November 27, 2012
Response of the Czech Republic to the Commission’s consultation on the recommendations of the High-level Expert Group on reforming thestructure of the EU banking sector
The role of banks, particularly in financing of small and medium enterprises, is clearly very important. Current difficulties of the European banking sector call for a reform to allow banks to continue with their business effectively with no need of extraordinary public support and with minimum impact in the event of an economic and financial deterioration. For this reason, the Czech Republic supports the Commission's efforts to find a suitable solution. We would like to present the opinion of the Czech Republic on the High-level Expert Group on reforming the structure of the EU banking sector (hereinafter the Group) final report (hereinafter the Report).
General position on the Report
Investment banking industry revenue is driven by the level of global financial stock. Global financial stock, especially in the derivative markets, has been growing strongly for last 30 years (in 2011 total notional amount of derivatives exceeded 600 trillion US dollars). From perspective of the banks, this phenomenon has initiated not only an increase in revenues of the investment banking industry but also a shift away from banks (and bank credit) as source of financing for the real economy towards capital markets as the primary source of finance. The fact that in some developed markets many non-financial corporates are viewed as less risky creditors than banks; further underpins and accelerates the trend of capital market financing replacing bank lending. This situation has been fuelled further by legislative changes in the 80s/90s (gradual repealing of the Glass-Steagall Act, implementation of the Basel or CRD – the creation of the CDS market is a result of the Basel I regulation), by a long-term trend of falling interest rates that have facilitated increased levels of leverage and by the rapid growth in both outstanding government debt and other credit market instruments. It is a pure logic that this trend has caused an increase in the market liquidity but also in the interconnectivity of the stock, debt and derivative markets as such.
We do not dispute the intention of structural separation of risky financial activities from retail/commercial banking. We believe that it could potentially help to limit the size of banks and their interconnectedness.
However, at present, it is not clear how the upcoming legislation (CRD IV, BRR etc.) will work in practice; therefore we would prefer to wait for the first experience and to analyze possible impact in the impact assessment. We expect that without the possibility to finance trading activities by client deposits, the volume of the more risky activities will be significantly lower. At the same time, it can cause problems in financing of capital market firms, as ring-fencing may limit the liquidity of corporate bonds market with impact to this form of corporate financing and with negative consequences for the real economy. We should be careful in terms of stricter regulatory framework for “lending” or credit markets. Lowering the investment banking industry revenue could decrease liquidity in the markets and finally it can cause significant difficulties encountered by corporates and governments. It is therefore necessary to analyze the possible impact of the proposal.
If mandatory structural separation is introduced, we consider more appropriate the second option proposed (Immediate functional separation of significant trading activities), because this option can better reflect the Groups’ objectives.
Mandatory separation of proprietary trading activities
What is concerning immediate implementation of structural separation of investment and retail banking when the threshold is reached, we believe that this form of separation is more transparent and is therefore more acceptable for financial institutions. This can strengthen the confidence of investors, depositors and financial markets in case of the rules (e.g. the threshold of transformation process) are set properly. In addition, we can assume that this option would reduce or overcome other obstacles including “too big to fail” or “moral hazard” problems. On the other hand, it should not be omitted increasingly important role of the group as a whole, in the management of the bank group as well as in the supervision.
In case that structural separation will be introduced we support the proportionality principle, however it is necessary to set the threshold properly. We believe that if the investment activities exceed the prescribed threshold, all those activities should be transferred to the newly established investment entity in order to maintain transparency of all trading activities within the financial group. We think that the total transfer of trading activities is necessary from the perspective of supervision. Unclear allocation of those activities within the institution or financial group reduces transparency and hence controllability by its supervisory authority and other external bodies (e.g. financial auditors).
We think that the investment activities that should be transferred to the investment entity should include also activities related to investments on behalf of clients (to reach a clear separation of trading activities from retail banking within the institution). Furthermore, the transfer of all investment activities to a separate entity will promote the fulfillment of objective to prevent unauthorized reducing of financing costs (interest rates cut) by banks. The full separation of banking activities will allow investors to differentiate between investment and non-investment part of bank. However, we consider it appropriate to keep the investment activities related to risk management within.
On the other hand, mainly fixed income market heavily depends on market making activities facilitating trades. Without lively market making there is no vibrant secondary fixed income market and thus no primary market. All this may cause enormous problems to governments and corporates when they try to raise funds through issuing bonds. All negative synergies of legislation must be carefully examined and assessed before taking any final decision. According to the proposal the two entities which can operate within a bank holding company must meet capital requirements independently and transfer risks between each other on market terms. Before setting down any rules these must be carefully examined. For example, EMIR excludes all intra-group derivative transactions, not only from mandatory clearing but also from mandatory collateralization. So it is obvious that the transfer of risks inside the group is not done on market terms requiring collateralization of all OTC derivative contracts. We do not think that it would be wise to revoke this exemption.
