When it rains, it pours – EU legal opinion puts UK on backfoot over revamped Liikanen rules

It’s not shaping up to be a great month for the UK government with respect to the EU – a pretty poor showing at the European elections, a looming defeat over the Spitzenkandidaten process and now, just to top it off, a troublesome legal opinion from the European Council legal service.

The FT and Reuters overnight reported on a leaked legal opinion from the European Council legal service which looks at the new rules on proprietary trading and the structural reform of the European banking sector published in January.

As a reminder, these proposals are the offspring of the Liikanen report and we covered them in detail here.

The wider political importance of these reforms relates once again to how much control the UK can retain over how to structure, regulate and, by extension, supervise its own banking sector (which, lets not forget, it continues to backstop alone) in light of further eurozone integration, which it cannot be part of. And whether the EU can be flexible enough to accommodate this.


The legal opinion, which Open Europe has seen, is a blow to the UK because it focuses on the specific article of the legislation which allows the UK and other member states which already have reforms aimed at overhauling or ring fencing their banking sector in place (such as the Vickers reforms).  The opinion notes that:

“The derogation mechanism established in Article 21 of the proposed Regulation is not compatible with the legal basis of the proposal, with the nature of the proposed instrument as defined in the TFEU and with the general institutional principles established in the Treaties.”

There are a number of justifications for this judgement given (these are the arguments of the council legal service not OE):

• Firstly, any derogation under the single market article (Art 114) should be “temporary” according to the treaty. Since the derogation seems to be permanent it falls foul of the treaty here.
• Secondly, allowing for exemptions here breaks Article 288 of the EU treaties because it stops the “general application” of a regulation across all member states. It also falls foul of the “uniform application” of regulations across member states.
• Thirdly, the legal service does not buy into the justification for the derogation, suggesting that the costs of changing legislation to meet EU rules would not be prohibitively high. This sets it apart from previous instances where objective justification has been given. Furthermore, the use of the derogation is reliant on member states making an application and does not rely solely on the Commission.
• Fourthly, the derogation only applies to countries where similar legislation has been passed before 29/01/14 – the opinion stresses that no justification is given for such a date and calls for more explanation. This cut-off date also means the exemption applies differently to certain countries which happen to already have passed their own legislation. On top of this, it only applies to certain credit institutions.
• Finally, since the exemption essentially allows national law to take precedence, it questions the primacy of EU law.

The legal services suggest a number of remedies including: allowing the derogation for a specific temporary time period, clearer justification for the cut-off date, adopting the legislation as a directive rather than regulation (allowing for greater national flexibility) or dumping the derogation altogether.

As we noted previously, the target adoption date for these rules is January 2016 and there are plenty of negotiations still to come, as such this opinion, while a blow to the UK, is the not the end of the discussion by any stretch. As the remedies suggest, there are options open to the UK and others for adjusting these rules.

Furthermore, there are plenty of other controversies in the rules, such as how to properly define proprietary trading and how all the technical standards are defined. This one will run for some time still.

The long lost Liikanen report returns – but it looks pretty different

Has the Liikanen report become the Barnier plan?

Update 30/01/14 11:45:

Some eagle eyed HM Treasury officials have flagged up that the recitals of the proposal (the preamble points before the articles of the regulation) do allow for the derogation to apply to secondary legislation as long as the key primary legislation has been passed. As we note below, this is the case with Vickers and the UK therefore certainly counts for the derogation. It is a bit strange that this isn't also spelt out in the article of the proposal but its inclusion is likely to be more that sufficient for the UK.

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Okay, maybe long lost is an exaggeration, but it’s certainly been off the front line agenda for some time.

The time away from the spotlight has been used to significantly overhaul the European Commission’s flagship proposal on reforming the banking sector in the aftermath of the crisis.

Here’s the full proposal, out this morning, while here are the press release and Q&A.

While the proposal was always expected to be the offspring of the Liikanen report, in this case the apple has fallen quite far from the tree. The proposal is quite a change from the original report and as expected focuses more on a Volcker-style rule on proprietary trading rather than a significant separation of large banks. That said, the focus remains on separating off risky trading activities, meaning the main impact is a lessening of scope. We outline our thoughts below.

A reform overtaken by events?
While this was originally flagged as a key proposal, it has been a long time coming. In the meantime, a new single supervisor has been created, new plans on capital requirements, a new macro prudential framework, new plans on bank bail-ins and a new bank resolution scheme have all been substantially developed. The new framework for the financial sector has largely grown up without this proposal, and how exactly it will fit in – both in terms of timeline and structure – remains unclear.

