TABLE OF CONTENTS

1............ Introduction. 5

1.1......... Policy context 5

1.2......... Procedural aspects. 6

1.2.1...... Consultation of stakeholders. 6

1.2.2...... Impact Assessment Steering Group and Impact Assessment Board (IAB) 7

2............ Problems related to the corporate structure of large, complex, and trading-intensive EU banking groups 8

2.1......... Problem driver: The unrestricted co-existence of core banking functions and trading activities within large banks. 10

2.1.1...... Problem 1: Impediments to resolution and supervision. 11

2.1.2...... Problem 2: Distorted incentives for banks. 12

2.2......... Manifestation of problems during the financial crisis. 17

2.3......... Reform efforts to date and complementarity of bank structural reform.. 18

2.4......... How would the situation evolve without EU action (baseline scenario) 22

2.5......... The EU's right to act and justification for acting. 24

3............ Objectives of reforming bank structures. 25

3.1......... General objectives. 25

3.2......... Specific or microeconomic objectives. 25

3.3......... Operational objectives. 25

4............ Reform options. 26

4.1......... Activities to be separated. 26

4.2......... Strength of separation. 29

4.3......... Preventing the risks emanating from shadow banking. 31

4.4......... Structural reform options. 33

4.5......... Issues related to implementation. 34

4.5.1...... Institutional scope. 34

4.5.2...... Role of supervisors. 36

4.5.3...... Timeline for implementation. 36

5............ Impact and comparison of reform options. 37

5.1......... Comparison criteria. 38

5.2......... Social versus private benefits and costs. 38

5.2.1...... Social benefits. 39

5.2.2...... Social costs. 40

5.2.3...... The impact on economic growth of reducing implicit public subsidies. 41

5.3......... Assessment of reform options based on subsidiarisation according to stricter rules. 42

5.3.1...... Social benefits. 43

5.3.2...... Social costs. 51

5.3.3...... Conclusion. 52

5.4......... Assessment of reform options based on ownership separation. 52

5.4.1...... Social benefits. 53

5.4.2...... Social costs. 55

5.4.3...... Conclusion. 56

5.5......... Assessment of retained reform options. 58

5.5.1...... Effectiveness. 58

5.5.2...... Efficiency. 63

5.5.3...... Coherence. 63

5.5.4...... Conclusion. 64

5.6......... Retained options aimed at increasing the transparency of shadow banking. 64

5.7......... Complementary aspects. 65

5.7.1...... Quantitative assessment of some benefits and costs. 65

5.7.2...... International aspects. 67

5.7.3...... Institutional scope. 68

5.8......... Impact on stakeholders. 70

5.8.1...... Impact on bank customers (investors, borrowers, etc.) and market liquidity. 71

5.8.2...... Impact on bank employment 75

5.8.3...... Impact on bank shareholders and unsecured creditors. 76

5.8.4...... Impact on regulators and supervisors. 76

5.8.5...... Impact on EU banking industry. 77

6............ Monitoring and Evaluation. 80

LIST OF ANNEXES

A1. Overview of structural reforms and reform proposals

A2. Summary of replies to the stakeholder consulta­tion

A3. Assessing the complementarity of structural separation with the current reform agenda

A4. Implicit subsidies

A4.1 Implicit subsidies: Drivers, Distortions, and Empirical Evidence

A4.2 Estimating the size and determinants of implicit state guarantee for EU banks

A5. Analysis of possible incentives towards trading activities implied by the structure of banks’ minimum capital requirements

A6. Qualitative assessment of benefits and costs of separating banking activities from deposit-taking entities

A7. Strength of separation

A8. Trading activities and functional structural separation: possible definitions and calibration of the institutional scope

A9. Summary of the main findings in literature on economies of scale and scope in the banking sector

A10. Quantitative estimation of a part of the costs and benefits of bank structural separation

A11. Impact on private costs – bank responses

A12. Economy-wide impact of structural separation

A13. Shadow banking – Securities finance transactions and transparency

A14. Glossary

1. Introduction 1.1. Policy context

Since the start of the financial crisis, the European Union (the "EU") and its Member States have engaged in a fundamental overhaul of bank regulation and supervision. This exercise has to a large extent been based on the reforms to strengthen global financial markets, agreed upon by global leaders at the G20 summits in London in April 2009 and thereafter and implemented in cooperation with the Financial Stability Board ("FSB") and the Basel Committee of Banking Supervisors ("BCBS").

In the area of banking, the EU has initiated a number of reforms to increase the resilience of banks and to reduce the impact of potential bank failures, the objectives being to create a safer, sounder, more transparent and responsible financial system that works for the economy and society as a whole (see in particular the new Capital Requirement Regulation and Directive ("CRR"/"CRDIV") as well as the proposed Bank Recovery and Resolution Directive ("BRRD").[1]

In line with these objectives several EU Member States (Germany, France, Belgium and the United Kingdom ("UK")) as well as third countries (United States ("U.S.")) have taken a step further and introduced, or are in the process of introducing, structural reforms of their respective banking sectors to address concerns related to financial institutions that are too-big-to-fail ("TBTF")[2]. Structural reform measures have also been suggested in reports published in the Netherlands. See Annex A1 for an overview and summary of the main legislative initiatives.

