With the European Union promoting a Better Regulation and REFIT agenda, the Call for Evidence and the need for jobs and economic growth, the financial sector may be forgiven for having entertained the notion that the regulatory rhythm would slow down. That is, however, not quite the state of the European legislative agenda for the European banking sector and financial markets.
On 23 November the European Commission unveiled a comprehensive package of legislative measures aimed at completing the EU regulatory framework for the banking sector. Characterised as a package of risk reducing measures, it seems closely linked to the proposal for a common European Deposit Insurance Scheme (EDIS) for the 19 Member States of the Eurozone which was proposed exactly a year ago. Considered the third and missing pillar of the Banking Union, EDIS has made particularly slow progress both in the Council and the European Parliament because of fundamental divergences between Member States on the sequencing of reduction and mutualisation of risks in the European banking sector.
This new package will have a deep impact on banks, financial markets and bank investors. In addition it comes amidst tensed international discussions on ‘Basel IV’, the regulatory uncertainty for the largest banking centre in Europe brought by Brexit and the increasingly complex relationship between the Banking Union and non-Euro Member States.
In this briefing we will provide an overview of the context and structure of the proposal, its key elements and the political dynamics that can be expected in the Council and the European Parliament.
What is the Commission proposing and where does it come from?
The package unveiled by the Commission is the culmination of four workstreams coming together simultaneously to address political priorities of the Commission as well as to ensure the EU follows through on its international commitments:
- Basel III Agreements – the package is making key parts of the Basel III framework such as a binding Leverage Ratio (LR), Net Stable Funding Ratio (NSFR) and Large Exposures (LE) regime, binding under EU law.
- International agreements – the package implements the Financial Stability Board (FSB) Term Sheet on Total-Loss Absorbing Capacity (TLAC) agreed in 2015 as well as IFRS 9, enacted by the International Accounting Standards Board (IASB) in July 2014.
- Call for Evidence – the package seeks to develop a more proportionate application of the Single Rulebook to smaller banks, an issue identified in the Commission’s Call for Evidence held in 2015.
- Basel IV? – the package is implementing the Basel standard on the Fundamental Review of the Trading Book (FRTB) through changes to the market risk framework. Not being part of the Basel III framework, the financial industry sees it as the first part of ‘Basel IV’ implemented in EU law.
The package is composed of the following legal instruments:
- Proposal amending the Capital Requirements Directive IV
- Proposal amending the Capital Requirements Regulation (CRR II)
- Proposal amending the Single Resolution Mechanism Regulation (SRMR)
- Proposal amending the Bank Recovery & Resolution Directive (BRRD) to implement TLAC
- Proposal amending the Bank Recovery & Resolution Directive (BRRD) to address creditor hierarchy
Key elements – an overview
The package introduces a large number of new issues that have an impact on the regulation, supervision and resolvability of banks:
Political environment and dynamics in the European Parliament & Council
Now that the Commission has unveiled its proposals, the European Parliament and the Council will start their internal negotiations to agree on the various proposals in the package. Past experience shows that the EU legislative apparatus can take on average between 1.5 and 3 years to agree on major packages of financial legislation.
An additional 18 months may be needed to finalise the necessary Level 2 rules that will contain the final detail. Bearing this in mind, this is probably the last package of this scale proposed by the current Commission before the European Parliament elections of May 2019. The package will be discussed in a political environment shaped by several key dynamics.
Following the Eurozone crisis, the Commission under President Juncker decided to implement the recommendations of the Five Presidents Report published in July 2015. In November 2015, it proposed a common deposit insurance scheme covering Member States from the Eurozone. That proposal has become entangled in deadlocked negotiations in the Council between two groups of Member States with diametrically opposed views.
Germany and several other Member States are keen to see a reduction of the risk in the European banking sector before any form of risk mutualisation with fiscal implications at Eurozone level. On the other hand, France, Italy and Spain see accelerated risk mutualisation as the way to relieve market pressure from indebted Eurozone countries and as a critical way of reducing the risky nexus between banks and sovereigns.
