The alternative French de minimis Liikanen approach
On 19 December 2012, the French government released a draft banking law (the Draft Banking Law) aiming in particular to implement one of President Hollande's promises made during his election campaign: to ring-fence banking activities considered useful for the economy (eg deposits-taking and loan activities) from what was described as their speculative banking/trading activities.The French legislator has not followed either the U.S. Volcker1 approach or the UK Vickers2 approach to structural reform. This is because most French banks are traditionally set up under a universal banking model and have shown resilience during the financial crisis. (It is worth noting that over the last 20 years only two out of the 16 credit institutions made bankrupt (or significantly affected by a financial crisis) were what one might consider to be "universal" banks). A mandatory full separation of trading activities from retail banking activities was not therefore considered necessary for French universal banks.
The French government chose to adopt the approach outlined in the Liikanen report,3 although the scope of activities to be ring-fenced under the French model is narrower than that proposed in the report. Following a first round of debates and amendments before the French Parliament which ended in March 2013, the ring-fencing measures contained in the Draft Banking Law can be summarised as follows:
- Any credit institutions (including financial companies and mixed financial holding companies) carrying out own account financial instruments trading activities, as well as uncovered transactions with leveraged alternative investment funds exceeding certain thresholds not yet determined (the Speculative Activities), must set up a fully owned subsidiary regulated as an investment firm or a credit institution dedicated for that purpose (the Ring-Fenced Subsidiary).
- The Speculative Activities do not include the provision of investment services to clients, the clearing of financial instruments, the hedging of the credit institution or its group's risks, market-making activities (which remain below thresholds to be further determined), the sound and prudent management of the cash of the banking group and financial transactions between credit institutions, financial companies and mixed financial holding companies, and their subsidiaries, belonging to the same group and the intragroup investment transactions. The scope of those exemptions from the Speculative Activities (mainly for the investment services provided to the clientele as well as the market-making activities) will be closely monitored by the French banking regulator to prevent any circumvention.
- To avoid any contagion or domino effect from the Ring-Fenced Subsidiary to its parent credit institution, the Ring-Fenced Subsidiary is not consolidated from a prudential perspective, ie it must have its own regulatory capital assessed on a stand-alone basis, as well as be treated as the unique beneficiary for the risk division ratio. Moreover, the Ring-Fenced Subsidiary cannot carry out any high frequency trading activities nor enter into OTC agricultural commodities derivatives transactions.
- The implementation of this separation approach does not affect any bad banks already set up for the run-off of portfolio of financial instruments.
As part of the Speculative Activities, transactions with leveraged alternative investment funds or funds invested or exposed to leveraged alternative investment funds fall into the scope unless the security interest granted to the credit institution will meet some liquidity and enforceability criteria assessed on a discretionary basis by the French banking regulator.
According to the French Ministry of Finance and major French banks, this separation requirement will not affect more than 2% to 5% of the turnover of the investment banking activities. The transfer of the relevant activities must take place prior to 1 July 2015.
The Draft Banking Law is significantly less ambitious and less onerous for banks than the Liikanen report (which ultimately requires the inclusion of market-making activities in the ring-fenced entity).
This French approach appears to be viewed as a credible alternative to the full separation initially promoted by the UK Independent Commission on Banking or the Volcker Rule. It is also a timely signal to Michel Barnier, the EU Commissioner for the Internal Market and Services, of a viable alternative approach to banking reform: the drafting process of the expected EU legislative proposal on banking structural reform is scheduled to begin this summer.
1. See s619 of The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) which significantly limis the ability of U.S. Banks to engage in proprietary trading and form certain relationships with hedge funds and private equity funds.
2. See the report of the UK Independent Commission on Banking (chaired by Sir John Vickers) dated September 2011, which has been followed by draft legislation in the UK.
3. The report produced by an expert group chaired by Erkki Liikanen on reforming the structure of the EU banking sector dated 2 October 2012.