Also international institutions such as the FSB, the Bank for International Settlements ("BIS"), the International Monetary Fund ("IMF"), and the Organisation for Economic Cooperation and Development ("OECD") have been working on a number of initiatives to improve the resilience of the financial sector and not long ago called for a broad and global debate on bank business models, which includes a review of bank structural measures. This review of structural measures was called for because of the continued growth of TBTF banks in relation to the size of the financial system, as well as because of the adoption or planned adoption of structural measures in several jurisdictions (e.g. separation of activities into different legal entities, intra-group exposure limits, etc.).

In this context, Commissioner Barnier announced in November 2011 the setting up of a High-level Expert Group ("HLEG") with a mandate to assess the need for structural reform of the EU banking sector and, with the objective of establishing a safe, stable and efficient banking system serving the needs of citizens, the EU economy and the Internal Market, to make relevant proposals for further action at EU level. In agreement with President Barroso, he appointed Erkki Liikanen, Governor of the Bank of Finland as chairman of the HLEG.[3]

The HLEG presented its report to the Commission in October 2012 (Liikanen (2012)). It concluded that the existing and on-going regulatory reforms do not address all the underlying problems in the EU banking sector, as these reforms do not fully correct incentives for excessive risk-taking, complexity, interconnectedness and intra-group subsidies. The HLEG stated that reforming the structure of banks is necessary to complement the existing and on-going banking reforms and recommended the mandatory separation of proprietary trading and other high-risk trading activities into a separate legal entity within the banking group. The HLEG envisaged that this separation would be mandatory only for banks where the activities to be separated amounted to a significant share of the bank’s business.[4]

Following a public consultation on the HLEG recommendations, the College of Commissioners debated bank structural reform in early 2013. President Barroso concluded the debate by noting a: “broad consensus in favour of an approach at European level, while stressing that the impact analysis would provide essential clarification.” The President called for an impact assessment to: “examine the various possible options and their implications”.[5]

On 3 July 2013, the European Parliament ("EP") adopted an own initiative report called "Reforming the structure of the EU banking sector"[6] with a large majority. The EP welcomes the Commission’s intention to bring forward a proposal for structural reform to tackle problems arising from banks being TBTF in order to provide greater resilience against potential financial crises, restore trust and confidence in banks, remove risks to public finances and deliver a change in banking culture. The EP calls on the Commission to: (i) provide for a principles-based approach to structural reform of the European banking sector and to that end stresses e.g. the need to reduce risk, complexity and interconnectedness; (ii) ensure the continuity of retail activities; (iii) ensure that trading activities reflect underlying risk and do not benefit from implicit public subsidies; and (iv) ensure that the separated entities have different sources of funding, with no undue or unnecessary shifting of capital and liquidity between these entities and activities. The EP also calls for further measures to strengthen bank governance and promote competition.

1.2. Procedural aspects 1.2.1. Consultation of stakeholders

During the process of considering structural reform of banks, stakeholders have been consulted on a number of occasions. The HLEG met with a variety of stakeholders during its mandate (e.g. different types of banks, bank investors, large corporates, SMEs, retail client associations, supervisors and European and international regulators) and held a public consultation targeting banks, corporate customers and retail clients and their associations.[7] The HLEG received 83 responses, the large majority of which were from banks and other financial institutions, followed by retail customers and their associations and, lastly, corporate customers.

The Commission also held a public stakeholder consultation after receiving the HLEG final report in October 2012.[8] Out of the 89 replies received, almost half came from the banking industry.

Structural bank reform has also been subject to discussions with Member States in the Financial Services Committee on 14 November, in the Economic and Financial Committee on 23 November and at the ECOFIN meeting on 4 December. The need for a coordinated action at EU level was clearly highlighted.

As part of preparing this Impact Assessment, the Commission services held an additional public stakeholder consultation during the course of spring 2013 based on a consultation paper. Amongst others, the consultation invited banks to model the impact of different types of structural reforms.[9] Annex A2 summarises the replies.

The Commission services received 540 replies. These responses came from the expected type of respondents: banks and other financial institutions, corporate clients, investors, public authorities, and consumer associations and individuals. The number of responses from individuals (439) and consumer associations (11) stand out.

The consultation responses highlight a clear distinction between the responses of banks, on the one hand, and consumers and non-bank financials on the other hand. The former are to an overwhelming extent against structural separation (with the exception of some cooperative banks). The latter are largely in favour. The views of other categories are more balanced. Corporate customers, while acknowledging the need to address TBTF, express opposition, based on the potential impact of such reforms on their cost of financing.

Regarding the type and strength of structural measures and what activities to separate diverging views show up again. A large portion of banks express a strong opposition to structural reform or endorse only the plain separation of proprietary trading from deposit taking. Consumer associations and individuals on the other hand argue that separation of proprietary trading and market making activities along the recommendations of the HLEG was the minimum effective, and expressed a preference for either separating all investment banking activities from deposit taking or prohibiting credit institutions from carrying out any investment banking activity.

1.2.2. Impact Assessment Steering Group and Impact Assessment Board (IAB)

An Inter-service Steering Group on bank structural reform was established in March 2013 with representatives from the Directorate Generals COMP, ECFIN, EMPL, ENTR, JUST, MARKT, SG, SJ, TAXUD and the JRC. The Impact Assessment Steering Group met in March 2013, April 2013 and September 2013 and supported the work on the Impact Assessment.

