equity Research, 25. 5.2012, page 20. | |
| [248] Regulation (EU) 575/2013 of 26.6.2013. | |
| [249] Directive 2004/39/EC 21.4.2004. | |
| [250] Regulation (EC) 1287/2006 of 10.8.2006. | |
| [251] Directive 2009/65/EC of 13.7.2009. | |
| [252] European Securities and Markets Authority’s Guidelines for
competent authorities and UCITS management companies on ETFs and other UCITS
issues of18/12/2012 ESMA/2012/832EN. | |
| [253] Directive 2011/61/EU of 8.6.2011. | |
| [254] Directive 2009/44/EC of 6.5.2009. | |
| [255] COM(2011) 656 final and COM(2011) 652 final. | |
| [256] FSB, Policy Framework for Addressing Shadow Banking Risks in
Securities Lending and Repos, 29.08.2013. | |
| [257] ESRB, Towards a monitoring framework for securities financing
transactions, March 2013. | |
| [258] D. Duffie, How Big Banks Fail and What to Do about it,
Princeton University Press, 2011, p. 39. | |
| [259]http://www.rolandberger.ch/media/pdf/Roland_Berger_Collateralized_trading_business_in_new_realities_20121102.pdf | |
| [260] BCBS, Consultative Document on Margin requirements for
non-centrally-cleared derivatives, July 2012, p. 32: “Securities or
funds collected as initial margin should not be rehypothecated or reused”. | |
| [261] IMF, Singh M., Velocity of Pledged Collateral: Analysis and
Implications, 2011. | |
| [262] Bank for International Settlements, Committee on the Global
Financial System, The role of margin requirements and haircuts in
procyclicality, March 2010. | |
| [263] "Securities lending in physical replication ETFs: a review of
providers' practices”, Morningstar, August 2012. | |
| [264] S. L. Schwarcz, Distorting Legal Principles, Duke
University School of Law, May 2010, p. 5. | |
| [265] These numbers are for cross-border funds, i.e. funds defined as
generating their assets from more than one market (threshold used is 20%).
Lipper "European Fund Market Review", 2012 and 2013 editions. | |
| [266] 49 responses were received from trade associations, intermediaries,
asset managers, market infrastructures as well as public authorities. | |
| [267] Cf. European Commission: Green Paper Shadow Banking, Brussels,
19.3.2012 and European Parliament: Report on Shadow Banking (2012/2115(INI)),
A7-03654/2012, 25.10.2012. | |
| [268]See section 10 of this annex, “detailed overview of existing and
proposed fund reporting requirements”, to have a detailed picture of the
exiting SFT reporting requirements in the UCITS and AIFMD frameworks | |
| [269] 18 European stakeholders responded to the section on transparency
to fund investors. | |
| [270] http://ec.europa.eu/internal_market/finservices-retail/docs/investment_products/20120703-proposal_en.pdf | |
| [271] FSB, Policy Framework for Addressing Shadow Banking Risks in
Securities Lending and Repos, 29.08.2013. | |
| [272] Cf. Annex 5, http://ec.europa.eu/internal_market/consultations/2010/securities_en.htm. | |
| [273] COM(2011) 656 final, 20.10.2011. | |
| [274] FSB consultation on Strengthening Oversight and Regulation of
Shadow Banking, 18.11.2012. | |
| [275] FSB consultations on Strengthening Oversight and Regulation of
Shadow Banking, 18.11.2012. | |
| [276] FSB consultations on Strengthening Oversight and Regulation of
Shadow Banking, 18/11/2012 | |
