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 German banking union

A deal emerges. It seems that the negotiations are finally coming to a conclusion on the issue of banking union – after just a year.

There has already been lots of coverage of the details of the deal, see in particular the excellent summaries from the WSJ and the continued coverage from the FT Brussels blog, so we won’t bother rehashing all the specifics here. Instead we’ll provide some analysis of the deal and flag up what we think are the most important implications.

First point to make to those who are frustrated about this deal not going far enough: what did you think realistically could happen? 

The deal is not that different from the previous version which we laid out here, although a few (if not all) of the unanswered questions have been cleared up.

What’s new?

• Earlier this week an agreement was reached on the structure of the funds. It was, as expected, decidedly German. A €55bn fund will be built up from levies on the financial sector between 2016 and 2026. In the meantime, any funding required to aid banks above bail-ins will come from national coffers or ESM loans to sovereigns. Only after 2026 will a centralised fund be created and while there may be some mutualisation, it is yet to be defined and will be subject to future negotiations. There is also scope for national funds to lend to each other but this is to be defined in an intergovernmental treaty.
• The decision making process will be thus: as supervisor the ECB recommends a bank be resolved, the board of national resolution authorities devises a plan and votes on it ( any release of funds will require approval  two-thirds of voting countries contributing at least 50% of the common fund). This will then have to be approved by the Commission. If there is a dispute at any stage of this process the Council of EU finance ministers will decide on simple majority (if not then it will approve through a ‘silent procedure’).

What does this mean for the eurozone?

• Well, we’re seriously at risk of repeating ourselves here, but here we go. A deal is positive and necessary. That said, the process remains incredibly complex and still seems highly national or intergovernmental. If there was a serious failure of a large cross border bank, such as we saw with Dexia, would the process really be any smoother or simpler than last time around?
• The funding remains minimal and only enough to cover the resolution of one or two medium sized banks. It will also not be available for some time and certainly will have little role in helping to deal with any recapitalisation costs outlined by next year’s stress tests.
• Taking a broad view, it’s easy to question how cross border this ultimate banking union is. The single supervisor under the ECB will only cover the largest 130 banks. The resolution mechanism will cover the same banks, plus another 200 or so which are cross border. However, there are around 6000 banks in the eurozone, and the very large majority of these remain under national purview.
• Generally, this also raises questions about how effectively the ECB can do its job as national supervisor. While the cracks in the system could push it to be harsher to ensure there is not a systemic crisis, it also poses problems given the current issues on bank balance sheets. It is crucial that next year’s stress tests are credible, if the ECB shows signs of insecurity about the ability to deal with a large bank recapitalisation it could raise questions about the process.
• Clearly, given the intergovernmental nature and the prevalence of national governments it is likely to be insufficient to break the loop between sovereigns and banks in the eurozone.

How about for non-euro countries?

• Again we have outlined these points before. It seems that they managed to secure specific protections to ensure they will never be on the hook for eurozone banks, which is good but also the absolute minimum that should be expected.
• The use of an intergovernmental treaty is tricky. It side-lines these countries somewhat but also shows the limits of what the eurozone can do within the EU treaties.
• The creation of the resolution board as a new agency within the Commission does raise some concerns. It is clear it should be its own separate institution for the eurozone only, however, the lack of willingness to open the treaties has created this system. If the eurozone continues to push new institutions into older ones and distort the structures of the EU for eurozone use, it could become problematic. It also creates a complex and ineffective decision making procedure for the eurozone as is clear above.

Winners and losers

• Germany. Plain and simple. For all the talk of a compromise earlier this week, it was incredibly minimal compared to how closely the plans as a whole match the German desires.  Think back to the original Commission plan, which was incredibly centralised. We said then it wouldn’t fly with Germany and it hasn’t.
• The structure is intergovernmental, has minimal pooling of funds, is built up overtime, excludes smaller banks, does not include direct bank recapitalisation from the ESM and has a large bail-in element. All key German demands. They have made a vague promise to have some sharing of funds in a decades time, the details of which need to be negotiated over and may be limited to an intergovernmental treaty.
• If there are any losers, then it is likely to be France and the Mediterranean bloc. They were pushing for significantly more pooling of funds and a more centralised process. That said, France did previous publish a joint vision of the banking union with Germany, which is not a million miles from the current structure. The deal also allows them some more scope to use bailouts rather than bail-ins if needed – something else they were keen on. 

As we have noted recently, 2014 is likely to be another year where governments come to the fore in eurozone. 2012 and 2013 were the ECB's years, where its actions held the euro together. With the focus now on growth, more emphasis will fall on the governments of the eurozone to develop a new structure and strategy to put the bloc back on a sustainable footing and a path to prosperity. 

As discussions stall, leaked docs show divergent plans for bank bail-in and resolution from EU institutions

The Times’ Juliet Samuel has an interesting story today looking at the progress on bank bail-in rules and resolution funds at the EU level (via some leaked docs relating to the EU's Bank Recovery and Resolution Directive).