The draft Impact Assessment was submitted to the Impact Assessment Board (the “IAB”) of the Commission on 19 September 2013 and discussed with the IAB on 16 October 2013.The IAB initially issued a negative opinion and provided its recommendations for improvement on 18 October 2013. The main recommendations were (i) to improve the problem description and baseline scenario, (ii) to better describe and explain the reform options, (iii) to better assess impacts and better demonstrate the effectiveness of the retained reform options, (iv) to better present stakeholder views, and (v) to add a glossary. The Commission Services resubmitted a revised Impact Assessment on 18 December 2013, alongside with a separate document explaining to the IAB how the IAB recommendations had been incorporated. The IAB subsequently issued a positive opinion on 15 January 2014, whilst providing further recommendations for improvement, asking in particular to strengthen the analysis of the justification, alternative reform options, impact, and stakeholder views with respect to the transparency measures that had only been introduced in the resubmission of the impact assessment. The IAB also recommended further strengthening the structural reform options presentation and the assessment of the impact and effectiveness of the retained reform options. The current, final version of the impact assessment has significantly expanded the analysis of the transparency reform measures and has further elaborated on the other two IAB recommendations.

2. Problems related to the corporate structure of large, complex, and trading-intensive EU banking groups

Banks play an important role in channelling funds from savers to borrowers. This intermediation role is particularly important in Europe, as reflected in the absolute and relative size of the EU banking sector compared to those in other major economies (Table 1 and Chart 1).[10]

Table 1: Size of EU, US and Japanese banking sectors (2010)

|| EU || USA || Japan

Total bank sector assets (€ trillion) || 42.9 || 8.6 || 7.1

Total bank sector assets/GDP || 349% || 78% || 174%

Top 10 bank assets (€ trillion) || 15.0 || 4.8 || 3.7

Top 10 bank assets/GDP || 122% || 44% || 91%

Notes: Top 6 banks only for Japan. Source: European Banking Federation (2011).

The EU banking system is also a highly diversified eco-system made up by around 8000 banks that operate according to different business models and different ownership structures. However, over time the market evolved to produce a few very large, complex, interconnected banking groups that offer a diversified set of services such as commercial banking, traditional investment banking, asset and wealth management services, and capital market activities such as market making, brokerage services, securitisation and proprietary trading.[11]

Chart 1: Size of selected EU banks (2012 assets in € billion and as % of national GDP)

Source: SNL Financial (total assets), Eurostat (GDP)

Several of these banking groups have weathered the crisis well, helped by extraordinary and unprecedented sector-wide state support. Without state support (which in some cases is on-going) the EU financial system would have faced a far worse banking crisis (European Commission (2011, 2012)).[12] The (contingent) taxpayer support to date that benefit the EU banking sector amounts to 40% of EU GDP (€5.1 trillion in parliamentary committed aid measures) and has undermined the solidity of several Member States' public finances.[13]

The on-going reforms including the BRRD and Single Resolution Mechanism (“SRM”) will undoubtedly ensure that the vast majority of banks will in the future be fully resolvable. The resolution of the largest and most complex banking groups may nevertheless involve specific challenges that could place a significant burden on both creditors and public the safety net. Moreover, to the extent that market expectations remain that government support may be forthcoming in a future systemic crisis, in particular for the largest and most complex banks, the latter may continue to benefit from an implicit public subsidy. Empirical analyses typically confirm that implicit subsidies exist and in most cases are significant with subsidies amounting to billions of euros annually. For example, JRC estimates that implicit public subsidies enjoyed by the largest European banks that jointly represent 60-70% of EU assets amount to approximately EUR 72-95 billion and EUR 59-82 billion in 2011 and 2012 respectively.[14]

Section 2.1 of this Impact Assessment argues that several of the problems that have materialised in the EU banking sector can be traced back to the unrestricted co-existence of core banking activities with trading activities within large and complex banking groups. This problem driver has contributed to banks growing, becoming TBTF and also too complex to fail ("TCTF") and too interconnected to fail ("TITF"). As further elaborated upon in section 2.2, the financial market activities of banks have contributed to the failure of major banks in Europe. These problems have not been fully addressed by current reforms, as outlined in section 2.3. As a result, section 2.4 highlights that several Member States have filled this gap by pursuing national structural reforms. While these national reforms share the same objectives, they differ in several respects, notably as regards the activities subject to separation and the strength of separation. Such divergences create tensions in the internal market. There is therefore a case for action at the EU level to ensure effective, efficient and coherent reforms (section 2.5).

2.1. Problem driver: The unrestricted co-existence of core banking functions and trading activities within large banks

Large European banks typically combine retail and commercial banking activities and wholesale and investment banking activities in one corporate entity[15] or in a combination of closely connected entities with limited restrictions on transactions between them.[16] The unrestricted co-existence of activities gives rise to the following two main problems, as visually summarised in the “problem tree” in Chart 2, and as discussed below:

· Problem 1: Impediments to effective resolution and supervision;

· Problem 2: Distorted incentives for banks: the implicit public safety net generates moral hazard and leads to excessive trading and balance sheet growth, misallocation of resources, distortions of competition, management and monitoring problems, and the combination of activities within a deposit taking entity can lead to conflicts of interest and flaws in bank culture and standards.

Chart 2: Corporate structure related problem driver, problems and consequences

2.1.1. Problem 1: Impediments to resolution and supervision

Intra-group links arise through, for example intragroup cross-shareholdings, trading operations whereby one group entity deals with or on behalf of another group entity, central management of short-term liquidity within the group, and guarantees and commitments provided to or received from other companies in the group. Amongst others, these economic links are put in place to promote group business activities, to enable the group to operate on an integrated basis across different legal entities, or to ensure competitive financing terms to the entire group (BCBS (2012)).

