Whilst some valid and justified arguments have been put forward in favor of ring fencing, that is, constructing a fire-wall between consumer and investment banks, and that such activities can be achieved without restructuring banks into separate legal entities, the Liikanen Report highlights why there is need for such re-structuring. As well as considering the merits of ring fencing and the establishment of separate legal activities and entities, this chapter aims to highlight why a suitable model aimed at mitigating risks of contagion can to a large extent, be justified on a cost-benefit analysis basis. Furthermore, the chapter ultimately concludes that even though a greater degree of separation of legal entities and activities persist with the model which is referred to as “total separation”, a certain degree of independence between bank activities would also be necessary under ring fencing if its purposes and objectives are to be fulfilled.
TopIntroduction
In the Final Report of “The High-Level Expert Group on Reforming the Structure of the EU Banking Sector, chaired by Erkki Liikanen,1 the need for re-structuring banks into separate legal activities is highlighted. In assessing such a need, two considerations were given due attention (See page i of the Report):
The important role of recovery and resolution plans – whereby the decision on possible separation of bank entities was to be conditionally based on the assessment of such plans; The mandatory separation of banks' proprietary trading and other risky activities.
The Liikanen Review was established in November 2011 by EU commissioner, Michel Barnier, to conduct a full scale analysis of Europe's lending sector and recommend banking reforms for the region.” (Varriale, 2012).
The mandatory separation of banks' proprietary trading and other risky activities could be distinguished from the case which exists with Volcker's Rule in that an outright ban or prohibition on proprietary trading (all forms of risky investment practices) and certain relationships with hedge funds and private equity funds is not implied under such mandatory separation.
The “Volcker Rule” which can be found under Section 6192 of Title VI of the Dodd Frank Act states that:
- 1.
Prohibition:Unless otherwise provided in this section, a banking entity shall not
- a.
Engage in proprietary trading; or
- b.
Acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.
- 2.
Nonbank Financial Companies Supervised by the Board:Any nonbank financial company supervised by the Board that engages in proprietary trading or takes or retains any equity, partnership, or other ownership interest in or sponsors a hedge fund or a private equity fund shall be subject, by rule, as provided in subsection (b)(2), to additional capital requirements for and additional quantitative limits with regards to such proprietary trading and taking or retaining any equity.
Whilst the Volcker Rule is considered by some commentators as being parallel to a separation of banking activities and entities, it is more draconian in the sense that the model allows for less scope and flexibility than the “hybrid” model which is being considered under the Liikanen Review. Those arguments which increasingly favor a more flexible model and which is directed in favor of ring fencing, arise from the inherent difficulties in the definitions attributed to financial and non-bank financial companies. Since such definitions present some ambiguities, is it really possible to effectively establish “completely” separate legal entities and activities? As the case, has always been, ambiguities with legal definitions will always provide a leeway for financial institutions (whether non-bank financial or financial institutions) to manipulate the rules. Furthermore, other complexities arise from corporate ownership structures of banking groups across various jurisdictions – particularly where such groups operate across various jurisdictions with huge differences in legal definitions and operating activities.
The Vicker's Report also adds that prohibiting only those activities caught by the Volcker rule would not achieve all the objectives of ring-fencing (ICB, 2011, p. 45).
It is interesting to note that the Liikanen Report also highlights that “in the discussions within the Group, some members expressed a preference for a combination of measures: imposing a non-risk- weighted capital buffer for trading activities and leaving the separation of activities conditional on supervisory approval of a recovery and resolution plan, rather than a mandatory separation of banking activities.” (page ii of the Liikanen Report):