Despite another round of meetings little progress seems to have been made in finalising the format of the resolution authority or the fund it would use to aid banks, i.e. the creation of the second pillar of the banking union – although there does seem to be a move to increasing the direct involvement of national authorities. Germany also looks to have conceded somewhat on using the ESM, the eurozone bailout fund, to aid banks as agreed over the summer. But given that this will still require a change in German law and approval in the Bundestag to activate it, the hurdles remain very high.

See here for a recap of the country differences on bail-in plans, here for a recap of our take on the plans as they stand and here for our view of the banking union so far.

With this in mind the internal Commission assessment (which can be found in full here) raises some interesting points (it's worth keeping in mind the the bail-in plans and banking union are separate but very closely related when it comes to questions of aiding banks). The paper essentially provides a comparison of the different bail-in approaches favoured by the European Commission (EC), the Council and the European Parliament (EP). The EC proposal sees a very strict bail-in structure with all levels of investors and uninsured depositors facing losses before resolution funds are tapped. The Council waters this down slightly, with some use of resolution funds at different stages. The EP goes further with greater protection of depositors and therefore more use of resolution funds (see graph below for a useful graphic on all this).

Although the analysis is significantly limited by numerous assumptions and data constraints, some interesting points can be gleaned, which we outline below:

Greater flexibility, leads to greater use of funds: The key point seems to be that any flexibility introduced into the bail-in system will significantly increase the level of resolution funds needed. Broadly, under the Council proposal this could reach €70bn under a 25% loss scenario. Under the EP structure the figure could top €200bn if there was a systemic crisis. These are rough figures gleaned from the numerous scenarios, but the message is a clear warning to the Council and Parliament about allowing too much flexibility from the planned bail-in rules.

Where would these funds come from? This is the obvious follow up. No plan is presented in the paper and the general idea is that they would be built up over time from taxes on the financial sector. But under the current plans this could take up to 10 years, from a start in 2018. What happens in between? There seems little choice but to infer that national taxpayer funds would be tapped if another crisis hit.

Bank investors and even depositors lined up to take big hits under bail-in: Another key feature of this paper is that, for the first time, it highlights the type of losses investors and depositors will face if a crisis hit under the bail-in rules. In nearly all scenarios, albeit to varying degrees, even senior debtors and uninsured depositors take large hits. As these discussions develop and the final structure becomes clearer the market will begin to reassess the pricing of different instruments – whether deposits, debt or other instruments are favoured could well affect bank funding structures.

Beyond these points there is little more significant to draw from the paper. It debatably raises as many questions as it answers – what will the final format be? When will it be introduced? How will any resolution funds be funded? Will this be done at the EU or eurozone level?

The motivation behind the paper is also worth considering. It’s clear the Commission is trying to send a bit of a message here, warning the Council and EP against watering down the bail-in plans too much – at least if they don’t want to put up significant resolution funds. Whether or not this will be taken to heart remains to be seen.

A subtle shift in German policy on banking union?

With talk of the upcoming German elections dominating over the weekend, a potentially important yet subtle shift for post-German election policy on banking union may have received less coverage than it ought to have.

Reuters reported on Saturday that Germany is working on plans to create a single eurozone bank resolution mechanism (SRM) within the EU framework without the need for changing the EU’s treaties – something the German government had previously insisted was necessary because it deemed the Commission had no legal base for the proposal to give itself the power to order banks to be wound down. Bloomberg followed this up with a report suggesting a tentative agreement had been struck with the Commission which would see the new resolution fund cover only the largest eurozone banks, thereby exempting the German savings banks (and their large pool of deposits).

German Finance Ministry spokesman Martin Kotthaus has since played down any German proposal, but stressed that "very many other member states" have also raised similar concerns to those of Germany.

It remains early days then, with lots of negotiating still to go but this could have important implications for the eurozone and the UK which are worth exploring.

What could this mean for the eurozone?

• As we have noted, Germany essentially had two choices following its stark rebuke of the Commission’s SRM plan – either work within the framework to alter it or propose an intergovernmental alternative (a similar ad-hoc set up to the temporary bailout fund EFSF). Judging from these developments it seems to have gone for the former, on the surface this is positive for the eurozone since any SRM enshrined in EU law will look more lasting and solid.
• That said, the German plan (if there is one) would clearly involve further watering down a mechanism which already looked woefully short of what was needed to help shore up the eurozone banking sector.  The crisis has clearly shown that smaller parts of the banking sector can cause significant problems (see Spanish cajas).
• The Commission is likely to have less responsibility but it remains unclear where the power will lie. Creating a new institution is impossible without treaty change while using existing ones for eurozone-specific tasks creates serious questions about the single market. The fundamental question of who decides to wind down a bank in crisis remains unresolved.
• Even if the above issue is settled, oversight of the banking sector would still look fragmented with many different institutional layers including – national regulators and supervisors, the ECB and the new SRM as well as possibly the ESM. Furthermore, the Council of Ministers, European Parliament and national parliaments will all have a role in decision making and/or accountability.
• Other problems, including the size of any resolution fund, remain – as we have pointed out. Last week’s legal opinion from the Council of Minister's legal service noted that the national budgetary implications of an EU bank resolution mechanism meant that the Commission's proposed legal base might need to be rethought.

