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EUROPE'S DEBT CRISIS HAS CAUSED A number of ruptures in the once-mighty single market. Investors have pulled money out of hard-hit peripheral countries and fled to the bloc’s northern core; the European money market has fragmented along national lines, making it harder for banks in the periphery to fund themselves; and regulators are demanding that financial institutions hold larger capital buffers in each country.

Now the European Union is bracing for the rise of a new series of barriers ­— this time inside the region’s leading banks. An advisory group led by Finnish central bank governor Erkki Liikanen last month recommended that major banks be required to place their proprietary trading and market-making activities into separately managed and capitalized subsidiaries. The proposal aims to insulate the banks’ deposit-taking and lending operations from their riskier market activities and reduce the potential need for future bailouts like those many governments extended during the global financial crisis of 2008 and ’09.

The Liikanen report echoes the findings last year of the U.K.’s Independent Commission on Banking, with a twist. The U.K. panel, headed by Sir John Vickers, an economist and head of All Souls College, University of Oxford, recommended that British banks be required to ring fence their deposit-taking businesses in separate subsidiaries to protect them from the risks of investment banking. But however the fence is constructed — by walling off market activities or walling off retail banking — the practical effect is likely to be similar in terms of added costs and managerial complexity for Europe’s big universal banks, analysts say. But unlike the so-called Volcker rule in the U.S., which will ban banks from trading for themselves and investing heavily in private equity, the segmentation proposed by European regulators will allow banks to continue their full range of operations.

Yet for all its popularity in Europe, ring fencing is proving very difficult to implement. Liikanen’s proposal is only a few weeks old, and it’s not yet clear whether Michel Barnier, the EU commissioner for internal market and services, will introduce legislation to adopt it. The U.K. has embraced the concept for more than a year, but regulators and politicians are months away, at best, from adopting legislation that would put it into practice.

The Vickers commission studied the industry for a year before proposing its ring-fencing solution in September 2011. The government of Prime Minister David Cameron endorsed the commission report immediately, released a white paper in June outlining how it intended to adopt ring fencing and published draft legislation last month, but the bill is moving slowly through Parliament, and lawmakers and regulators are struggling to define essential features of the new regime. “I’m still not clear as to what ring fencing will actually mean,” says Ian Gordon, a banking analyst at Investec Securities in London. “There are more questions than answers at this stage.”

What isn’t in doubt is the determination to impose tighter regulations on banks. The Libor scandal that erupted in June after Barclays paid $455 million to settle charges that it tried to manipulate the benchmark interbank rate has unleashed demands for tougher constraints on banks. In July, Cameron appointed the ten-person Parliamentary Commission on Banking Standards to investigate conflicts of interest and issues of “culture and professional standards” in banking as well as advise on the best way to implement the Vickers commission’s ring-fencing proposal.

At hearings last month parliamentarians said they were determined to stamp out the “cross-contamination of culture” that investment banking divisions can cause inside big banking groups and indicated that a ring fence alone might not be sufficient. Several members spoke favorably of the Volcker rule and indicated they might favor an outright ban on certain activities. “We have an open mind,” says Andy Love, a Labour Party member of the commission.

The Libor scandal helped convince the Liikanen panel that the EU needed to impose structural barriers on the industry to protect deposit-taking activities from banks’ riskier market operations. Although Barnier hasn’t yet committed the European Commission to adopting a ring-fence rule, some officials believe the pressure for EU legislation will be overwhelming, if only to head off the creation of differing national rules. In France, François Hollande promised to introduce measures to separate banks’ riskier market activities during his recent successful presidential campaign, and officials have vowed to present legislation before the end of this year.

The Liikanen group recommended that banks be required to separate their proprietary trading and market-making activities in cases where those businesses have assets of more than €100 billion ($129 billion) or exceed a range of 15 to 25 percent of the group’s balance sheet. Jon Peace, a banking analyst at Nomura Securities Co. in London, estimates that the rule would affect 19 banks, including Germany’s Deutsche Bank, France’s BNP Paribas and Société Générale, Italy’s Intesa Sanpaolo and Spain’s Banco Santander.

