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Big headaches headed Lord Hill’s way

The news that the UK’s Lord Hill had secured the coveted post of commissioner for financial stability and regulation in the new EU Commission, prompted plenty of celebration in UK political circles, writes Jeremy Jennings-Mares.

Upon taking up his new office though, Lord Hill’s attention will quickly have turned away from brimming champagne to the overflowing in-tray of regulation aimed at reshaping Europe’s banks. So, what legislation, both closer to home and at the wider EU level, does the new commissioner need to get to grips with?

Too big to fail?

By the end of this year, EU member states should have enacted much of the legislation enabling regulators to resolve a failing bank with minimum cost to the public purse. Bail-in legislation should follow within the year. But, large gaps in the framework still remain.

Firstly, in relation to multi-national groups there is the subject of cross-border regulatory co-operation and recognition of home state resolution actions. Can resolution authorities in the different jurisdictions be expected to play together nicely?

For instance, the Bank of England has stated that it would, in principle, be prepared to step aside and allow UK subsidiaries of a US financial group to be resolved by the US authorities, so long as it receives a reciprocal “in principle” statement from US authorities. Similar mutual understandings will be needed between the UK and other major jurisdictions.

On the subject of bank capitalisation, the phased implementation of Basel III minimum capital requirements is already underway in Europe with the liquidity and leverage ratio requirements waiting in the queue. Added to the mix are the latest proposals from the Financial Stability Board as to the total loss absorbing capacity to be held by those banks judged to be systemically important.

The headline-grabber is the minimum level (16-20% of risk-weighted assets), but equally important are the proposals on where that loss absorbing capital should be located in a cross-border group structure. Authorities in each relevant jurisdiction will be eager to keep as much capital as possible within their reach.

ISDA has played its part too: with the support of 18 global banks, it has commenced a process of getting parties to derivatives and securities financing transactions to agree to the temporary suspension of their early termination rights against banks under resolution.

Add a fence

Attention is now turning to another key feature of solving the too-big-to-fail conundrum – that of structural reform of banking groups, in order to make it easier for resolution authorities to preserve continuity in critical economic functions. At EU level, draft legislation has been adopted by the European Commission on bank structural separation. The European Parliament intends to consider it in plenary session in April 2015.

The approach of the UK to structural change has revolved around the functional separation of certain banking activities, or ‘ring-fencing’. The primary legislation adopting these recommendations, made in the Vickers report, has now been enacted.

Although initiated by the Liikanen report of 2012, the EU legislative proposals now under consideration have moved some way from those original concepts. The EU proposals (similar to their US counterpart) firstly prohibit trading for own accounts using own capital or borrowed money, and prevent investment in alternative investment funds. However, unlike the Volcker rule in the US, this will not apply to all deposit-taking institutions in the EU. It is expected to apply to the approximately 30 largest banks.

The second strand of the EU legislation borrows from the ring-fencing concept of the UK legislation. However, in contrast to the relative clarity of the UK’s ring-fencing requirements, the EU version does not clearly mandate the separation of a banking group’s trading activities from its retail and commercial banking activities.

Instead, it directs national regulators to “consider” the separation of trading and other activities, depending upon the risk that each credit institution presents. It leaves it to the European Banking Authority and the EU Commission to legislate for the thresholds and methods of determining when a bank’s activities need separating.

Challenges to certainty and consistency

All of these differing regulations could present big headaches for Lord Hill. The EU legislation around structural reforms and ring-fencing create high levels of uncertainty, particularly in regards to where and when the ring-fence will be required and whether states such as the UK will be granted a derogation.

Although the ability exists to apply for a derogation from the EU ring-fencing rules, on the basis that states already have equivalent national legislation in place, it is currently uncertain whether or not the UK’s legislation will be considered sufficiently equivalent.

The EU proposals are intended to have extra-territorial effect by applying to the non-EU subsidiaries of EU banks, and to the EU branches of non-EU banks, unless the EU Commission considers the relevant non-EU jurisdiction to have equivalent laws.

However, in order to be considered equivalent, the non-EU jurisdiction is likely to require both Volcker-style prohibitions as well as ring-fencing provisions, and will also be required to recognise EU legislation in the same way as the EU legislation recognises its laws.

This raises questions as to how effective and consistent these different structural separation requirements are going to be for cross-border banking groups. In the context of derivatives legislation and rule-making, under EMIR in Europe and Dodd Frank in the US, the challenges of achieving mutual recognition between different jurisdictions have proven to be immense.

Good night and good luck

In short, Lord Hill and his colleagues in the EU Commission have their work cut out for them. By the looks of their current plate, it may be sometime before we see an entirely new menu.

Jeremy Jennings-Mares is a Partner at Morrison & Foerster in London

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