Monday, March 18, 2013

The Banking Reform in Germany – The Baby and the Bathwater

A few days ago, Germany’s finance minister, Dr. Wolfgang Schäuble, introduced Germany’s planned banking reform to the parliament:

Wir versuchen, Wege zu finden, wie wir Eigenhandel, Investmentbanking und die normalen Bankgeschäfte so voneinander abgrenzen können, dass Risiken in einem Bereich keine Ansteckungsgefahren für andere Bereiche bedeuten können.
We are trying to find ways to separate proprietary trading, investment banking and normal banking transactions to ensure that risk in one area does not entail a risk of contagion for other areas.

Ich glaube, es ist vernünftig, dass wir bei der Regulierung von Banken nicht das Kind mit dem Bade ausschütten, sondern immer daran denken, dass die Funktion und Leistungsfähigkeit unserer Banken in einem starken Maße vom Erfolg auf den Weltmärkten abhängt.
When it comes to banking regulation, I think it is reasonable not to spill out the baby together with the bathwater, but to keep in mind that the function and performance of our banks depends, to a great extent, on their success on the world markets.

The general goals of the German reform are to allow a winding-up of systemically relevant financial institutions without impairing public funds and counter effectively “too big to fail” situations.

It has three main pillars:

  • Restructuring and liquidation of financial institutions
  • Risk protection for financial institutions
  • Criminal liability of risk management executives

A. Restructuring and liquidation of financial institutions

Reorganization Plan

Systemically important financial institutions are bound to establish a reorganization plan.

The German regulator qualifies a financial institution as systemically important on the basis of qualitative and quantitative factors such as

  • size;
  • domestic and cross-border business activities;
  • interconnectedness with other financial institutions in the financial system;
  • (im)possibility to replace the financial institution as regards its financial services and infrastructures.

The reorganization plan

  • defines indicators to disclose a crisis early on;
  • describes stress scenarios;
  • analyzes the firm’s structure, business model, and main activities from a strategic point of view;
  • evaluates the possibility for the financial institution to be rescued;
  • reveals the firm’s options to restructure;
  • sets up a communication plan for a crisis scenario.

The German regulator can intervene if he feels that the implementation of the reorganization plan is compromised. He can, for example, order the financial institution to recapitalize or to revise its refinancing strategy.

If, nevertheless, the financial institution continues to lack a sufficient degree of operational security, the regulator might

  • ask to conclude service agreements;
  • put limits on the institution’s risk exposure;
  • entrench information rights;
  • order asset sales and spin-offs;
  • require to reduce the complexity of the firm’s structure.

Liquidation Plan

In case a financial institution is systemically relevant but not part of a financial group that is monitored by the German regulator, the administration will put a liquidation plan in place. Amongst other elements, the plan analyzes the institution’s business strategy and internal structure and illustrates if and how the business units can be isolated in a crisis situation. The liquidation plan will not necessarily be disclosed to the financial institution.

B. Risk protection for financial institutions

Germany's government intends to proscribe two types of activities:

  • Proprietary trading (= trading activities on the bank’s balance sheet as opposed to deals done on behalf of clients)
  • Granting of credit and guarantees to hedge funds and other comparable, highly leveraged institutions

By contrast, market-making activities are, as a general rule, permitted. Exceptionally, the regulator can prohibit them if they compromise the solvency of the financial institution. Market-making refers to activities which consist of

  • posting firm, simultaneous two-way quotes of comparable size and at competitive prices, with the result of providing liquidity on a regular and ongoing basis to the market;
  • fulfilling orders initiated by clients or in response to clients’ requests to trade;
  • hedging positions arising from the fulfillment of the tasks above.

In addition, the above restrictions only apply to financial institutions whose balance sheet outstrips, on a consolidated level, one of the following thresholds:

  • Available-for-sale financial assets exceed 100 BEUR.
  • Available-for-sale financial assets represent a minimum of 20 % of total assets and, over the past 3 financial periods, total assets were at least 90 BEUR.

Finally, the proposal expressly exempts asset liability management activities and long-term strategic participations in other companies. Also, a brokerage institution can still perform speculative activities if it is economically and legally separated from any financial institution. This independence namely means that the broker must refinance its balance sheet on a stand alone basis. The exception intends to leverage advantages linked to size and diversification of a financial conglomerate.