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Europe Looks to Impose New Curbs on Universal Banks

With the Libor scandal stoking demands for reform, U.K. and EU regulators embrace the idea of separating retail and investment banking.

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.

The recent regulatory debate has introduced unwelcome uncertainty for U.K. bankers, who thought that ring fencing was all decided except for the details. Before the Vickers commission published its final report, several banking executives had spoken out strongly against the idea of imposing barriers between retail and investment banking. In June 2011, RBS chief executive Stephen Hester told the House of Commons’   Treasury Committee that ring fencing would create moral hazard by effectively guaranteeing state protection to retail banks.

The government’s quick endorsement of the Vickers recommendations quieted most bankers, though. And Hester was in no position to oppose the government, given that his bank is 82 percent state-owned after receiving a massive bailout. In October 2011, Hester told another Commons committee that ring fencing was a “done deal,” even though he complained that “the costs of the proposals would not be balanced by the benefits.”   The most outspoken opponent of ring fencing — former Barclays CEO Robert Diamond Jr. — was forced to resign over the Libor affair.

Now the banks have gone quieter still. One senior executive at a U.K. retail bank, who says he talks to regulators almost every day, predicts that the costs of ring fencing are likely to be “not insignificant, but manageable.”   This banker predicts that lobbying over the detailed implementation of the banking bill is likely to continue for another 18 months. “I think 50 to 70 percent of the detail is yet to come,” he says.

It would be no surprise in coming months if the banks lost at least one battle, over derivatives. Chancellor Osborne has asked the parliamentary commission to consider whether ring-fenced retail banks should be allowed to sell simple derivatives. His move followed recent revelations that Barclays, HSBC, Lloyds and RBS had improperly sold complex interest rate swaps to thousands of small businesses. The banks will have to pay compensation that could total as much as £1.4 billion ($2.3 billion), estimates Sandy Chen, a banking analyst at Cenkos Securities in London.

Estimates of the cost of requiring U.K. banks to put their retail activities into separate subsidiaries vary, but nearly everyone acknowledges that the change will not be cheap. The government forecasts that the provisions in the draft bill would cost banks between £2 billion and £5 billion a year; most analysts think the actual figure will be higher. “We believe the annual cost will be up to £7 billion, or 20 percent of the U.K. banks’ total profits,” says Nomura’s Peace. Barclays, which has the largest U.K. investment bank, will be the principal victim, with annual costs of as much as £2 billion, he estimates. The main factors? A need for more capital and a higher cost of funding for investment banking subsidiaries because they would no longer benefit from the ratings, and U.K. retail deposit bases, of their parent companies.

“The cost of funding will vary a great deal within the same group,” says Anik Sen, a member of the investment management team for global equity funds at PineBridge Investments in London. “Apart from anything else, an implicit government guarantee is worth at least a two-notch credit rating upgrade — and there could be much higher volatility in the cost of debt, depending on the point in the cycle for the investment banking arms.”

The government also plans to raise capital requirements for the new ring-fenced retail banking operations. Those entities would have to hold primary loss-absorbing capital amounting to 17 percent of their risk-weighted assets, including equity capital of at least 10 percent and long-term unsecured debt — so-called bail-in debt — that could be drawn on to cover losses in a crisis. By contrast, the Basel III banking accord that major nations have adopted in response to the crisis sets a minimum capital requirement of 7 percent, and requires systemically important institutions to hold an additional capital buffer of up to 3.5 percent.

Bankers warn that the costs of a ring fence could dampen lending by retail banks. “It will add to the cost of funding of the bank as a whole, and this will trickle down to the retail and wholesale arm,” Mark Harding, Barclays’ group general counsel, told the House of Lords’ committee on banking reform last month.

For EU banks the costs of adopting the Liikanen group’s proposals are also expected to be significant. Peace believes that for the largest banks in continental Europe, such as BNP Paribas, the annual costs could be €1 billion a year.

Aside from the expense, there are legitimate doubts about whether ring fencing will be effective. By protecting established, systemically important retail banking players, the ring-fencing solution could conflict with the government’s stated aim of encouraging greater competition in retail banking. As PineBridge’s Sen says: “I think this could end up enhancing the oligopoly in U.K. retail banking as an unintended consequence. The big banks will have an aura of greater protection, and they will probably attract the larger flows of deposits.”  The retail arms of Barclays, HSBC, Lloyds, RBS and Santander UK will be beneficiaries, he says. They currently dominate the retail market, collectively providing 69 percent of new mortgages in 2011 and 60 percent of all credit card lending, according to industry bodies.

Osborne has endorsed the Vickers commission’s call for fresh competition in retail banking, noting that the crisis led to the disappearances of HBOS (acquired by Lloyds, in which the government holds a 43 percent stake) and Bradford & Bingley, a mortgage specialist whose viable operations were bought by Santander in 2008. Vickers commission chairman Tyrie also called for greater competition in his recent speech at the BBA. “There is not enough market discipline on the retail banks,” he said. “They are oligopolistic.”

In the eyes of many politicians, requiring banks to legally separate their retail activities doesn’t adequately address the issue of investment banking culture. Announcing his decision to form the parliamentary commission, Prime Minister Cameron said it was “outrageous” that homeowners might have had to pay higher mortgage rates because of Libor manipulation, and he added that some of the banks’ activity was probably illegal.

Liikanen acknowledged the limits of his ring-fencing proposal when he appeared before the parliamentary commission last month. “I can’t claim that it will change a transaction-based culture to a customer-based culture,” he said.

Several witnesses told the parliamentary commission last month that a ring fence would not be sustainable. Martin Taylor, a former Barclays CEO and a member of the Vickers commission, said he preferred the prohibition of certain risky activities. The only reason the Vickers panel did not recommend full separation was out of concern that some banks would move abroad, hurting London’s position as a financial center, but that is less of a concern now, he said.

Andrew Haldane, executive director for financial stability at the Bank of England and an increasingly bold thinker about regulatory reform, made the case for a stricter separation of retail and investment banking in a speech last month by expounding on the conflicts inherent in universal banks. “High-private-return investment banking activities may crowd out the human and financial resources devoted to high-social-return commercial banking activities. Investment banking activities might also piggyback on the cheaper cost of deposit funding,” Haldane said. “In effect, universal banking allows privately optimal but socially suboptimal cross-subsidization.”

Increasingly, many of the banks’ customers share that view. Mike Spicer, senior policy adviser to the British Chambers of Commerce in London, which represents 100,000 small and medium-size businesses, told the commission that his members wanted a broader shake-up of banking to boost lending. “There should be long-term benefits” of regulatory reform, he tells II. “Half of our members mistrust banks, according to our surveys. Banks have moved away from relationship banking, and separating retail from investment banking can be part of a broader effort to help banks to rediscover their roots.”

Europe moved more slowly than the U.S. in embarking on regulatory reform, but the Libor scandal has concentrated minds and fueled politicians’ appetite for change. Ring fencing looked radical when the Vickers commission proposed it a year ago. Now it may be just the first step of a broader crackdown on banks.  •  •

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