Eurozone banks to separate risky activities: Can they stay afloat?

Joint press conference by Michel Barnier, Member of the European Commission (on the right), and Erkki Liikanen, Governor of the Bank of Finland following the publication of the report prepared by the High-level Expert Group on reforming the structure of the EU banking sector. (EC Audiovisual Services, 02/10/2012).

Yesterday EU Commissioner Michel Barnier, in an interview to the German financial newspaper ‘Handelsblatt’, said that the European Commission has decided to go ahead and propose legislation to safeguard Eurozone’s banking system, along the lines of the recommendations of the high-level expert group, chaired by Erkki Liikanen, governor of the Bank of Finland. The main recommendation of the Liikanen report is the mandatory separation of proprietary trading and other high-risk trading activities of banks, from their standard business, “if the activities to be separated amount to a significant share of a bank’s business”. In this way deposits’ money would no longer be used to finance risky trading activities.

The EU authorities have been characteristically reluctant so far, to favour the separation of those two banking business lines, namely the risky bets and the traditional deposit and loan activities. The reason is that the major British, German and French banking conglomerates have been extensively exploiting other people’s money (deposits) for their own risky bets in every possible and impossible world market. The problem is how deep this usurp is and if the separation is possible? Let’s start the story from the beginning.

The Liikanen recommendations

The European Commission in November 2011 mandated a high level group, to study the European banking system. Erkki Liikanen, Governor of the Bank of Finland and a former member of the European Commission was appointed as its chairman. The mandate was to determine whether, in addition to the ongoing regulatory reforms, “structural reforms of EU banks would strengthen financial stability and improve efficiency and consumer protection”, and if that is the case, to make recommendations as appropriate. The Group held monthly meetings, inviting different stakeholders, and organised a public consultation in May. On 2 October 2012 the group presented its report containing important recommendations.

In brief, the Group recommended 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, and finally strengthening of the governance and control of banks”.

Still reading the proposals

Unfortunately, all along the last twelve months the EU authorities and more precisely the ECOFIN council was totally absorbed by the German objections, around the legal base of the Single Resolution Authority and Fund. At last today the article 114 of the Treaty seems to be accepted as such a base. Understandably the ECOFIN council has arrived to a compromise around the pending issues for the enactment of the European Banking Union.

Market sources say that Germany is now pressed by others apart from its Eurogroup peers to agree over the functioning of the bank resolution procedures. On top of that it seems that the largest Eurozone lender, the mighty Deutsche Bank, is exposed to risks that may surpass even the ability of Berlin to safely cover potential holes in the bank’s assets. Actually, OECD’s warning this week, about ‘shocks’ to Eurozone’s banking system, coming from the developing world, was an urgent message, that Europe should fix the holes of its banking system now. As a result, Berlin has softened its stance and now appears open to compromise.

To this effect, Commissioner Barnier proposed yesterday that along with the presently under discussion reshuffle of Eurozone’s banking system, the Liikanen group proposals should constitute a structural part. It’s a pity to watch the EU languishing behind the US in protecting consumers from bankers’ greed. Five years after the still ongoing western financial crisis and Europe has omitted to force the banks to stop financing their proprietary high risk trading activities with depositors’ money. The Americans have already accomplished this separation of banking activities.

Who can afford it?

This division appears now ‘cine qua non’, given that the European Central Bank has already launched its stress tests on assets and liabilities of the major 130 Eurozone lenders. If their results are to be convincing and transparent, all those banks must now start the separation exercise, distinguishing their risky market bets from traditional deposit and loan activities.

This exercise will of course entail the creation of two new banks, out of every banking conglomerate, one undertaking the risky assets and the other for the traditional part of the business. The question is which Eurozone banking group can safely realise that, without extra capital injections. After the separation, the ‘investment’ banks should still comply with EU directives about capital quality and adequacy provisions. Who will provide the extra capital needed, being of the order of at least €70 billion?