What does this mean for the UK and other non-eurozone countries?

• How the SRM is established could well set the tone for future eurozone integration, therefore ensuring it does not alter the dynamic of the EU to serve eurozone ends using a single market legal base is important for both the UK and other non-euro countries.
• That said, a purely intergovernmental legal arrangement, outside the EU treaty, could reduce the UK's ability to influence the outcome still further. The upshot being that there probably needs to be a treaty change to ensure eurozone crisis resolution is kept distinct from and yet compatible with the single market. 
• Despite this latest attempt to avoid treaty change, Finland has also voiced concerns about the legal base for the SRM, while Germany still has concerns about the separation between the single supervisor function and monetary policy at the ECB - suggesting treaty change as solution. So, both are still keen on shoring up the banking union via treaty change in the not too distant future.

Some interesting developments then, but a long way to go yet. In any case the time line for the banking union looks the same with the process being phased in over the coming years to 2018 – far from an immediate solution to the crisis.

Meanwhile, the whole discussion over the extent to which the treaties can be stretched to help solve the eurozone crisis once again reminds us of the inherent tensions and structural flaws in the current eurozone/EU setup. Even if not done through the banking union, this will have to be settled at some point.

The EU wades into the murky world of shadow banking

The European Commission this morning unveiled its initial proposals to regulate ‘shadow banking’ and money market funds (MMFs) – the press release is here and the FAQs are here and here.

We covered this issue back in May when we exclusively released the initial drafts of the proposals – not too much has changed since then. We’ll refrain from recapping the details since the press releases lay them out but below we outline some of our thoughts.

• The key point in the regulation is that MMFs will be required to hold a ‘Net Asset Value’ Buffer, equal to 3% of all assets under management; the Commission predicts this will “result in an increase of the management fees of 0.09% to 0.30% annually”. There will also be harmonisation with UCITS and AIFMD to move towards a uniform set of rules for the shadow banking sector.

• As we noted before, the required buffer has real potential to harm the MMF industry. Given the record low interest rates, and very low returns on liquid short term debt, many funds are struggling to stay afloat (with some already shutting down). Although an outcry against increased costs may be expected from the industry, in this case many of the concerns seem valid given the very small margins involved in these funds.

• There are also some requirements on MMFs holding very liquid assets which can be sold off quickly, while also limiting the level of assets taken from a single issuer to encourage diversification. These rules seem sensible but add further constraints to the returns and flexibility of these funds. There is always a risk in dictating the investment decisions to the market, although its important that the risks in these funds is made clear. It also seems to be doubling up the effort of the buffer mentioned above  - given that losses of such funds rarely exceed 3% (as the Commission itself notes), pushing beyond this level seems slightly redundant.

• The question of ‘sponsors’ – the banks or institutions which own and/or backstop an MMF – is also vital for a couple of reasons. First, its clear that some sponsors have a competitive advantage, larger institutions will have the ability to provide greater financial aid to its MMF if it gets into trouble – this gives large banks a significant advantage over smaller asset managers. Secondly, it also provides another clear link between the shadow and traditional banking sector, this could potentially become an avenue for contagion (as was seen in the financial crisis) if MMFs get into trouble and need to be bailed out.

• Much of the rest of the regulation looks fairly sensible at first glance. It’s clear there needs to be greater transparency within the MMF sector – it can no longer be assumed to be equivalent to bank deposits. There also needs to be significantly less emphasis on external ratings by the credit rating agencies (equally true of the standard banking sector ). Furthermore, investors need to be clearer on the risk taken on when investing in these funds and their approach used to make profit (short term funding of long term assets).

• The broader shadow banking communication remains fairly vague but it is certainly an area which needs to be regulated. The main aim should be to incorporate international regulatory efforts with the existing multitude of EU regulations (many of which cover parts of the shadow banking sector) and avoid duplication. Tackling the issue of ‘collateral chains’ (using a single piece of collateral many times) is also vital, although the importance of the repo market should not be forgotten (see failure of the FTT).

All that said, there is a long way to go in these regulations yet. There is likely to be significant industry opposition (or at least discussion) and approval from both the European Parliament and member states will be tough to gain. It also seems unlikely that this will be completed before next May’s European elections, adding further delays but also raises the question of whether the next Commission will push in the same direction on this issue.