In our view, it is also necessary to define comprehensively the trading activities to be separated, since a large part of the business operations of banks is closely related to clients’ transactions.
Additional separation of activities conditional on the RRP
Beyond the aforementioned, we think that structural separation based on the decision of the supervisory authority and recovery and resolution plans (RRP) will be subject of serious uncertainty (reputational risk of supervisory authority, resolution and recovery plans or threshold are likely to be inconsistent with the nature of future crisis etc.). That will have fundamental impact on the process of the separation of investment part of firm, as well as a direct impact on retail banking, as it can hardly be expected whether participants of financial market will distinguish among separated parties.
We have supported the idea of the RRP during the meetings of the Council on the Crisis management directive; hence we are in favor of their efficiency in an actual crisis situation. Apart from the essential RRP matter, that it must target just the biggest institutions of the specific market, we do agree that the burden of the plans must stay with banks. It shall force them to structure its activities in line with functional plan evaluated by the competent authority of the market too.
However, we do not support any other than advisory role of the EBA as the sufficient harmonization of the legal environment in the EU will be satisfied by the common rules in the future directive itself. Decision making (e.g. technical standards on powers) is above technical role of the EBA, which can be sustained by the guidelines. Stronger position of EBA would be also administratively burdening and paralyzing for the competent authorities in their basic functions (such as preserving of the financial stability in their respective markets).
We are also very much in favor to differ an importance of the banks for the specific market and as mentioned above we also support a bank behavior in line with its ability to act in accordance with the RRP. However any such evaluation must always stay with the jurisdiction of the respective authority
Possible amendments to the use of bail-in instruments
The Czech Republic is generally in favor of the bail-in tool. However we still have some concerns about the applicability of the instrument and its impacts on the market. In this context we find any additional recommendations of the Group on this matter very interesting. The BRR proposal deals with the bail-in as with the administrative tool accompanied with the minimal requirement on bail-in-able liabilities and the list of its structure under recent negotiations. The sector separation of the bail-in-able instruments is an additional measure to sustain the stability of the market and we need further analyze of this approach.
A review of capital requirements
We support tightening of capital requirements in relation to the trading books of financial institutions. However, we do not consider it necessary to introduce additional, albeit non-risk weighted, capital buffers. It is necessary to consider new aspects of regulation introduced in Basel2,5/CRD III to ensure better securitization of risks associated with trading book. The ability to reduce the risk through the CRD III regulation has not been adequately evaluated. For this reason, we believe it is important to assess the ability to reduce the risk of regulatory rules already in place, before these rules will be supplemented or replaced by new ones. In addition, the Basel Committee on Banking Supervision (BCBS) carries out a fundamental review of the trading book, which will lead to a tightening of capital requirements for trading books of financial institutions. Based on the BSBC consultation paper we can expect the better risks treatment (e.g. replacing the current “Value at Risk” model by “Expected Shortfall” model which better treats tail risk). For this reason we believe that is necessary to wait with introduction of capital buffer until the BSBC review is completed. Furthermore, we think that it is necessary to consider the implications of introducing additional capital buffer on financial institutions.
Therefore, we are identified with the conclusions of Group and we agree with its recommendation for possible introduction of additional capital buffer in reaction of BSBC trading book review. This will also require a review of regulatory rules under CRD III.
Implementation of the proposed model is not considered very appropriate because such model supports creation of complicated banking structures (“too big to fail”), risk and the moral hazard and it reduces transparency and legal certainty. This model is based on proportional growing of capital buffers to the amount of deposits. The separation of business activities of financial institution is subject to a decision based on review of recovery and resolution plan by supervisory authority. In addition, setting of appropriate threshold will expose supervisors to reputational risk.
If a new capital buffer based on the Group recommendation is introduced it will be necessary to define relationship among all other established capital buffers (e.g. the current CRD proposal includes several of them).
Strengthening the governance
With regard to the governance and control of banks, we should pay attention to the fact that the harmonization of regulatory governance in the EU is very difficult, mainly because of differences in corporate law of the individual EU member state. The excessive regulation can impact competitiveness and may lead to regulatory arbitrage. In the case of potentially unjustified and excessively burdensome regulation of corporate governance there is a danger of relocation of companies’ registered offices to more liberal jurisdictions.
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