Intra-group links complicate the resolution and recovery process in the event of failure. They can also impede effective supervision and resolution efforts and increase contagion risk across the group. The financial crisis has highlighted the problems of resolving large banking groups in bad times; the sheer complexity of banks' organizational structures and business models with economic functions and business lines spanning multiple legal entities make it extremely difficult to quickly isolate the problematic and non-viable elements of a banking group. As a result, resolution has up to date been disorganized, involved entire banking groups (as opposed to only the non-viable parts) and has relied significantly on public support. More simplicity in terms of organizational and business structure could therefore lead to easier and more effective supervision and also resolution. Anticipating public intervention in resolution leads to the so-called implicit subsidy which in turns distorts incentives of banks and other relevant stakeholders.

In addition, impediments to resolution can arise from banking groups being highly connected to each other through interbank borrowing and lending and derivatives markets. This is primarily because when highly complex banks are “interconnected” it may not only be difficult for the supervisor/resolution authority to gain insight into the operations of the group but also because it may be difficult to isolate banking groups (or parts of them) that are so connected and resolve them safely and quickly without destabilizing the entire financial system. JRC also finds that banks which are more interconnected are likely to benefit from a higher implicit guarantee (see Annex A4.2).

2.1.2. Problem 2: Distorted incentives for banks

Deposit taking-banks are by nature exposed to potentially damaging depositor runs. Therefore public safety nets in the form of deposit insurance and lender of last resort facilities (as well as bail-outs) have been introduced. Despite these safety nets, deposit-taking banking groups are currently largely unrestricted in the type of banking activities they undertake and benefit significantly from the explicit and implicit public safety nets. The public safety nets distort incentives by encouraging banks to take excessive risks which in turn give rise to excessive trading and balance sheet growth, misallocation of resources, distortions of competition, management and monitoring problems, conflicts of interests and culture shocks as well as flaws in banking standards.

Moral hazard, excessive trading and balance sheet growth and misallocation of resources: Deposit-taking banks are by nature exposed to potentially damaging depositor runs. Therefore public safety nets in the form of deposit insurance and lender-of-last-resort facilities have been introduced.[17] However, the public safety nets also have the effect of incentivising banks to expand and take excessive risks with the funds available to them (the so-called "moral hazard" problem) because monitoring and market discipline is muted when risk is not appropriately priced. For example, insured depositors do not lose part of their investment upon a bank’s failure. As a result, they have no incentives (let alone the ability) to monitor the actions of the banks to which they lend. More generally, explicit and implicit public safety nets reduce disciplining incentives of depositors and/or bank creditors and lower a bank’s funding cost. This allows banks to expand and increase their debt issuance and hence to leverage up more quickly, in particular if they are not restricted to relationship-oriented banking activities. High leverage in combination with limited liability incentivises excessive risk-taking by banks even further given the asymmetric payoffs to bank managers and shareholders as upside gains are being privatised, whilst downside losses are being socialised.[18] Even a bank manager that is entirely unaware of the existence of the implicit public subsidy will take advantage of it by assuming high levels of artificially cheap debt and by assuming risky positions that are expected to benefit his shareholders.

Residential real estate bubbles and crashes illustrate that wholesale and investment banking activities do not necessarily have to be more risky than retail and commercial banking activities. However, it is difficult to separate the real estate bubbles from the role of financial innovation, including securitisation of mortgages and derivatives to structure these products for distribution to investors. Moreover, the recent real estate crises, unlike most in history, imperilled sovereigns because sovereigns have been obliged to bail out not only traditional deposit banks, but also banking groups and activities that they should not have had to bail out. Targeting the safety net to those core banking activities that deserve subsidisation and protection because they address a market failure reduces the scope of the public safety net. The nature of the banking activity is what matters the most. The ability to take risks will depend on whether the activity is relationship-oriented or transaction-oriented. Whereas relationship-oriented retail and commercial banking activities are difficult to scale up quickly and easily, market-based and transaction-oriented wholesale and investment banking activities can to the contrary be scaled up more easily.[19] Genuine relationship-oriented banking activities are time-consuming to build and maintain, whereas transaction-oriented banking activities are more deal-oriented and can be replicated more easily.

In addition, JRC analysis points to the possible existence of an incentive for banks towards trading and away from lending activities as a result of the current minimum capital requirements. Such an incentives bias is found not be (fully) eliminated by the Basel III minimum capital requirements reform (see Annex A5).

Bank balance sheets in the EU, particularly those of the largest banking groups, grew significantly in the years leading up to the financial crisis (see charts 3 and 4 below).[20] Much of the balance sheet growth that took place was driven by intra-financial-sector borrowing and lending, rather than real economy lending. For the EU aggregate bank balance sheet, loans to households and non-financial corporations only make up 28% of total assets (March 2012). A significant part of banks' explicit and implicit taxpayer-subsidised pre-crisis activity consists in inter-group financial borrowing and lending.

