02 April 2012

IPE: Custody and banking reform

Michel Barnier, the EU commissioner for the internal market, has formed a ‘high level’ group of experts to investigate structural reform of Europe’s banking industry. The group has been mandated to determine whether, on top of the regulatory changes in the pipeline, further ‘structural reforms’ would ‘strengthen financial stability and improve efficiency and consumer protection'.

Barnier has stated that the Volcker rule will be considered by Liikanen’s group. It is due to report by the end of summer 2012. “This report may come to similar conclusions to those of the Vickers Report”, says David Strachan, co-head of the Deloitte centre for regulatory strategy. “There are two agendas at work here, the G20 agenda is to strengthen balance sheets, while the European agenda is that checks have to be placed on the extent of financial markets freedom.”

The continental European securities services industry is far from being as efficient as those of the US or the UK. European depositary and custody services are often run within banking and wider financial services groups on captive assets. A large number of small depo-banks also survive, not to mention practices such as private and local investment banks offering in-house custody to private clients, forms of business little known in the US and UK. If Liikanen follows Vickers, the consequences will be far greater in Europe than in the UK.

The notion of ring-fencing sits at the core of the Vickers Report. The emphasis is not on ring fencing ‘casino banking’ but protecting retail and SME deposit-taking in separate, financially independent legal entities, subject to higher prudential requirements. The principles behind this fence are first to mandate services for encirclement; these comprise retail and SME deposits, overdrafts and other forms of credit. Next there are services that are to be excluded. Finally, activities within the ring fence that would not otherwise be permitted are allowed if ancillary to the provision of mandated, fenced-in services.

We can expect the term ‘ancillary’ to be the subject of much debate. It certainly excludes proprietary trading. Many desks have already closed; banks like the troubled RBS are withdrawing from these activities. Meanwhile, the aim of the report is to isolate and insulate those banking activities where continuous provision is vital to the economy. Activities that are deemed incidental to this core and might threaten its continuity are due to be moved outside the ring fence.

One key area of risk likely to be prohibited is that of acting as, or being exposed to any, counterparty risk. The UK government has also responded to Vickers with the intention to undertake further analysis of the characteristics of any entities potentially acting as counterparties to ring-fenced banks. They have also promised to look in detail at the characteristics of products prohibited by reference to their function. Here derivatives and trading book assets get a special mention; it seems likely that ‘simple’ contracts will be allowed within the fence insofar as they are integral to core functions but not otherwise.

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