In the U.K. the Vickers commission proposal called for the ring fencing of all “systemically important” retail banks, which effectively means the country’s Big Five: Barclays, HSBC Holdings, Lloyds Banking Group, Royal Bank of Scotland Group and Santander UK. Those companies would have to make their retail operations legally and operationally independent from their parent banking groups and provide them with their own capital backing, according to the draft bill. The proposed legislation provides little detail about how the new arrangement would work, though. Many of the blanks are supposed to be filled in later by Treasury officials in so-called secondary legislation, just as the Dodd-Frank Wall Street Reform and Consumer Protection Act requires U.S. regulators to write scores of detailed rules. “Essentially, the only concrete proposal is that retail deposits cannot be on the same side of the ring fence as prop trading,” Mark Garnier, a Conservative member of the commission, tells Institutional Investor.

“The draft bill appears to leave a lot of detail to be determined in secondary legislation,” commission chairman Andrew Tyrie said in the House of Commons last month. “We will press vigorously to find out what that is going to contain.”

The draft bill says “core activities” must be placed within a separate company, and it refers to “excluded activities” that must be moved outside the ring fence. But the bill specifies only one example of a core activity — the taking of deposits — and identifies only one excluded activity: “dealing in investments as principal,” or prop trading. The Treasury must decide where other activities should go.

The bill will also give the Treasury and regulators considerable discretion in devising the rules governing the relationships between ring-fenced entities and other companies within the same group. The draft legislation spells out only certain basic principles, such as the need to restrict the number of shares a ring-fenced company can own in other companies, and that contracts with other companies in the group must be done “on arm’s length terms.”

Corporate governance issues raised by ring fencing haven’t been addressed yet, either in the U.K. or at the EU level. In an appearance before the parliamentary commission last month, Liikanen was asked by Lord Turnbull, a commission member who sits on the board of U.K. insurer Prudential, “How does the group exert its discipline on a [ring-fenced] subsidiary?” The central bank governor offered little in the way of an answer. “Work remains to be done,” he said. “We have not solved every problem.”

The vagueness of the U.K. draft bill is encouraging commission members to consider broader changes to banking regulation. Labour parliamentarian Love says outrage over the Libor scandal could push the commission to take a tougher stance toward the banks. “There’s been something of a reassessment because of recent events, and there is more evidence to look at,” he notes.

Love says it’s too early to say what the commission will recommend when it makes its final report, which is due by the end of the year, but it is notable that commission members were positive in their questioning of former Federal Reserve Board chairman Paul Volcker when he appeared before the panel last month. Volcker asserted that a ring fence would be “difficult to sustain” because two subsidiaries of the same group could not be entirely independent of each other. Complete separation would be more logical, he said.

Commission chairman Tyrie described Volcker’s testimony as “extremely impressive.” At a British Bankers’ Association conference the same day as Volcker’s appearance, Tyrie said the commission would consider whether to add fresh constraints on banks — including “a deeper separation” between retail banking and trading activities — as a result of the Libor affair.

The talk of tighter restrictions is hardly surprising. Since the crisis the U.K. has arguably seen stronger public condemnation of banks than the U.S. Chancellor of the Exchequer George Osborne ripped into big banks after the Barclays Libor settlement, telling the House of Commons that “through 2005, 2006 and 2007 we see evidence of systematic greed at the expense of financial integrity, and they knew what they were doing.” The ring-fencing proposal by the Vickers commission was something of a compromise between the status quo of universal banking and a strict separation of retail and investment banking along the lines of the old Glass-Steagall Act, enforced in the U.S. until 1998. Sir Mervyn King, governor of the Bank of England, said a year ago that he preferred a modern-day Glass-Steagall law for British banks.

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