The increasing dominance of intra-financial business is also reflected in global currency and derivatives markets developments, where large (“broker-dealer”) banks’ trading with non-financial customers (e.g. corporates, governments) has decreased substantially over time both for foreign exchange and interest rate derivatives (BIS (2013)). Recent OECD research raises important concerns about derivative trading giving rise to excessive leverage, interconnectedness, and conflicts of interests (Blundell-Wignall et al. (2012, 2013)). The notional value may not be informative about the riskiness of the derivative positions. Chart 5 Plots the “gross credit exposure” of derivatives positions for the biggest systemically important banks. First, the Gross Market Value (GMV) measures what it would cost to replace all trades at current market prices. It is typically significantly smaller than the notional value. While the notional value of global derivatives was 586 trillion USD in December 2007, the GMV at the same time was only 16 trillion USD. Even when valued at GMV, derivatives will still be important as a proportion of the balance sheet. Second, financial firms have offsetting positions that can be netted and banks expressly hedge most of their positions. The GMV minus netting is the Gross Credit Exposure (GCE). It is against the GCE that collateral is held. It amounted to 3.3 trillion USD in December 2007, against which 2.1 trillion USD was held. The final global open exposure hence amounted to 1.2 trillion USD. Changes in volatility may shift the GMV quickly and netting provides no protection against such shifts in market risks, because netting is about settlement amounts using prices at the point of close out. When the crisis hit in 2008, the GMV more than doubled from 15.8 trillion USD to 35.3 trillion USD, the GCE increased from 3.3 trillion USD to 5 trillion USD and the estimated collateral had to rise from 2,1 trillion USD to 4 trillion USD. Banks faced significant margin calls in a highly risky environment.

Chart 3: Evolution of liabilities 1998-2012 (euro area, € billion) || Chart 4: Evolution of assets 1998-2012 (euro area, € billion)

||

Notes: Customer deposits are deposits of non-monetary financial institutions excluding general government. Source: ECB data. || Notes: Customer loans are loans to non-monetary financial institutions excluding general government. Source: ECB data.

Chart 5: The gross credit exposure (gross market value minus netting) of derivatives and collateral

Source: BIS, ISDA, OECD

Research also suggests that the deepening of financial markets in the last 10 to 15 years has fundamentally destabilised banks by introducing a trading and fee-based culture in large banking groups. As a percentage of total assets, smaller banks tend to engage more in traditional commercial banking business, resulting in a balance sheet that has more loans (chart 6) and fewer assets held for trading (chart 7) compared to larger banks. These average figures hide significant variations between banking groups, though (chart 8).

Chart 6: Importance of loan making for EU banks (2011) || Chart 7: Importance of trading activity for EU banks (2011)

||

Source: ECB consolidated banking data. || Source: ECB consolidated banking data.

Chart 8: Assets held for trading, share of total assets (2012)

Source: SNL Financial

The implicit public safety net also leads to a misallocation of resources. The expectation of public support artificially increases the size of the financial sector in aggregate and hence diverts resources away from other sectors of the economy. According to academic research, the benefits of more banking activity may not always compensate for increased financial stability risks and other disadvantages. Cecchetti and Kharroubi (2012) empirically find that the enlargement of the financial system beyond a certain size is associated with reductions in real productivity growth. In part this may be due to the financial sector competing with the rest of the economy for scarce resources. Arcand et al. (2012) also find that there can be “too much” finance. When private credit reaches 80% to 100% of GDP (which is largely exceeded for several crisis-affected EU Member States such as Cyprus, Denmark, Ireland, the Netherlands, Portugal, Spain and the UK) further private credit is found to be negatively associated with GDP growth. The hypothesis is that excessively large financial systems may reduce economic growth because of the increased probability of a misallocation of resources, the increased probability of large economic crashes[21], or the endogenous feeding of speculative bubbles. Philippon (2008) observes that outstanding economic growth was achieved in the 1960s with a much smaller financial sector.[22]

Competition distortions: Implicit public subsidies distort competition in the market place and raise barriers to entry to the extent that: (i) small and medium-sized banks are less likely to benefit from such subsidies to the same extent as the large ones and are therefore being disadvantaged; and (ii) weak banks in strong Member States are more likely to enjoy a good support rating[23] and are not disciplined by the market place. These findings have been confirmed by the work undertaken by JRC (see Annex A4.2) as well as other papers (Schich and Lindh (2012) and De Grauwe and Ji (2013)).

Managing and monitoring problems: The financial crisis has highlighted the problems associated with the complexity of banks' businesses and the scope of their operations. There are increasing signs that investors shun this complexity[24] and find it difficult to monitor and therefore understand the underlying risks.[25]

Banks with a variety of activities also require more complex management and are more difficult to regulate.[26] More simplicity in terms of corporate structure could lead to easier and more effective management and regulation. The prudential regulation of banks is also difficult for investors to understand. Accordingly, investors do not fully exercise the “watch-dog” monitoring function granted to them under Basel's “pillar 3” (market discipline).[27]

Conflicts of interests, bank culture shocks and flawed standards: There are significant cultural divides within banking groups. In general, conflicts of interest are more likely to materialize when an institution provides multiple financial services. The main concern is that the bank uses the informational advantage it gains from conducting different activities to its own advantage, instead of seeking to meet the best interest of customers and investors. Whereas regulation and self-regulation aim to address such conflicts of interest, it is difficult to monitor and control the flow of information within large banks. Recent and large-scale events such as the rigging of the Libor benchmark rate – legal fines to date amount to more than USD6bn[28] – and ongoing investigations by several regulators relating to trading on global foreign exchange markets illustrate the limited effectiveness of softer forms of governance separation (e.g. Chinese walls). It is also illustrative of how banks have increased their profits to the detriment of their customers by exploiting proprietary customer information to their own benefit.

