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Large uncertainties haunt the banking sector in the EU. A lack of clarity about the scope and timing of several pieces of financial sector legislation that are in the pipeline, the macroeconomic headwinds from the unresolved problems of the Eurocrisis and the prospect of a risky transition to a smaller, safer and better-regulated banking system are weighing on investor interest in the sector. Without a renewal of interest from investors in recapitalizing and funding banks, the sector will remain in limbo. In this piece, first published in the Quantum Magazine of the Qatar Financial Centre, Sony Kapoor highlights the key aspects of reforms underway.

The European Union’s initial legislative response to the global financial crisis was much slower than that of the United States, which moved rapidly to introduce the Dodd-Frank bill on financial reform. But, as the economic crisis in the EU deepens, new legislation on the functioning of the financial system continues apace and the Eurozone is now pressing ahead with plans to create a banking union.

The reforms which are in the pipeline will result in a radical transformation of the banking sector. There will be changes in the structure of banks, their capital and liquidity requirements and even a single supervisory authority. However, the speed at which these reforms are to be introduced is much less clear. The new structure will have to be approved by EU governments, balance the needs of Eurozone and non-Eurozone states and take into account the views of the banking sector, which itself remains divided on some of these reforms.

An example of the difficulties in getting rapid decision-making in the EU is the slow progress of the flagship regulation on bank capital and liquidity, which aims to incorporate Basel III into EU law. Before this can happen, the European Council and the European Parliament have to reach an agreement; but they remain split over important matters such as minimum capital requirements, the timing of the mandatory introduction of liquidity ratios and restrictions on bankers’ bonuses.

New Capital and Liquidty Laws

Divisions between the governments of Member States and the European Parliament are delaying progress on implementing Basel III into EU law.

The European Parliament wants higher capital levels, a differentiated but proportionate approach to banks based on their size or business models, the introduction of mandatory liquidity ratios sooner rather than later and caps to ensure that bonuses are not higher than the basic salary. It is likely to achieve some of what it seeks on capital, may lose the battle on a stricter approach to liquidity (given that the Basel committee itself has watered down proposed liquidity ratios), and will probably compromise on the level of bonus caps – but not on the principle.

This will have consequences for Europe’s financial sector. The requirement for additional capital levels may drive some consolidation, particularly as some weaker institutions find themselves unable to raise additional capital. Certain kinds of banking activities will be less profitable, which may also lead to some structural changes. Restrictions on bankers’ pay may affect staffing, but less so than banks claim. For funding, far too many EU banks remain dependent on public support so any strict implementation of the new liquidity ratios is likely to be very challenging.

However, the total impact on EU banking of the new capital and liquidity regime, while significant, will not drive large structural changes. Uncertainties about the timing and stringency of the final regime do pose additional challenges to an already troubled banking system.

The Liikanen review

A more dramatic change is likely to come as a result of the Liikanen review into the EU banking sector. It recommends that banks with “significant” trading activities relocate all proprietary trading, and assets or derivative positions associated with market-making, into a separate legal subsidiary. The aim, says the report, is to ensure that that the “risky” trading activities of banks do not affect the more core operations of deposit-taking and lending.

The review was commissioned because the European Commission believed that it was politically necessary to respond to the UK’s Vickers Report and the US’s Volcker Rule. The first recommends ring-fencing retail operations, and the second forbids deposit-taking banks from engaging in proprietary trading. In response to these reports, France’s president, François Hollande, has already promised to separate the speculative and mainstream functions of banks, while Peer Steinbruck, the SPD challenger to Chancellor Angela Merkel in this year’s German elections, has proposed that investment banking be separated from commercial and retail banking.

Although the Liikanen review is non-binding, it is almost certain that the EU will similarly push for some form of legal separation between retail and investment banking. The most likely outcome is that the trading activities of banks will have to be put into a separate legal subsidiary, while remaining in the same holding company. This solution is attractive to Europeans as it will not fundamentally challenge their cherished universal banking model. Moreover, it will only apply to institutions above certain size and risk thresholds, making its adoption easier. It is also likely to allow countries some discretion to introduce their own initiatives, such as the Vickers proposals in the UK.

Nevertheless, the result is likely to have a significant impact on the shape of banking in the EU. There will also be a general reduction in trading activity and banks may need to mobilize additional capital and liquidity buffers over and above those required by Basel III.

The Liikanen review also calls for banks to issue significant amounts of ‘bail-in’ debt that can automatically provide a loss-absorbing cushion when a bank gets into trouble. The Commission is likely to adjust its current proposal on recovery and resolution, under which all unsecured bondholders can be haircut when problems arise, to include a special role for bail-in bonds. Having such bonds will make the senior unsecured bonds that banks depend on for a significant proportion of their funding less risky. But the investor appetite for bail-ins has not yet been seriously tested.

A further complication for regulators is that, even as banks have started to submit recovery and resolution plans to supervisors, it remains unclear how effective these can be. Problems facing a bank with thousands of legal entities can hardly be effectively resolved over a weekend, so a drastic simplification of legal structures of banks in the EU may be necessary. The question is how radical this reform will be and at what speed it will be introduced. But any credible recovery and resolution process will require a substantial reduction in the complexity of EU banks. While beneficial in the long term, it may add to uncertainties in the short term.

The report also strongly recommends changes in risk-weighting. Those used in the internal rating models of large banks should be tightened, while those used for trading books and in real estate lending should be increased. Thus EU banks would probably need to raise even more capital than already necessary under the forthcoming capital requirement directive and the measures likely to be introduced to separate retail and investment banking. Even small changes may require a large increase in capital, as the recommended increase in risk weights will apply to all Internal Risk models and across the real estate portfolio, the largest component of many bank balance sheets.