Bank bail-in plans finally agreed, but its only a small step towards banking union

Despite some sizeable differences, EU finance ministers finally managed to reach an agreement on the bank bail-in plans last night (after only 25 hours of talks in the past few days). As always with this type of EU deals, it is a compromise and often an imperfect one. The agreement was much as expected in the end, given the drafts circulating over the past week. Below, we lay out the key points and the positives and negatives of the deal as we see them.

Key points

• Some more flexibility included, with government allowed to inject funds but only after minimum bail-in of 8% of the total liabilities of the failing bank – although such intervention is capped at 5% of the bank’s liabilities.
• The ESM, the eurozone's bailout fund, can also inject funds but only after all unsecured bondholders wiped out.
• The UK secured wording which allows it to avoid setting up an ex-ante resolution fund, as long as it is already receiving funds from the bank levy and/or stamp duty. Sweden also secured an adjustment to the text which allows for it to maintain its current model to a large extent.
• The agreement sees the bail-in plans coming into force in 2018, while the directive as a whole still needs approval from the European Parliament - so it could yet change.
• Certain creditors are excluded: insured deposits, secured liabilities, employee liabilities, interbank and payment liabilities with maturities of less than seven days. National resolution authorities can also exclude other creditors in exceptional circumstances.
• As in earlier drafts, insured deposits are completely protected, and the preference given to SMEs and individuals deposits (see here) has been retained as well.

Positives

• Reaching a deal is positive in itself, as it adds some much needed certainty following the Cypriot crisis. It also keeps the progress towards banking union inching along.
• The burden has been shifted away from taxpayers towards bank creditors.
• The added flexibility is important between eurozone and non-eurozone countries, with the UK and Sweden scoring some important caveats. The deal highlights that non-eurozone countries can still have influence on such rules and the acceptance of the need for flexibility between the two groups.

Negatives

• From a eurozone point of view, the flexibility could be counterproductive, particularly the use of exemptions in exceptional circumstances. How exactly will this be defined and determined? If at national level, then there could be clear political pressure in a crisis to invoke this. For example, it is hard to imagine that the crises in Greece, Portugal, Ireland and Spain would not have triggered this in some way.
• Could see cost of bank funding rise, particularly in terms of unsecured credit due to fairly strong depositor preference.
• Lots of unanswered questions – not least, when and how will these rules apply? It’s not clear in exactly what situation and at what time the new rules would kick in. Does it rely on a request for aid from the bank or the national government?
• Furthermore, there are questions over how this will work practically in different circumstances – for example, the difference between a bank which has almost completely failed and one which is simply struggling to recapitalise.
• The timeline also still seems very long, with the actual bail-in rules not in force until 2018, even though the directive is due to be in place by 2015. That said, the broad template may well still apply, particularly where banking union is involved.

In the end, this seems to be a reasonable compromise - not least because all sides seem fairly happy. It’s clear than a new set of rules was needed with the focus on creditors rather than taxpayers. That said, though, this is in the end only a very small part of banking union and the pace at which the eurozone is proceeding towards it remains fairly limited.

The key remains the single resolution mechanism and/or authority. As we have argued before, until this is in place it is hard to see how the poisonous sovereign-banking-loop will be broken or how cross border lending will begin flowing freely again. Until that is settled, the effectiveness of other factors such as the bail-in plans will remain unclear at best.

Bank bail-in plans: is France becoming nervous about being left alone with Germany?

As we have pointed out repeatedly, those who think that the eurozone is one German election away from a full banking and fiscal union (which includes a surprising number of British eurosceptics) should have another look around Europe.

As we noted last week, the latest draft of the bank recovery and resolution directive left plenty of questions unanswered.

[Background - this is the proposal which looks to establish a clear and standardised pecking order for losses in the instance of a bank failure. It is not the full 'banking union' proposal, which involves some form of combined backstop. Despite being first suggested as far back as 2010 and with a proposal put forward last summer which was largely ignored, this has become an important piece of legislation since the Cypriot crisis.]

That EU finance ministers failed to reach an agreement after 18 hours of talks on Friday is therefore not entirely surprising. What is perhaps slightly more surprising is the dividing lines and in particular which countries found themselves arguing the same side.

We highlighted before where each country broadly stands on this issue. This does not seem to have changed much, although the focus of the discussions has. Previously, much of the emphasis was on ‘depositor preference’ – i.e. when and to what extent uninsured depositors would face losses during a bank bail-in. Not exactly surprising given the Cyprus debacle.

A broad consensus seems to be emerging around a structure which protects insured depositors completely and gives added seniority to those uninsured deposits held by individuals and small and medium size enterprises. With the pecking order broadly settled, focus has shifted to the level of flexibility allowed within the structure, in particular whether bail-ins should be automatic or whether there should be sizeable national discretion to decide on which format to use.