This rift is already emerging around the new package where Germany feels banking regulators should be able to apply specific measures to each bank that may go beyond requirements in EU rules and the international TLAC standards. France and Italy on the other hand viewed the TLAC as an absolute maximum not to be exceeded by European regulators. The ability of regulators to apply more institution-specific measures may be part of a trade-off around how to address the Too-Big-To-Fail (TBTF) challenge. If allowed, this may provide sufficient political backing for the withdrawal of the proposal on bank structural reform (BSR) that has been hopelessly blocked in the European Parliament since May 2015.
If the package becomes politically closely interlinked with EDIS, there is a real risk that negotiations will advance at a very slow pace – bar a Eurozone crisis of the magnitude of 2011-12. This in turn means that the EU is unlikely to have its regulatory framework operational in line with its international commitments around Basel III and the TLAC agreement. If the package is to be adopted swiftly enough, it will be critical to keep it politically separate from the EDIS discussions. However, France, Italy and Spain may seize the opportunity of the package – perceived as disproportionately affecting their large banks – to push for significant progress on EDIS in exchange.
Finally, in the middle of this Eurozone ‘thug of war’ it raises serious questions about the ability of the non-Euro Member States – in a context of Brexit – to ensure their specific issues and concerns are reflected in a Single Rulebook that applies to all 28 Member States.
In recent years large European investment banks seem to have been losing out to their US-based rivals. They have repeatedly complained they face unfair competition because of a more stringent regulatory framework and regulatory barriers when operating in the US.
The Commission’s proposal contains rules on the need for global systemically important non-EU banks to have holdings in the EU that comply separately with capital and liquidity requirements. These rules are perceived as mirroring rules proposed by the US Federal Reserve in 2014 and as anti-American.
The issue of competitiveness is not new. It became an issue in 2015 during the negotiations around the BSR proposal where attempts were made to include subsidiaries of global systemically important non-EU banks in the scope of provisions on the separation of certain trading activities.
The election of Donald Trump as the next President of the US will not facilitate this dialogue as his administration is expected to push for the repeal of key parts of the Dodd-Frank Act. Additionally, steps by the US Department of Justice to impose a $14bn fine on Deutsche Bank is equally perceived as heavy-handed and distorting the level-playing field.
This may have two major impacts on the negotiations. The EU is likely to deviate more openly from international agreements when deviating support its competitiveness agenda. This in turn will contribute, along with the repeal of parts of Dodd-Frank by the future US administration, to a fragmentation of the international regulatory framework. This could become a major problem for banks operating internationally. And this is particularly important for the future outcome of ongoing negotiations on ‘Basel IV’ standards where the EU and the US find themselves on opposite sides of the argument.
This new package adds an additional layer of complexity for large banks based in the UK. Bearing in mind the political complexity of the package and the fact that Level 2 legislation takes on average an additional 18 months to design, it seems very unlikely the EU legislative apparatus will deliver fully implemented and operational legislation by 2019 when, based on the current timetable, the UK is due to leave the EU.
Where should these banks then turn for guidance on future rules? The UK Government and Parliament will not be able to start discussions on future rules implementing Basel III and TLAC in the UK as long as the UK is a member of the EU. On the other hand, in the context of Brexit, UK-based banks may see their ability to effectively influence the outcome of EU legislation much reduced. And when you add into the equation the future ‘Basel IV’ rules currently being developed the regulatory uncertainty seems daunting.
This is quite an outcome when the regulatory rhythm in the aftermath of the Global Financial Crisis is supposed to have slowed down significantly.
How can Hume Brophy help?
We offer to our clients a unique combination of high-level political connectivity and capacity to analyse EU, UK and international politics with a deep understanding of the EU regulatory framework for financial services. This allows us to advise clients on how to position themselves and interact with policymakers, politicians, regulators and civil society in an increasingly complex and uncertain world.