Tackling too-big-to fail banks and other measures: are banks being reformed?

By Myriam Vander Stichele, SOMO

After the Economic and Monetary Affairs Committee (ECON) of the European Parliament had exceptionally rejected a draft legal proposal on diminishing the risks of too-big-to fail (TBTF) banks by restructuring them, a compromise was reached at the end of October 2015 between two large parties, the Social Democrat (S&D) and Centre Right (EPP) parties. The compromise proposal would result in not having a decision that investment and retail banking should be separated at globally systemically important credit institutions, as defined by EU law, or at banking institutions that have had total assets of at least €30 billion over the last three years and trading activities of at least €70 billion (or 10% of their total assets).

Many conditions would apply before a competent authority could decide whether a bank’s non-loan activities have become too risky for TBTF banks, for financial stability or for depositors, e.g. the bank first has the opportunity to prove that these risks do not exist. If there were such risks, the supervisors would have the discretion, under conditions that take time, to require a risky bank to increase its capital buffers or to stop certain trading activities. The other element of the compromise is that trading at the risk of the TBTF bank itself (“proprietary trading”) and some financial connections with hedge funds or private equity funds will be forbidden. Since disagreements were raised again in late November, it is unlikely that ECON will vote on a new text in December 2015. The draft ECON texts have weakened the possibility that and when competent authorities can make decisions to restrict a TBTF bank, a far cry from the original call to split TBTF banks, and whether these decisions will even be useful. Once ECON has agreed, negotiations will need to find a compromise with the different position of the Council of Finance Ministers to arrive at a final legal text.

The banking industry has been fiercely lobbying(opens in new window) against any bank structural reform, arguing that their competitiveness as compared to US investment banks will further diminish and that they will be less able to serve large corporate clients or be strong players on financial markets. There is a growing rhetoric in the EU that banks have been over-regulated, which has led to a consultation by the EC until 6 January 2016(opens in new window) and a Financial Stability Board report(opens in new window) about the impact of the regulation so far. It is argued that bank restructuring is not needed because the following additional measures are being taken to strengthen the European banks.

Second Pillar

In order to be prepared for times of crisis, the second pillar of the Banking Union has already resulted in a Single Resolution Mechanism(opens in new window) that has a separate decision-making body (Single Resolution Board) and a Single Resolution Fund. From January 2016 onwards, the Single Resolution Board will be responsible(opens in new window) when a bank that is part of the Banking Union (in the Euro-zone or other) is in serious difficulty and needs funds to recover or to be resolved with minimal costs to the tax payer. The EU’s Bank Recovery and Resolution Directive(opens in new window) stipulated that since January 2015 national resolution funds are available, but some EU members states failed to implement the directive(opens in new window) . In addition, banks have plans that enable basic banking functions to continue when a bank is to orderly recover in times of financial distress or to be orderly resolved when a bank goes bankrupt.

Third Pillar

In order to finalise the third pillar of the Banking Union for Euro area banks and to increase the trust in banks, the European Commission made a proposal on 24 November 2015(opens in new window) on how to establish a European Deposit Insurance Scheme (EDIS) by 2024 in three successive stages. This would allow all savers in Euro countries to have their deposits guaranteed for up to EUR 100,000 in the event that a bank in the Euro-zone becomes insolvent. EDIS would gradually replace national deposit guarantee systems (DGSs) for up to EUR 100,000 in savings, which are obligatory under EU law(opens in new window) and have to cover at least 0.8 per cent of the value of guaranteed deposits by 2024, but whose implementation is lagging. The new proposals(opens in new window) would require a slow build-up of a Euro-zone guarantee fund (EDIS) with bank contributions: During the first three years, EDIS would only contribute to a certain extend if the money at DGSs were to be exhausted (i.e. a reinsurance scheme); for a second period of four years, EDIS could contribute a small amount needed for savers in case of a bank collapse (co-insurance scheme), apart from payments by DGSs; and by 2024, there should be a full insurance system in place providing deposit guarantees for all countries with national DGSs. To avoid funding from countries with stable banks having to pay for weak banks, conditions have been built in before access to EDIS is allowed – for instance, riskier banks will pay higher contributions to EDIS than safer banks. The proposal is already meeting strong opposition, e.g. by Germany.