This debate has seen the EU split into two broad groups: 

• One led by France, the UK and other non-eurozone countries, arguing for greater flexibility and national discretion – although presumably for different reasons, the UK because it fears its financial sector is larger and more varied than many in the eurozone and France because it is keen to keep open the option of a bank bailout due to fears automatic bail-ins could increase funding costs (souveraineté). 
• The second group is led by Germany and the Netherlands, both of whom are keen to limit flexibility to allow for a standard framework across the eurozone and also partly because they fear governments will put domestic political needs above those of the single currency as a whole. This is a trust issue as these countries' taxpayers may one day have to stand behind the continent's banks.

Ignoring the technical details for a bit, the wider political dynamic at work here is fascinating. France is actually on the side of the non-eurozone countries. This is bending assumptions as it's usually France that is the keenest on doing stuff at the level of 17 rather than 27, as Paris is proportionally stronger in that smaller constellation. Germany, on the other hand, prefers 27 to 17, for the opposite reason.

There seems to be good reason to expect some greater flexibility for non-eurozone countries, with the idea reportedly gaining support towards the end of negotiations.

Now, we don't want to read too much into this but first, this dynamic suggests that France could actually find itself isolated within the eurozone (we're looking forward to that FT headline). Secondly, as we have mentioned in the past, perhaps this is another indication of how Paris - who used to see the euro as a way to lock in Germany - is actually getting quite nervous about losing the UK as a balancing force in the EU.

As ever in Europe, there's always that political sub-story worth keeping an eye on.

EU edges towards compromise on bank recovery and resolution plans

Tomorrow and Friday will see the next round of meetings between eurozone and EU finance ministers respectively.

The meetings will focus on a number of issues, but the key ones will arguably be the Bank Recovery and Resolution Directive (BRRD) and the plans for a single eurozone resolution mechanism.

The full agenda is spelled out in detail in this background briefing.

As we have noted before, the proposals for new rules for bank resolution are quite controversial and have caused significant splits both within the eurozone and the EU more generally. See our previous blog here which laid out each EU country's position.

Ahead of the meetings, we have managed to get a look at the latest draft of the Recovery and Resolution Directive. Despite being 300+ pages, it makes for some interesting reading.

From what we can see there are two key changes:

1. A compromise on depositor preference:
The previous draft looked to establish a clear hierarchy for bank bail-ins and put uninsured depositors on level pecking with other senior creditors. This draft moves away from that towards a bit more depositor preference. It says:

“In order to provide a certain level of protection for natural persons and micro, small and medium enterprises holding eligible deposits above the level of covered deposits, such deposits shall have a higher priority ranking over the claims of ordinary unsecured, non-preferred creditors under the national law governing normal insolvency proceedings.”

So under the current plans, insured depositors are the most senior, as previously. Uninsured (i.e. over €100,000) deposits from individual private citizens and SMEs will also be given preference over other senior creditors. Essentially, large firms' uninsured deposits will rank level with senior creditors (bondholders etc.)

As we noted before, this is similar to an idea put forward by Italy, but is also likely to appease France, Spain and Portugal.

2. A reduction in ex-ante funds
This is another controversial measure, with many (including the UK) disputing the usefulness of ex-ante funds (funds which are collected on an on-going basis and are therefore in place before any crisis). In the latest draft, the level of ex-ante funds has gone from 1% of all deposits to 0.5% of covered deposits – a fairly sizeable cut given that covered deposits are only a proportion of total deposits.

This looks like a concession to the other side of the spectrum, including the UK, Netherlands and Denmark.

Some concessions on key points to both sides then, as may have been expected. That said, there are likely to be plenty who are unsatisfied by the current draft and hopes of a final agreement this week may be premature.

We’ll keep trawling through the mammoth doc, and bring you any important developments.

Another blow in the bank bonus debate - but there's something far more fundamental at work here

Yesterday saw the opening salvo of what is sure to become a heated debate over the new ‘technical standards’ for the EU’s banker bonus rules.

Why is this so important? Well, these rules will essentially determine how far reaching the EU's already controversial bankers' bonus cap will be. But this decision also encapsulates a range of other issues that will have a defining impact in the way Europe is governed in future - and whether there's a future for the UK in there somewhere.

With that in mind, the first draft produced yesterday to launch a period of public consultation on the standards would have been particularly worrying. The key points are:

Standard quantitative criteria: related to the level of variable or total gross remuneration in absolute or in relative terms. In this respect, staff should be identified as material risk takers if:

 (i) their total remuneration exceeds, in absolute terms,  €500,000 per year, or
 (ii) they are included in the 0.3 % of staff with the highest remuneration in the institution, or
 (iii) their remuneration bracket is equal or greater than the lowest total remuneration of senior management and other risk takers, or
 (iv) their variable remuneration exceeds €75,000 and 75% of the fixed component of remuneration.