An EU Volcker rule – the Barnier rule?
The key part of the new proposal is a ban on “proprietary trading in financial instruments and commodities, i.e. trading on own account for the sole purpose of making profit for the bank.” While this is well intentioned, it does come with some complications:

• It has proved very difficult to identify what exactly classifies as proprietary trading, compared to necessary trading to manage risk and to act as a market-maker.
• The current definition in the proposal is fairly narrow, and refers to activities specifically dedicated to making a profit for the bank itself. In other words, it looks as if it could be fairly easily side-stepped. It also exempts trading of government bonds and money market instruments for cash management.

Separation power – moving away from national control?
As we have noted before, the prospect of a supranational body ordering the break-up of a flagship national bank has the potential to be incredibly explosive. The banking union has brought this closer, but final decision on how to resolve a bank remains mostly national. This proposal would allow such a decision to be taken not just to resolve a bank, but also if its non-retail activity was impacting financial stability. However, it seems that the final say will now rest with the ‘competent authority’ (a definition which is never spelled out), which in the case of large eurozone banks would likely be the ECB as the SSM (Single Supervisory Mechanism).

Has the UK secured a derogation?
As expected, a clause has been included on a general derogation (not specific and only applying to the separation rule not the prop trading ban) which allows for the rules on separation to be superseded by any national rules which aim to achieve the same goals. While Vickers would certainly qualify on this front, the text specifies that the derogation can only apply to legislation adopted before 29/01/2014. Currently, all legislation relating to Vickers is not expected to be adopted in the UK until mid-2015. However, the key banking reform act (which includes the ring-fencing plans) was made into law in December.

For the most part then, it seems the UK has secured a derogation, which can be put down as a small but important win for the government. Plenty of other states have also secured scope for their national plans.There is clear encouragement in the wording for states who are yet to put a comprehensive system in place, to adopt the EU framework. That said, with lots of different national plans in place, one has to question how effective this system will really be.

A long way to go
As the points above suggest, this remains a controversial proposal and negotiations will be tricky. Little should happen this year, due to the European Parliament elections and the new Commission entering office. Assuming the next Commission picks up the same proposal (which is not guaranteed) the aim is to have the necessary legislative acts approved by January 2016, with the prop trading ban coming into force at the start of 2017 and the separation powers in mid-2018. As with some of the other regulations, it seems the EU response to the financial crisis will only be in place a decade after the crisis hit.

These are just some of the key points of contention upon first reading. There is much more to go in this process with the input of member states and the European Parliament likely to be very different, and sometimes even adversarial. There is also a lot of scope for the rules to be altered using delegated acts and technical standards – these will ultimately determine how the prop trading ban and separation rule work in practice.

So far, a large part of the banking sector (mostly smaller banks) will probably be happy. Larger banks will see it as an improvement, but will likely push for a further watering down. Questions can still be raised over whether costs will be passed onto consumers and whether it will really help limit risky activity, which can often be related to mundane retail bank activity. But then the idea is that other parts of the framework will also help limit this effects.  

In any case, the proposal is likely to once again fall away from the frontline and it could yet come back with a different face once again.

The quest for a healthy European banking sector

Yesterday saw the release of the hefty Liikanen report (a dense 153 pages) on the European banking sector. We’re yet to fully sift through the report but there a quite a few eye catching graphs and statistics which we thought worth flagging up.

In brief, the Group recommends actions in the five following areas:

• Mandatory separation of proprietary trading and other high-risk trading activities. 
• Possible additional separation of activities conditional on the recovery and resolution plan. 
• Possible amendments to the use of bail-in instruments as a resolution tool. 
• A review of capital requirements on trading assets and real estate related loans. 
• A strengthening of the governance and control of banks. 

Many ideas which will be familiar to those in the UK and there are plenty of reasonable suggestions - which we'll return to. We would note though that in Europe even small banks caused problems while the largest banks which caused the initial financial crisis were investment banks with no retail element. In some cases better supervision and enforcement of regulations is more important than the actual structure of the banking sector itself. But for now, take a look at these graphs - from the report - which raise some interesting questions over the proposition of a eurozone banking union:

The table and graphs above demonstrate the simply massive size of some of Europe's banks, even in comparison to those in the US and Japan. This drives home the fact that, for a banking union to ever really work or be effective there must be combined deposit and resolution fund backing it up, something which the eurozone is now shying away from. This is also a much larger decision than the eurozone is currently making out the banking union and single supervisor creation out to be.