Other legislation, such as directives on deposit guarantee schemes and on crisis resolution, is at various stages of development, but is set to change drastically as the Eurozone countries make gradual progress towards a banking union.

The Banking Union

Whatever the intellectual merit of a more unified banking system in a monetary union, it is on the agenda solely because of the problems exposed by the crisis over the euro. The clamour for supervisors to be independent of national interests grew as European partners gradually lost faith in the ability and willingness of national supervisors to tackle endemic banking problems, while stress-test exercises exposed the limits of the European Banking Authority’s powers over national supervisors.

The weakness of the current system was most clearly exposed by the deepening problems in the Spanish banking sector. These raised the prospect that the Spanish government might need external aid, but the loss of faith in the Spanish supervisor meant that this aid could only be delivered under independent external supervision. These factors, plus the increasing threat of deposit flight from peripheral economies such as Greece, meant that a euro area solution became necessary. The European Central Bank (ECB), with its independence underpinned by EU treaties, became the supervisor of choice, particularly as representatives on the EBA board of supervisors voted primarily along national lines.

The emerging consensus, now formalised by European Council declarations, is that the ECB will take over the responsibility for supervising Eurozone banks. This is expected to improve both the independence and the quality of bank supervision, and the level of confidence that both Member States and the ECB have in the assessments of the health of banking systems.

It may also make the ECB more comfortable if it needs to deliver another long-term refinancing operation to support Eurozone banks, because it will be able to better distinguish between banks that are merely illiquid and those that are also insolvent. ECB supervision may also help mitigate the kind of individually rational but collectively disastrous behaviour that national supervisors have been engaging in – requiring their banks to limit their exposure to peripheral economies such as Portugal, Italy and Spain, worsening the credit crunch there.

A compromise, with the ECB directly supervising only large systemic banks and those that have sought public support, with the supervision for smaller banks staying with national bodies, has now been agreed. However, over time, the ECB’s real supervisory powers may increase, as the banking union deepens.

Another major fault-line has been the divide between euro and non-euro countries. The 17 euro countries, it is argued, would have a permanent majority on the board of the 27-member EBA, as their positions would be coordinated under the aegis of the ECB. The non-euro countries want safeguards to ensure that this will not be the case and that their interests in the single market will be preserved.

While a voting formula compromise has been found, it is almost inevitable that the banking and broader financial industries of those countries in the euro will integrate more closely. This is likely to be done at some cost to the integrity of the EU-wide single market – in particular, the links between the UK financial industry and the rest of the EU financial system may begin to fray.

While having a single supervisor may be necessary for a banking union, it is certainly not enough to ensure the Eurozone’s success. This will depend on the way the newly-structured financial sector can help tackle the euro crisis. For a banking union to make a real difference, it must go much further and include a pan-euro bank resolution authority. The recently launched European Stability Mechanism can provide the fiscal backstop for such a process – as long as the ECB is able to certify that this is necessary and offer safeguards. However, sharp disagreements on the timing and scope of any ESM capital injections for troubled banks mean this discussion will drag on into 2014 or beyond.

Understandably, Germany and Spain are on opposite sides as to whether and how the ESM can directly inject equity to help rescue undercapitalised banks. As things stand today, such equity injection will be rather limited in scope and would only be made with a sovereign guarantee. This means that there will be no effective risk transfer from the troubled sovereign to the ESM. However, unless such a risk transfer happens, the sovereign-bank link that has driven the eurocrisis is unlikely to be broken.

The possibility of cross-border deposit flight – driven, as it has been, by credit or redenomination risk – can only really be addressed by a move towards providing a pan-Eurozone deposit guarantee scheme that can credibly repay deposit-holders in euros if their banks fail. But this crucial issue has been kicked into the long grass.

Given the many factors at play, it would be foolish to hazard a guess about what sort of a banking system will emerge out of the crisis. Nevertheless, provided the Euro crisis is finally brought under control, it is possible to argue that by 2020 the EU will have an inner euro core of about 3,000 banks. There is likely to be some form of legal separation between commercial and investment banking, capital levels that are 150-200 per cent of current levels and tighter liquidity rules. There will also be a functioning pan-Eurozone crisis resolution scheme, backed by the ESM and supervised by an increasingly powerful and assertive supervisor ECB and a perhaps even a pan-euro deposit guarantee scheme.

The transition, from the current overbanked, undercapitalized, underfunded financial system in the European Union to one that is smaller, stable and able to fund itself without public support is a very risky one. It is not obvious at all whether it can happen in a manner that is gradual and non-traumatic, particularly given the very weak macroeconomic environment. The plethora of regulations still to be implemented poses additional uncertainties. No wonder investors are so reluctant to commit capital and long-term funding to European banks. They have a hard time figuring out what they may be buying into.

Much can be done to help reduce the layers of uncertainty that now haunt EU banks. A clearly laid-out regulatory end goal showing what sort of a banking system the EU has in mind would be helpful. Fiscal support for troubled sovereigns could help lighten the dark macroeconomic headwinds. A new bout of stress tests that aim to recapitalize the banking sector once and for all would help secure the stability of the banking system. And last but not the least, a clearly defined exit strategy from the large doses of public support being provided to banks to fund themselves would show investors where they stand.

No matter how matters develop, two things are clear: First the European Banking system that emerges at the end of the crisis will look very different, Second the transistion to this new state is unlikely to be smooth or easy.

Sony Kapoor is Managing Director of the think tank Re-Define. A version of this piece was first published by Camel Publishers for Quantum, the magazine of the Qatar Financial Centre