2.2. Manifestation of problems during the financial crisis

The problems highlighted in section 2.1 are at the root of the financial crisis. Capital market-based activities have contributed to the failure of major banks in Europe. The majority of the large and complex EU financial institutions that received state support in 2008 and 2009 had trading income to total revenue ratios that were relatively large. For example, having analysed a sample of large and complex EU banking groups, IMF research suggests that almost 80% of all supported banks that received official support in 2008/2009 traded significantly more than average (Chow and Surti (2011)).

Deeper markets have allowed banks to trade more and take larger trading positions with higher associated profits in the good times. However, the higher profitability comes with higher risks, which may compromise bank stability in the bad times. Analysis by the JRC allows disentangling the return on assets (ROA) by type of activity (see also Annex A5). Chart 9 below illustrates the higher profitability and volatility of trading activities.

Chart 9: Average return on assets of European banks as a percentage of total assets by type of activity

Source: SNL and JRC. See Annex A5.

The shift towards a transaction-oriented banking model and the corresponding excessive trading also contributed to boost the size of bank balance sheets. The expansion of bank balance sheets outpaced GDP growth and hence could not be funded by retail funding sources which are more tightly linked to GDP growth and increasingly pushed large banking groups towards short term wholesale funding (repo, money market funds, interbank borrowing, etc.). As a result of their trading activities and increasingly transaction-oriented banking model, banks such as RBS and Allied Irish Bank had significant exposures to structured credit and securitised assets. Also, the capital market activities of TBTF banks effectively enabled other banks to inappropriately rely upon short-term wholesale funding to finance their activities (e.g. Spanish cajas). If Lehman Brothers or any large European bank would have been less connected to deposit taking banks, the impact of their failure would have been less disruptive (see also section 5.8).

As a result, governments would have a smaller incentive to resort to bail out policies, as concerns on contagion and on the continuity of business for deposit banks concerns would be more contained.

2.3. Reform efforts to date and complementarity of bank structural reform

The EU has already initiated a number of reforms to increase the resilience of banks and to reduce the probability and impact of bank failure. These reforms include measures to strengthen banks' solvency (the capital and liquidity requirements part of the CRR/CRDIV package); measures to strengthen bank resolvability (the proposed BRRD); measures to better guarantee deposits (the revision of the Deposit Guarantee Schemes directive (the "DGS"); measures to improve transparency and address the risks of derivatives and to improve market infrastructures (European Market Infrastructure Regulation (the "EMIR") and related revisions to the Markets in Financial Instruments Directive ("MiFID")). Additionally, in order to break the negative feedback cycle between the sovereign and banking risks and to restore confidence in the euro and the banking system, the European Commission has called for further development of a Banking Union, building on the single rule book that will be applicable to all banks in the entire EU. This will include a Single Supervisory Mechanism (“SSM”) and a Single Resolution Mechanism ("SRM), which will be mandatory for members of the euro area but open to voluntary participation for all other Member States.

Despite this broad-ranging reform agenda further measures are needed to reduce the probability and impact of failure of TBTF banks. Such measures have global support, as evidenced by recent statements by G20 leaders and ministers.[29]

As regards the probability of failure, the business of credit intermediation is inherently unstable and prone to liquidity and solvency shocks. Banks are therefore required to put in place adequate shock absorbers, in the form of liquid assets that can be sold without loss to meet unexpected cash outflows ("liquidity buffers") and in the form of sufficient own funds to absorb potential losses ("solvency buffers"). The CRR/CRDIV reform package has increased the quantity and quality of such funds and will thus enable banks to absorb more losses before defaulting.

However, capital requirements are not a panacea and there are limits to what they can achieve. More specifically:

· Addressing remaining TBTF problems by means of higher capital requirements would not address the fundamental inconsistency of on the one hand "taxing" systemic risk and excessive trading with high capital requirements while at the same time allowing these activities to be performed by entities that enjoy explicit coverage of public safety nets;

· Irrespective of the changes to the market risk capital requirements that increase the amount of capital that is required, banks could still have significant incentives for engaging in trading activities given the particularly substantial profits of such activities (see Annex A5). This has induced a broad-based shift towards these activities, at the expense of traditional activities, with an increase in systemic risk being the consequence (Boot and Ratnovski (2012));

· The ratio of risk weighted assets to total assets is significantly lower for TBTF banks, which typically have an important trading book, than for other banks (see chart 10).[30] In addition, the risk-based capital requirements based on value-at risk ("VaR") model calculations can still be small compared to the size of trading assets.[31] Standard setters at both international and European level are currently critically assessing the consistency and accuracy of the risk-weighted asset approach;[32]

· Whereas nominal, non-risk weighted capital buffers could be considered to address these risks, such buffers are blunt and also distort adequate risk-taking incentives. They would have to be set at a high level to fully off-set the remaining incentives in favour of trading. Introducing such additional buffers would also further complicate the prudential framework. This complexity also stems from the increased variety and complexity of bank activities that have required much more complex capital standards (Hoenig and Morris (2011)). These complex standards are difficult to monitor and understand for banks, supervisors, and the market.[33] Structural reform may help to simplify supervision and enforcement of capital requirement regulation;

· Capital requirements also do not address several problems referred to above, such as conflicts of interest and a misalignment between a commercial banking and an investment banking culture within a single “unstructured” banking group;

Chart 10: RWA to total assets: G-SIFI banks versus Non G-SIFI banks

Source: Bloomberg, OECD, Blundell-Wignall et al. (2013)

While capital requirements are a major instrument in reducing the probability of failure, it would appear unwise to rely on one instrument only to address the TBTF problem. Structural bank reforms complement the reforms related to capital requirements by imposing direct constraints on specific activities, as opposed to capital requirements that depend on the riskiness of the individual entity and/or of the consolidated group. Structural reform would also be a more direct way of making sure that insured deposits are not used freely throughout integrated groups to fund transaction-oriented activities that are not customer-oriented and hence should not benefit from the implicit government support. It could also complement the systemic risk charges for systemically important banks by adding another disincentive towards banks excessively expanding their risky trading activities, thus putting a break to the main source of unsustainable bank growth in recent years.