Loss absorbency capacity

The updated list of 30 global TBTF banks(opens in new window) , called global systemically important banks (G-SIBs), is being published by the Financial Stability Board (FSB) in November 2015. In order to avoid a situation in which the tax payer has to pay for all the losses in the event that a bank goes bankrupt, the G-SIBs are subject to more risk management requirements and mechanisms. Moreover, from January 2016 onwards, G-SIBs have to acquire more financial means to deal with situations when they face financial problems. This so-called higher “loss absorbency capacity” is complementary to reforms that increase capital buffers for banks to absorb especially loss-making loans or activities. The loss absorbency instruments only provide extra capital when certain crisis situations occur, and are often “bail-in” instruments (e.g. continent convertible bonds – CoCos – become shares so that banks do not have to pay the bonds’ debt to the bond holders). They have to be easily available or convertible (i.e. to be “liquid”). Other new minimum standards for total loss-absorbing capacity“ (TLAC), agreed at the G20 mid November 2015, require that the resolution entities of the G-SIBs, which are responsible for resolving a G-SIB when it goes bankrupt, have loss absorbing instruments that are 16 per cent of their risk-weighted assets by 2019 and 18 per cent by 2022.

Shadow banking

On shadow banking, progress is still scarce. Efforts are being made to make shadow banking acceptable as “resilient market based finance(opens in new window) ”. The G20 Summit in mid-November 2015 did not issue specific decisions. The FSB has continued to monitor shadow banking(opens in new window) and has made attempts to deal with particular issues, such as simplifying securitisation and additional standards to avoid the financial risks of “securities financing transactions”. At EU level, one of the two legislations proposed in 2014, which covers a small but important aspect of shadow banking, was adopted on 29 October 2015, namely the Regulation on Transparency of Securities Financing Transactions (SFTR)(opens in new window) . It should allow the risks to be monitored and assessed when assets, such as shares or bonds, are used as collateral to finance activities in the real economy or transactions in financial markets, e.g. when borrowing securities, or for repurchase transactions (repos).

The G20 is also enabling better transparency and stability in the financial sector, through a new “Legal Entity Identifier” system (LEI)(opens in new window) that has already registered 390,000 entities, with the cross-border bank resolution(opens in new window) , and with better control of misconduct(opens in new window) in the banking sector.

Research EBA

In the meantime, the European Banking Authority (EBA) has published its research(opens in new window) on the stability and transparency of big banks in 21 EU countries and Norway. It concludes that European banks, with important differences among countries, are more stable due to increased capital buffers and are more able to lend to the economy. However, they still have quite a high level of bad debts on their books and are still quite exposed to governmental bonds (“sovereign debt”). EBA also reported on the leverage ratio which each bank has to disclose from 1 January 2015 onwards. A new leverage ratio requirement will become binding from 1 January 2018, ensuring that banks build up financial buffers in relation to the total balance sheet of the bank, and not according to weighing the risks of their activities. Until that date, banks are required to individually disclose their leverage ratio data. The leverage ratio aims at avoiding a situation in which banks are lending too much without their own reserves, and in which they are assessing, or “weighing”, the risks of the loans they provide too lightly.

Notwithstanding all these financial reform measures, after having made a thorough assessment of financial reforms, the 2015 UNCTAD Trade and Development Report(opens in new window) concluded that “so far these [measures] have failed to get to grips with the systemic frailties and fragilities of a financialized world.”

Climate change risks

In light of the increased attention on the link between the financial sector and sustainable development with a focus on climate change (see for instance SOMO’s recent report(opens in new window) ), the FSB was asked by the G20 Leaders to continue activities on how the financial sector can take climate change risks into account. This is a theme that the Chinese Presidency of the G20, which started on 1 December 2015, is likely to actively support. China has done comprehensive work in this area, e.g. with many reports in cooperation with UNEP Inquiry into the Design of a Sustainable Financial System(opens in new window) . The FSB has proposed(opens in new window) to set up a voluntary industry-led disclosure task force enabling the financial industry’s efficient assessment of climate change risks and the transition to a low-carbon economy. In the meantime, many banks(opens in new window) have given in to civil society campaigning(opens in new window) to stop financing the coal industry and coal energy plants, since coal is the number one source of carbon emissions.