Sunday, February 17, 2013

German Legislation Creates Modified Proprietary Trading Ring-Fence for Retail Banks, Mandates Living Wills

The German Government has approved legislation separating commercial and investment banking on the basis of a modified ring-fencing approach embodied in the E.U. Liikanen Report. The legislation also provides for the winding up and reorganization of financial groups. Finally, the legislation provides for criminal liability for executives at banks and insurance companies should such executives violate their duties.
The legislation, which was presented by German Finance Minister Wolfgang Schäuble, contains important additional building blocks in Germany’s new regulatory framework for financial markets. Finance Minister Schäuble stated that the German Government is committed to ensuring that no financial market, stakeholder or product goes unsupervised. This legislation, continued the Minister, takes a head-on approach to the financial system’s lack of resilience to crisis as well as the lack of accountability.
Living wills for banks. The legislation creates rules for planning the reorganization and winding up of credit institutions and financial groups, so that preventative action can be taken in good time to help systemically important banks that have got into difficulties. The affected institutions will have to present reorganization plans so that in cases of doubt the authorities can act more quickly and obstacles to winding up an institution can be removed. The regulator will be able to demand that obstacles to resolution be eliminated even before problems arise.
This is an additional element that is required in order to effectively tackle the problem posed by having banks that are too big or too interconnected to fail. These are financial institutions that are so large and complex that they cannot be wound up without negative consequences for financial markets as a result of their high level of interconnectedness with other parts of the financial system.
The new law is designed to prevent the situation arising in the future where taxpayers are left to cover the costs of a bank collapse. This is also the objective of Germany’s Restructuring Act of 2010, which created instruments for orderly bank resolution including the bank levy and the Restructuring Fund. By taking this step, Germany will become one of the first E.U. countries to tackle the legislative implementation of this contingency planning for banks, known as living wills, that was agreed internationally at the October 2011 meeting of the Financial Stability Board.
The German Government will continue to play a constructive and committed role in the discussions relating to the E.U.’s Recovery and Resolution Directive that began in June 2012. However, the German Government wanted to take the lead by approving the draft law and is pressing forward with national regulatory arrangements, as in the areas of high frequency trading, short selling and fee-based investment advice.
Separation of banking activities. An important goal of the legislation is to enhance the protection of retail banking against risks arising from speculative activities. This will benefit retail customers and ultimately also taxpayers. The legislation largely follows the findings and recommendations of the E.U. Liikanen Report. The Report of the High Level Expert Group on E.U. Banking Reform (Liikanen Report) recommended that proprietary trading and other significant trading activities should be assigned to a separate legal entity if the activities to be separated amount to a significant share of a bank's business.

Under the German legislation, if certain thresholds are exceeded, deposit-taking institutions and groups that include deposit-taking institutions will no longer be allowed to combine in one entity deposit-related activities and proprietary trading, which is defined as the purchase or sale of financial instruments on the financial institution’s own account that is not a service for a third party. Instead, the financial institution will have to spin off proprietary trading into a company that is legally, economically and organizationally separate and that will require a license in accordance with Germany’s Banking Act.
Separating risky activities from retail banking will increase the solvency of an institution and contribute to the stabilization of financial markets. If a financial group exceeds the relevant thresholds, it will only be allowed to make loans to hedge funds and other comparable highly leveraged companies, or issue guarantees for their benefit, if it does so via the independent company that conducts its proprietary trading.
The thresholds, which are based on the recommendations of the Liikanen expert group, are as follows: The relative threshold is exceeded if assets associated with trading activities comprise more than 20% of the total balance sheet, while the absolute threshold is surpassed if trading-related assets are worth more than €100 billion.
The relative threshold is supplemented by a simple criterion which stipulates that only companies with total assets of over €90 billion will be affected by the rules. This is intended to ensure that the regime does not apply to an excessive number of smaller banks that would otherwise exceed the relative threshold. Additionally, a trading unit that has been separated off may not benefit from less stringent supervisory requirements that apply to other institutions in the same financial group.
However, deposit-taking credit institutions will still be able to carry out proprietary trading on behalf of their clients, such as to conduct the purchase and sale of financial instruments for their own account as a service for third parties, including market-making. The German Federal Financial Supervisory Authority, BaFin, will, however, be empowered to demand the separation of market-making activities in individual cases, so that it is able to deal with special circumstances.
Criminal-law provisions. Finally, the legislation tackles the issue of individual responsibility by significantly strengthening and clarifying the ability of the authorities to take criminal action in cases of severe breaches of duty that could get an entire bank or insurance company into difficulty. The legislation assigns specific responsibilities for risk management to senior managers at financial institutions. The violation of important risk-management duties will be punishable with a maximum of five years’ imprisonment should it threaten a firm’s viability as a going concern or if it jeopardizes insurance companies’ abilities to meet their obligations relating to insurance policies. These provisions create sanctions for mismanagement that will help to prevent future corporate crises and their associated negative effects on society and the economy.