As regards impact of failure, implementation of the BRRD will pave the way for the orderly resolution of normal EU banks and thus significantly reduce the impact of failure of such banks on public finances.[34] The resolution powers will be challenging to exercise for TBTF banks, given their particularly large, complex and integrated balance sheets and corporate structures. As a result, while the potential for eventual public support is certainly reduced, it may still not be eradicated if the powers are not in all instances fully applied. The impact of a failure of a large and complex bank may still be significant. Structural reform will increase the options available to authorities when dealing with failing banking groups. By increasing orderly resolution credibility, it will also improve market discipline and bank balance sheet dynamics ex ante.

The resolution planning offers a vehicle to address potential impediments to resolution. However, it is built on judgement by authorities in individual cases. In the absence of a more clearly structured corporate group structure, it might be extremely difficult for a supervisory authority to exercise its discretionary judgment and impose e.g. a divestment of a part of a large and complex diversified banking group, especially if other competent authorities are not responding with similarly harsh measures in comparable cases.[35] All this may explain market perceptions of remaining implicit subsidies and call for further clarity as regards potential additional structural measures.[36]

Structural reforms could help the orderly resolution of TBTF banks. It could make the newly granted powers in BRRD more effective for TBTF banks, as resolution authorities would deal with separate, segregated and simpler balance sheets. This would make it easier to monitor and assess the different entities of a banking group and it expands the range of options at the disposal of resolution authorities. Additional measures for TBTF banks would be in line with the BRRD’s proportionality principle.

Structural reform can potentially curtail contagion by clearly mapping and controlling intra-financial sector exposures. If left uncontrolled, bail-in may give rise to undue contagion (as bail-in related losses may create losses and distress at other linked financial institutions). As a result, the credibility and effectiveness of the bail-in tool may be hampered.

Ex ante structural reform would also complement the available preventative powers of the BRRD that imply a more institution-specific reorganisation of selected banking groups and which have a narrower resolution objective only. Combining structural reform legislation with the BRRD could over time lead to a greater alignment between business lines and legal structures.

Banking Union is meant to reduce the inappropriate links between sovereigns and their banks. However, by doing so, implicit subsidies and the corresponding problems of moral hazard, aggressive balance sheet expansion, and competition distortions discussed in section 2.1.2 become even more prominent. As a result, Member States may be reluctant to mutualise (future) risks through Banking Union, in the absence of structural reform and credible orderly resolution mechanisms. Targeting the safety net to those core banking activities that deserve subsidisation and protection because they address a market failure reduces the scope of the public safety net and will be a catalyst for the willingness of EU Member States to push ahead with Banking Union.

Chapter 4 develops different forms that structural separation could take. These different reform options are then assessed and compared in chapter 5. That comparison demonstrates in both qualitative and quantitative ways that structural reform has value added in further addressing the problems of TBTF banks. While the exact impact depends on the specific design of the reform option in question (e.g. range of activities to be separated, strength of separation), in general structural reform along the lines outlined in chapter 4 would increase the private cost of engaging in excessive trading activities of primarily intra-financial nature, thus leading to a contraction of such activities as banks adjust to the new reality and hence, other things being equal, a reduction in bank size. It would thus contribute to a better deployment and allocation of resources towards the real economy. It would also facilitate the task of resolution authorities, which in times of stress would imply lower costs related to bank failures. This would benefit the EU economy, as public finances would no longer need to be imperilled to support failed banks. Targeting the safety net to those core banking activities that deserve subsidisation and protection because they address a market failure reduces the scope of the public safety net. At the same time, depending on the scope of activities to be separated and strength of separation, a degree of efficiency might in principle be lost owing to notably reduced economies of scope (see Annex A9). As stated above, the magnitude of these benefits and costs depend on the specific reform option chosen.

2.4. How would the situation evolve without EU action (baseline scenario)

As a response to these concerns, several EU Member States (Germany, France, Belgium and the UK) as well as third countries (U.S.) have introduced or are currently in the process of introducing structural reform measures applying to their respective banking sectors. The reforms in France, Germany, Belgium, the UK and the U.S. all have in common that they prescribe the separation of selected banking activities from a deposit taking entity (for banks above certain thresholds in all countries except the U.S.). Structural reform measures are also under consideration in the Netherlands (Annex A1).

