The Case for a Structural Reform, The Proposals of the High level Expert Group
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1 The Case for a Structural Reform, The Proposals of the High level Expert Group 12 February 2013, Helsinki Governor Erkki Liikanen Chairman of the High level Expert Group SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND
2 The Group s mandate Assess whether banking structures need changes in order to 1. achieve a safe, stable, and efficient banking system, 2. which provides for the needs of the EU citizens, the EU economy and the Internal Market Take account of the on-going regulatory reforms especially capital adequacy regulations and the Commission s recovery and resolution proposal Assess the existing structural reform proposals Vickers report, Volcker rule/dodd-frank Act SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 2
3 Rapid growth in the EU banking sector Total assets of MFIs in EU Note: Bar charts show total t assets, dotted d line shows assets as % of GDP Source: ECB data as presented in High-level Expert Group Final Report SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 3
4 Shifts in focus of operations as illustrated by shifts in assets structures Evolution of assets of MFIs in EU the euro area ( billion) Notes: Customer loans are loans to non-monetary financial institutions excluding general government Source: ECB data as presented in High-level Expert Group Final Report SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 4
5 Increased leverage as illustrated by shifts in funding structures Evolution of liabilities of MFIs in the euro area ( billion) Notes: Customer deposits are deposits of non-monetary financial institutions excluding general government. Source: ECB data as presented in High-level Expert Group Final Report SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 5
6 Implicit subsidies remain high Credit ratings and systemic support uplift for a sample of EU and US banks (previous and current after downgrade d in 6/2012) Source: Moody's (2012) as presented in High-level Expert Group Final Report SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 6
7 Insufficiencies in capital requirements on trading book positions Capital requirements for market risk for large EU banks (2011, as % of trading assets) Notes: Capital requirements calculated as 8% of RWA for market risk Source: Data from Bloomberg as presented in High-level Expert Group Final Report SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 7
8 Focus of current regulatory reforms Regulatory reforms have been focused on two crucial areas Capital adequacy and liquidity requirements as set by Basel III and implemented in EU by means of regulation and a directive The Commission s recovery and resolution framework The regulatory reform will, at least to some extent improve the resilience of banks, reduce incentives for excessive risk taking and leverage, reduce complexity and interconnectedness and reduce the social costs of bank failure and the need for implicit government guarantees SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 8
9 Two avenues as a possible way forward were considered Avenue 1 Avenue 2 A non-risk weighted capital requirement is imposed on trading activities. Conditional separation of activities is imposed, if the bank cannot prove that the required recovery and resolution plan is credible. Mandatory separation of retail banking and investment banking is imposed on banks. Cf. Darrell Duffie Cf. Alan Blinder SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 9
10 The five proposals of the High-level Expert Group 1. Mandatory separation to deposit bank and trading entity 2. Additional separation requirement If the recovery and resolution plan otherwise not credible 3. Bail-in instruments Pre-defined scope and terms to facilitate pricing and liquidity 4. A review of capital requirements on trading assets and real estate related loans 5. Strengthening the governance and control of banks Including the use of bail-in instruments in compensation SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 10
11 The High-level Expert Group s proposal for mandatory separation Activities separated to the trading entity : Proprietary trading and market-making ki Loans, loan commitments and unsecured credit exposure to hedge funds, SIVs, and private equity investments Activities which are permitted to deposit banks : Hedged, client-driven transactions that fall within narrow risk position limits Securities underwriting Activities permitted only to deposit banks Insured deposits and supply of retail payment services Restrictions on transfers and exposures between the separated entities The entities can be operated within a banking group SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 11
12 Proprietary trading Market making HF, PE, SIV loans Retail payments Lending Securities underwriting Forex and interest rate swaps Trading entity Restrictions on transfers and risk exposures Deposit bank Capital Funding from the market Insured deposits Capital Funding from the market Liikanen Group s proposal SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 12
13 Rationale for mandatory separation Prohibit banks with insured deposits from engaging g g in trading activities whose risks are potentially high and difficult to measure precisely Complements risk-based capital requirements Reduce complexity and interconnectedness Facilitates recovery and resolution and thus helps make it credible Enhances bank management and supervision Makes the pricing of funding of the separated entities more efficient and risk-based Reduce mixing of management cultures One-stop shopping still possible SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 13
14 Mandatory separation aim to tackle some of the problems in EU banking identified by HLEG Identified problem by HLEG Excessive risk-taking in trading, lending, funding Complexity (making bank management, monitoring, supervision and resolution challenging) Limited loss absorbency Intra-group subsidies Ineffective governance and control Result Increased probability of failure Interconnectedness Limited resolvability Bank-sovereign feedback loop Increased impact of failure Inadequate EU institutional framework Excessive focus on intra-financial business, as opposed to real economy Competitive distortions and implicit subsidies Inadequate consumer protection Reduced internal market efficiency and level playing field SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 14
15 Comparison of suggested structural reforms Volcker banking group Proprietary trading, Hedge fund (HF) and Private equity (PE) exposures HLEG banking group Market making Swaps push-out Investment and commercial banking Proprietary trading Market making HF, PE and SIV unsecured exposures Investment, commercial and retail banking Vickers banking group Investment and commercial banking, Proprietary trading, Market making Retail banking with higher capital requirements SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 15
16 Comparison of the structural proposals p HLEG vs. Vickers Vickers ring-fences deposit banking, HLEG separates high-risk trading Differences: Vickers deposit bank with higher capital requirements Securities underwriting not allowed in Vickers deposit bank Restrictions regarding g non-eea customers in Vickers deposit bank HLEG vs. Volcker HLEG avoids the fine line between proprietary trading and market making Volcker Rule pushes proprietary trading outside banks. This has been criticized for definitional problems and potential market liquidity and stability implications. SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 16
17 HLEG s proposals 2 and 3 (to further support recovery and resolution) 2) Wider than mandatory separation should be possible, if a credible recovery and resolution plan for a bank so requires 3) Improving the market for bail-in instruments If a bank in financial distress, bail-inable inable debt can take a haircut or be converted into equity Clear contractual terms make pricing more efficient and support liquidity Issuance up to a certain amount to non-financial investors SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 17
18 Proposals 4 and 5 4) Capital requirements review The Commission should assess whether the outcome of Basel Committee s review of trading book capital requirements is sufficient for covering risks in the EU A similar review recommended on capital requirements on real estate related loans 5) Enhancing corporate governance and control in banks Risk management function should have a more central role Curbing size and improving incentives of compensation Improving risk reporting SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 18
19 On the role of banking Banks play an important role in the society Provide payment services to ease trade Mobilise and pool savings and allocate these to investments Engage in maturity transformation Manage risk on behalf of less sophisticated stakeholders Banks have a pivotal role in providing finance to the real sector particularly in Europe Strengthening banks ability to provide socially vital financial services efficiently and in a stable manner benefits our societies at large SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND 19
20 Thank you! SUOMEN PANKKI FINLANDS BANK BANK OF FINLAND
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