As the numerous press reports today have highlighted, these are far more wide ranging than many expected and are likely to further raise concerns that these rules will have a substantial negative impact on the City of London (and therefore the UK economy). (For background on these concerns see here and here). There are several different things going on here:

Are the EU agencies already exceeding their mandate? As we flagged up at the time of their creation, there's a substantial risk of mission creep under the EU's three supervisory agencies - EBA, ESMA, EIOPA - due to the fluid nature of these bodies. Remember, under the ECJ court case which allowed these agencies to be established under the EU single market (via QMV and co-decision), they should be blocked from having any type of decision-making powers. But EBA's standards on remuneration comes worryingly close to legislation.

Politicisation of ‘technical standards’: Related to this, and as we also flagged up at the time, technical standards have a worrying tendency to become politicised - which clearly is the case here. This type of stuff should be decided through political negotiations and defined within the regulation. Any necessary technical background and info should be provided for and incorporated, even is this means delaying the legislation slightly.

Need for non-eurozone safeguards ASAP: Though this isn't strictly a eurozone vs non-eurozone issue, it does illustrate just how vulnerable the UK and other outs could be to eurozone caucusing in banking / financial rule-making. This is also exactly why the UK and other non-eurozone countries need to ensure that the agreement in principle for double majority at the European Banking Authority - that Open Europe first floated - are held up and pushed through.

Trade-off between "single rulebook" and control: The UK says it likes the EBA since it contributes to a single rulebook for the single market, and can, for example, contribute to stamping out protectionist implementation of banking rules in Europe. This is all true. However, it does, of course, assume that the UK itself is writing the single rulebook, which may or may not be the case.

Democratic accountability: As the Times noted today, with central banks such as the Bank of England (BoE) and the ECB taking over financial supervision they must become more transparent and accountable. In this case it is unclear what role the BoE played in drafting the rules or whether they raised the concerns pushed by the government and firms in the UK.

What next?

Again, this is only a first draft. The public consultation is open until August, after which the EBA will review the evidence and provide a new draft - so a lot of the issues we highlight below should be considered with this in mind. There will then be a vote in the EBA with the final standards needing to be submitted to the Commission (which will approve or reject them) in March. One final interesting point here is that any vote in the EBA could come close to coinciding with the introduction of any double majority rules, although there are a lot of hurdles to overcome before then.

Expect a summer of furious lobbying and behind the scenes discussions as the UK and others make a final push to water down these proposals.

Where do EU member states stand on bank bail-in plans?

It’s been pretty tough to follow where countries stand on the latest proposals for the EU’s Recovery and Resolution Directive, not least because the debate has lasted three years with people mostly talking past each other.

But the Cypriot crisis has now focused minds and a deal is top of the agenda. The proposal will lay out rules for bank bail-ins and dealing with cross-border banks, while it also links closely with plans for a eurozone banking union. To clear up the differences, we have put together a table.

(The table is broadly ordered by how strongly the country is in favour of uninsured depositor preference and how strongly against flexibility it is. Hence Spain which is strongly for depositor preference and little flexibility is near the top, while Sweden which barely favours a bail-in plan and wants significant flexibility is near the bottom – click to enlarge):

As you can see, there are some big splits remaining. The ECB, Spain, Portugal and France (amongst others) want a clear depositor preference regime – where uninsured depositors are the last to be written down. On the other hand, Germany, the Netherlands and the UK want more equality between senior bondholders and uninsured depositors. Going even further, there are Sweden, Poland and Denmark - which have already clearly defined national schemes which do not fit well with the EU plans for a bail-in hierarchy.

Another area of disagreement is the amount of national flexibility. Sweden, the UK and the Netherlands are pushing hard for flexibility, particularly for non-euro members. This has some backing from Germany. Further disagreements over the timeline for implementation and the level of resolution funds needed remain a bit of a free for all.

The few points they do agree on include: complete protection for insured depositors, a broad bail-in scheme and (somewhat ironically) the fact that this legislation is urgent.

We will keep updating the table as the negotiations develop. There is a lot of talk of compromise but as of yet there is a long way to get there.

Exclusive: Internal docs give first look at EU plans to regulate 'shadow banking'

The Times reports today on another round of exclusive documents leaked by Open Europe, this time regarding European Commission plans to regulate the ‘shadow banking sector’. See here and here for the docs.

A rather niche story you might think but it could have important implications for the way money is lent throughout the economy. Below we provide some background and our thoughts on the proposals.

What is the shadow banking sector?

“The FSB defined the shadow banking system as "the system of credit intermediation that involves entities and activities outside the regular banking system". This definition implies the shadow banking system is based on two intertwined pillars.

First, entities operating outside the regular banking system engaged in one of the following activities:

• accepting funding with deposit-like characteristics;
• performing maturity and/or liquidity transformation;
• undergoing credit risk transfer; and,
• using direct or indirect financial leverage.

Second, activities that could act as important sources of funding of non-bank entities. These activities include securitisation, securities lending and repurchase transactions ("repo").”

Essentially, it is made up of institutions outside the banking sector but which provide paths for borrowing and lending as well as significant financial investments. According to the Financial Stability Board (FSB) in 2011 it totalled €51 trillion worldwide.

