29 Jan 2014

Towards safer and simpler banks

The JRC provided the quantitative analyses for the European Commission's proposal to further
The JRC provided the quantitative analyses for the European Commission's proposal to further reform the banking sector.
© EU, 2012

Today the Commission adopted a proposal for a new Regulation on the structural reform of the EU banking sector. Since the start of the financial crisis, the EU has initiated a large number of reforms in a fundamental overhaul of the financial system to make it more robust and resilient, while ensuring its support to the real economy. The JRC has worked on the preparation of the quantitative analyses underpinning this proposal.

Complementing earlier reforms such as the increase of capital requirements or enhanced transparency, the current proposal aims to address remaining concerns arising from banks being too-big-to-fail or too-interconnected-to-fail. They play such a critical role in the financial sector and the economy that investors believe governments will never let them fail. Due to the perceived lack of risk, investors lend abundantly and cheaply to these banks which can result in uncontrollable growth. In case of failure, resolving them in an ordinarily manner becomes increasingly difficult, also because of their increased interconnectedness.

The JRC's scientific contribution to the proposal consisted of four main work streams.

Firstly the JRC has developed a statistical study to set quantitative thresholds allowing the identification of banks to be considered for reform, based on their size and their investment in trading activities. It has also quantified the implicit State subsidy that EU banks have enjoyed in recent years. The creditors of large and complex banks do not demand full compensation for being exposed to banks’ risks, because they expect government bailouts in case of need. The JRC estimated the funding advantage implied by this distortion for a sample of large EU banks, which amounted to 65-95 billion euro billion per year in 2011 and 2012.

In addition, the JRC found that banks have unintended regulatory incentives to engage more in trading activities than in traditional, commercial banking activities, including lending to firms and households. JRC analyses demonstrate that the return per unit of minimum capital requirement has been much higher for trading activities than for commercial ones.

Finally, the JRC has contributed to the assessment of costs and benefits of structural bank reform using the JRC’s Systemic Model of Banking Originated Losses (SYMBOL).

With these studies, the JRC continues its scientific support to the bank reforms, making progress towards a safe and sound EU financial system. Previous scientific contributions have underpinned reforms in the areas of Deposit Guarantee Schemes, bank capital requirements, the bank resolution and recovery framework and a European Single Resolution Fund.

Key elements of the Commission Proposal

The Commission proposal on structural reform of the EU banking sector aims to:

  • ensure that banks do not remain or become too big, too complex or too interconnected to fail;
  • reduce excessive intra-group complexity and conflicts of interest, thus facilitating management, regulation, supervision, and resolution of banks;
  • guarantee the resolvability of banks and to safeguard they do not require taxpayer bailout when facing difficulties;
  • ensure that banks will no longer be allowed to use public safety nets to artificially expand their risky activities that are not linked to core banking activities.

To this end, the proposal would ban banks that are too-big-to-fail from engaging in proprietary trading (risky investments for the sole purpose of making profits for the bank). It would also give supervisors the power – and in certain cases the obligation – to require the transfer of other high-risk trading activities into separate legal entities within the group. The proposal provides rules on the economic, legal, governance and operational links between the separated trading entity and rest of the bank. Moreover, the regulation would increase transparency on shadow banking activities - financial activities carried out by non-bank financial institutions - which have been a source of leverage and contagion in the crisis.