Friday, January 31, 2014

E.C. Proposals Would Ban Proprietary Trading, Illuminate Shadow Banking

The European Commission (E.C.) has issued twin proposals to ban big banks’ proprietary trading and to improve shadow-banking transparency. The proposed regulations work in tandem to avoid a scenario in which a bank could evade the proprietary trading ban by hiding risky activities in other corners of its business, said a press release announcing the proposals.

The proprietary trading ban is a more aggressive tack than the one floated in the 2012 Liikanen report, which recommended that banks separate their riskiest activities from their deposit-taking functions. The report had concluded that excessive risk and the interconnectedness of financial institutions, not any particular banking model, likely explained the 2008 global financial crisis. A summary of the proposed ban, however, said the E.C. did not intend to end the universal banking model.

Commissioner Michel Barnier described the proposals as the “final cogs” needed to ensure the end of too-big-to-fail and the era of taxpayer bailouts. “This legislation deals with the small number of very large banks which otherwise might still be too-big-to-fail, too-costly-to-save, too-complex-to-resolve.”

Commissioner Barnier also noted that the proposals would establish a common framework to uphold the E.U.’s single market and would seek to balance regulatory goals with economic growth. Said Barnier, “The proposals are carefully calibrated to ensure a delicate balance between financial stability and creating the right conditions for lending to the real economy, particularly important for competitiveness and growth.”

Private sector reaction to the proposals was mixed. Clifford Smout, co-head, Deloitte Centre for Regulatory Strategy, said that passage by the European Parliament and Council is not assured. He also noted that the ban on proprietary trading is similar to the U.S. Volcker Rule, but is much tougher than current European Union rules. “Even if the ECB ends up taking the lead on these issues within the eurozone, there could be inconsistencies between these rules and those in operation elsewhere,” said Smout.

“Although well trailed, the big surprise is the total ban on proprietary trading which goes beyond the original Liikanen proposals,” said Giles Williams, regulatory partner, KPMG, in a statement. Williams also cautioned that the proposal may spur regulators to focus on shadow banking. “These proposals signal an intentional push of risky trading activity into the shadow banking sector, which is likely to be the next target for regulation.”

Proprietary trading. Article 6(1) of the bank structural reform proposal would ban all proprietary trading that is done solely to enhance bank profits. The ban, however, would not apply to financial instruments issued by a member state’s central government or to bank cash management processes that involve cash or highly liquid cash equivalent investments with low risk and shorter maturities.

The proprietary trading ban also would apply only to the largest banks that meet the “entities” definition in Article 3. As a result, the ban applies to any credit institution or E.U. parent that has been designated a global, systemically important institution under the relevant E.U. directive. The ban also applies to an E.U. credit institution that is neither a parent nor a subsidiary, an E.U. parent that has a group entity that is an E.U. credit institution, and E.U. branches of credit institutions organized in third countries. These other entities must have, in a consecutive three-year period, at least €30 billion in total assets and trading activities in excess of either €70 billion or 10 percent of total assets.

The proposal also would permit subsidiarization within a banking group to deal with some risky trading activities. Article 8(1) defines “trading activities” to mean activities other than insured deposits, consumer and commercial lending, financial leasing, payment services, travellers’ cheques and bankers’ drafts, money broking (including safekeeping and administration of securities), credit reference services, safe custody services, and the issuance of electronic money.

Bank supervisors would need to monitor banks’ trading activities regarding market making, securitizations, and derivatives trading under Article 9(1). If the supervisor found that a bank’s trading activities threatened the bank’s (“core credit institution’s”) financial stability or the whole E.U. financial system, it must begin proceedings under Article 10(1) or 10(2) to determine if the trading activity should be separated from the bank’s deposit taking functions.

A bank can rebut the supervisor’s decision under Article 10(3). A bank that is subject to a decision under Article 10, however, may still engage in trading activities under Article 11 to prudently manage its own risk. Likewise, Article 12 lets a bank that is the subject of an Article 10 decision sell certain types of derivatives for hedging purposes if the bank’s funds requirements do not exceed a proportion of its total risk capital requirement as set by a future E.C. delegated act.

Upon a banking supervisor’s finding that a trading activity is not permitted to a bank that is part of a group, the trading activity may be done only by a separate “trading entity” that is legally, economically, and operationally distinct from the bank. A bank also may voluntarily separate trading activities into a trading entity upon the banking supervisor’s approval of an Article 18 separation plan.

Shadow banking. The E.C.’s related proposal on shadow banking would shed new light on banking-like activities that occur outside the traditional banking sector. These activities can resemble bank deposits, enable maturity or liquidity transformation, or involve the transfer of credit risk or the use of leverage. According to a FAQ, the proposal aims to improve shadow-banking transparency in a way that is consistent with prior recommendations of the Financial Stability Board.

Article 2(1) would apply the proposed transparency regime to counterparties to securities financing transactions (SFTs) established in the E.U. and to certain foreign SFTs that use E.U. branches. Management companies of undertakings for collective investment in transferable securities (UCITS) and managers of alternative investment funds (AIFMs) that are subject to the E.U.’s UCITS and AIFM directives are included. The proposal’s scope also snares counterparties who engage in certain rehypothecations.

The heart of the proposal is a reporting regime that would make SFTs less opaque. Article 4(1) requires SFT counterparties to report these transactions to a trade repository. Details of SFTs must be reported by the working day after the SFT was concluded, modified, or terminated.

Trade repositories would be required to register with the European Securities and Markets Authority (ESMA) under Article 5(1). The proposal said the use of trade repositories for SFTs would better equip banking supervisors to spot ties between traditional banks and entities that operate within the shadow-banking system. To achieve transparency, Article 12(1) would require trade repositories to “regularly” publish aggregate data on the SFTs reported to them by SFT counterparties. Article 19 lets ESMA recognize third countries’ trade repositories and enter into cooperation agreements with third countries.

Article 13(1) mandates certain disclosures by UCITS firms and AIFMs to their investors regarding how these entities use SFTs. Article 15 provides for the right of counterparties to rehypothecation if the specified requirements are met.

Under Article 20, E.U. member states must establish administrative sanctions for breach of the Article 4 reporting obligation and the Article 15 rehypothecation right. Article 21 lists the factors member states must consider when imposing administrative sanctions. Article 24 requires that decisions resulting in administrative sanctions, and any appeals of those decisions, must be published by the member state’s supervisory authority on its website.

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