Why are there concerns regarding it and are they valid?

• Shadow banking came to light in the aftermath of the financial crisis where it is thought to have played an important role in allowing the financial sector to hide the true level of risk in the system.
• There are some valid concerns over shadow banking. It operates outside but closely related to and interlinked with the regular banking system. This means it falls outside of scope of regular supervision and regulation.
• Often pursue highly leveraged activities, search for high yields and transform maturities from short to long (can cause a mismatch in funding if a crisis hits). There is significant use of opaque securitisation, hard to judge real value.
• Often have very low levels of capital, funded in the short term by lending and investments which needs to be regularly rolled over. This is used to fund long term assets. Helps boost profits but also magnifies losses. Due to this set up, the system very exposed to liquidity crises which can hit hard and fast.
• IMF recommended recently that key aims should be to reduce spill over from shadow banking to regular banking system (reduce prospects for rapid contagion in a crisis) and to reduce the procyclicatlity of the shadow system.
• All that said, it does provide a valuable service in many cases, particularly as an alternative method for distributing credit to the real economy when the banking sector is failing to do so sufficiently.

Thoughts on the EU proposals so far

• The proposals are still at an early stage and subject to change. A key issue is how any shadow banking regulation will fit with the raft of other financial regulation in the pipeline or already in force – AIFMD, CRD IV, EMIR, UCITS, and Solvency II to name but a few.
• Importantly, many of these other regulations already cover many of the institutions involved in the shadow banking sector. Avoiding double regulation and inefficiency is vital, therefore judging and implementing the current regulations is important before a shadow bank regulation is brought in.
• Shadow banking is not part of regular market and those involved do not have deposits so there is no question of a government backstop or bailout scenario. Can and should go bust. The main point is that any shadow banking crisis should not transform into a ‘systemic crisis’. The approach should therefore be ‘macroprudential’, taking an overview of the market and ensuring it is not overly risky and/or that it is not too heavily intertwined with regular banking sector.
• This may be more effectively done by setting out guidelines for supervision and cross border data collection that a strict regulation.
• The EU must also be wary of regulating against specific financial instruments, which could have perverse effects. For example, ‘securitisation’ has become a hot topic. This tool was misused during the financial crisis but is not an inherently bad thing. As ECB President Mario Draghi pointed out recently, effective securitisation of SME loans could help boost lending to SMEs and increase level of quality assets in Europe.
• Money Market Funds are different to many other parts of this sector. They are essentially pools of deposits or excess funds from finanical firms which are invested in the short term to gain small gains above what standard deposits would reap. They invest heavily in short term government, corporate and finanical debt and play a key role in providing liquidity to the market. The Commission looks to be regulating these separately, which is the right way to go. However, any small increase in costs could hamper the whole industry since their margins are so low - in fact some have already been closed due to the record low interest rates. 

As we said the proposals are just getting going so all this is still open. Regulation of the shadow banking sector is necessary but its also vital to note that it plays an important role in providing credit to the real economy (despite its rather ominous sounding name). At this point in time its not clear that a regulation is needed immediately and it may be more effective to improve and work with what is currently on the table. Furthermore, in an ideal world, any attempt to tackle it would be done on a global level in the form of a set of guidelines and plans for data sharing and increased transparency.

Has Germany really gone off the idea of an EU treaty change?

Usually technical meetings behind closed doors in Brussels are pretty dull. However, judging by some of the reports floating around, yesterday’s meeting of the EU Committee of Permanent Representatives (COREPER) may have bucked the trend somewhat. This is the negotiation forum for member states' EU ambassadors - the key guys involved in talks over EU policy. This is where a lot of decisions, de facto, are being made.

As we noted in today’s press summary the UK was outright outvoted on the plans for capital requirements for banks (CRD IV), which entail the controversial caps on bankers' bonuses. 

However, though it was already clear that the UK had lost that particular battle, it was the talks over the EU's proposed, and in part agreed, banking union which caught our eye. EU ambassadors failed to reach agreement amid continued North-South divisions, but the reason why is interesting.

Most media failed to pick up on this, but the WSJ Real Time Brussels blog rightly notes that Germany was strongly pushing for a clearer separation between the ECB's monetary duties and supervisory responsibilities, to avoid a running conflict of interest (see here). The only way this can really happen is to give the supervisory board the final say over supervisory decisions (as opposed to now when it rests with the ECB's Governing Council). This, in turn, requires EU treaty change. The Germans wanted a clear commitment from other member states that this would happen.

According to the WSJ, Berlin also insisted on giving national parliaments (not just the European Parliament) the right to ask questions and get answers on supervisory policy, and giving states under the single supervisor along with the EP the power to remove the Vice Chairman of the supervisory body.

A couple of interesting points there. This is an incredibly fluid target but those who say that Germany has 'gone off the idea' of Treaty change - in light of David Cameron's speech where he mentioned EU treaty change as an avenue for reform - clearly haven't quite appreciated the nature of the proposals floating around. Of course, Berlin won't be shouting it from the rooftops ahead of a national elections and with the relationship with France at an all time low (well almost), but in many of the Germans demand on eurozone governance is an implicit acknowledgement that something has to change in the EU's institutional framework (see our table here of the broad proposals being discussed [p.9]).

The scope (limited or full treaty change), nature (EU treaty or inter-governmental) and timing will be discussed, but it will likely happen sooner or later.

What next on the EU bank bonus cap?

Today has been billed as the final chance for UK Chancellor George Osborne to secure a change in the proposal to limit bank bonuses across the EU.

It is true that any change to the broad political agreement (including the level of the ratio limiting bonuses) would probably need to be secured today – a move which looks unlikely. However, as we note in today's press summary, the technical discussions over the specifics will continue for some months, presenting the opportunity to water down the proposal behind the scenes. Numerous issues remain unresolved such as: whether the cap will apply to all staff or just the highest paid, whether it will apply to all banks or only larger ones and, most importantly, whether the EU will stick with the plans to apply it to subsidiaries (both EU ones located elsewhere and foreign ones located in the EU).

So there could yet be room for some improvements to the proposal. There are also two other issues which have cropped up in this discussion: the possibility of the UK invoking the Luxembourg compromise and potential legal challenges against the proposal.

What is the Luxembourg compromise?

See below for a box from p.31 of our ‘Continental Shift’ report (really a worth a read by the way to understand the context of this and related debates) which explains the premise (click to enlarge):

It has been muted that Osborne could trigger this at today’s meeting. This is a last resort and seems unlikely – besides it is not clear how effective it would be in this case, as it is only a gentleman's agreement.

Is the proposal open to legal challenges?

According to the FT, banks have been receiving legal advice and believe they may have a case based on Article 153.5 of the Lisbon Treaty, which says:

“The provisions of this Article shall not apply to pay, the right of association, the right to strike or the right to impose lock-outs.”

Article 153 is in the social policy chapter of the treaties. Currently, the legal base for the rule is as part of CRD IV, i.e. under financial regulation and looking to address financial risk taking. 

The Commission and MEPs have also dismissed claims of illegality, on the grounds that the rules do not limit total pay, but simply set a ratio on variable pay in an attempt to reduce risk taking, and it is not therefore social policy.

It looks likely that there will be some legal challenges, although from the private sector rather than the UK Government.

EU tightens the noose on bank bonuses

As we noted in today’s press summary, a tentative EU deal was struck last night on bank bonus curbs, as part of the broader agreement on CRD IV (which implements Basel III). We’ve discussed this in detail before, so we refer you to that post for the background.

The deal looks much as expected, although a couple of changes have been added:

• Bonuses should be limited at a 1:1 ratio to salary, which can rise to 2:1 with explicit shareholder approval.
• Up to a quarter of variable pay can be discounted and issued in instruments deferred for more than five years, which could increase the ratio above 2:1.
• Bonuses in the form of long term equity or debt that can be bailed in if a bank fails will also be given more favourable treatment.

Surprisingly, the deal still includes plans to force subsidiaries of foreign banks in the EU to adhere to the bonus rules and, more importantly, forcing all subsidiaries of EU banks in the rest of the world to do so. This could hamper competitiveness and, we suspect, may still be subject to changes. This is also an area where the UK might have expected to receive a concession.

What happens now then? EU finance ministers meet next week and will discuss the proposals. Significant changes seem unlikely, which could mark a loss for the UK, which has vehemently opposed the rules from the start.

The real question for the UK is whether it should try to force a formal vote on the issue at the meeting of finance ministers. This would raise the prospect of voting down the UK on a financial services issue – that this has never happened before is often cited by the EU as a counterargument against UK concerns over EU financial regulation. If the UK is outvoted it would mark a potentially significant precedent for the UK's future relations with the EU.

It should be remembered though that this is only a small part of the large CRD IV package, which has been continuously delayed due to MEPs' demands for bank bonuses to be included. The UK has managed to secure favourable treatment on the key aspect of the legislation – the ability to adjust national capital requirements for banks.

As we have suggested before, the debate on bank bonuses seems slightly tangential in terms of the wider debate over bank capital and broader financial stability (indeed there are valid question about why it has been lumped in with CRD IV at all). For all the talk of needing bank bonuses to limit risk taking and moral hazard in banks, the EU has supported and approved €1.6 trillion in state aid to banks over the course of the financial crisis. Many countries have pushed for limits to capital requirements and supported the easing of the Basel III liquidity controls. The EU, and the eurozone in particular, has also consistently argued for and supported bank bailouts and refused to countenance imposing losses on bank creditors, instead shifting the burden to taxpayers.

Trying to limit moral hazard by tackling excessive bank bonuses is all well and good, but it is a drop in the ocean when it remains clear that states and central banks will continue to bailout banks at any cost.