Given the fundamental freedoms set out in the Treaty of the Functioning of the European Union (the "TFEU") divergent national legislation may affect capital movements and establishment decisions of market participants. Under the freedom to provide services, banks authorised in one Member State can freely provide all banking services in other Member States. Under the freedom of establishment, banks can either open a branch or a subsidiary in other Member States. The rights and obligations linked with the two differ. Branches are legally dependent parts of the credit institution. As such, they continue to be supervised as a part of the whole bank by the home Member State supervisory authority. A subsidiary is an independent legal part – and considered as any other legal entity – and becomes subject to supervision in the Member State where it is established, which is thereby considered its 'home'. National structural reforms can accordingly only apply to institutions that are headquartered in that Member State – and their branches in other Member States – as well as locally incorporated subsidiaries of banks from other Member States. Local branches of banks from other Member States are not affected.

This means that under national structural reform, banks operating in the same national market would be subject to different rules depending on whether they are subsidiaries (subject to reform) or branches (not subject to reform).[37] National reforms accordingly run the risk of becoming ineffective, if locally incorporated banks were to relocate and branch back in (for local banks subject to reform) or switch from subsidiary to branch status (for banks from another Member State).[38] However, the effects could also be more pervasive in the sense that banks, rather than relocating by legal means, could relocate in "economic" terms and thus avoid national rules by moving particular activities (by e.g. booking certain transactions in another part of the banking group located in another Member State).

Regulatory arbitrage could over time, and to the extent it became material, compound some of the underlying problems. Divergent national legislation may also undermine efforts to achieve a single rulebook applicable throughout the Internal Market. This is a general problem, as the financial crisis has highlighted that the single financial market does not work optimally if national legislation is significantly different from one country to the other. It can also create specific problems regarding supervision, notably for the future SSM, where the ECB would have to supervise banks subject to different legislation regarding bank structure, thus undermining the establishment of a single rulebook within the EU. Divergent legislation would also make the management of cross-border institutions more difficult and costly, notably in terms of ensuring compliance with divergent and possibly inconsistent rules. It would also lead to safety net distortions, as the DGS of the Member State subject to relocation would face a heavier burden. In sum, if not all Member States address TBTF banks in a roughly consistent way, not all relevant TBTF banks would be subject to reform.[39] Moreover, even those banking groups subject to national reforms would be able to circumvent the rules thanks to the Treaty freedoms, their existing cross-border network of branches and subsidiaries and their right to transfer capital and liquidity across EU borders. Conversely, those arbitrage opportunities would be closed if common rules were to be adopted at EU level. In sum, addressing TBTF banks in an effective manner requires a coordinated EU approach (chart 11).

Chart 11: Potential problems and consequences of uncoordinated national reforms

The default option for this Impact Assessment is to take no policy action as regards structural bank reform at the European level. This represents the baseline against which the incremental impact of structural bank reform options will be evaluated. That baseline includes the non-structural reform elements of the current reform agenda, notably CRR/CRD, BRRD and the first two pillars of the Banking Union (SSM, SRM). The incremental impact will be measured by means of relevant social benefits and costs of the different reform options (see Chapter 5).

2.5. The EU's right to act and justification for acting

In accordance with the principles of subsidiarity and proportionality set out in Article 5 of the TFEU, the Union shall act only if and in so far as the objectives of the proposed action cannot be sufficiently achieved by the Member States, while the content and form of Union action shall not exceed what is necessary to achieve the objectives of the Treaties.

In this case, only EU action can ensure that EU banking groups, many of which operate in several Member States, are regulated by a common framework for structural reform. If the EU does not provide a common framework, divergent national legislation have the potential to distort the Internal Market for the reasons highlighted above. Uniform rules on bank corporate structure are needed to enhance financial stability, facilitate the orderly resolution and recovery of the group, enhance cross-border provision of services and the establishment in other Member States, and prevent regulatory arbitrage.

Common rules on bank structural reform are particularly important for an effective Banking Union. Different national rules would make the task of the ECB in its capacity as a single supervisor difficult, as it would have to supervise banks subject to different, and potentially inconsistent, national rules. Similarly, the future SRM would have to resolve banks subject to potentially different national requirements regarding their organisational and operational structure. The advantage of uniform rules are particularly clear for TBTF banks in Banking Union participating Member States by (1) making supervision easier, by providing for one set of rules that would over time contributing to simpler and more transparent group structures with clearer delineation of business lines; (2) facilitating the task of the Single Resolution Mechanism; and, (3) limiting the risks to be insured by a future EU DGS subject to risk mutualisation (and hence increased implicit subsidies).

The objective of an EU initiative on structural reform would be to adopt uniform measures which have as their objective the establishment and functioning of the Internal Market in financial services. The appropriate legal basis is Article 114 of the TFEU. Article 114 leaves the choice of legal instrument open (either directive or regulation). The advantage of using a regulation is that it would be directly applicable to relevant institutions and create legal certainty as opposed to a directive which would require national implementing legislation that could well be divergent. With a regulation institutions would know when and how the rules apply and be ensured that they apply in a similar fashion to all banks across the EU. A regulation is particularly important for the SSM and SRM for the reasons elaborated upon above.

3. Objectives of reforming bank structures

The objective of bank structure reform is to address the problems and underlying problem drivers highlighted in Chapter 2. To that end, Chapter 3 distinguishes macroeconomic (Section 3.1), specific or microeconomic objectives (Section 3.2), and operational objectives (Section 3.3).

3.1. General objectives

Reducing the risk of systemic instability – reducing the risks of banks becoming or wanting to become TBTF, TCTF and TITF: A key objective of structural reform is to make banks that provide essential services to the real economy more resilient in the event of endogenous or exogenous shocks but also more resolvable in the event of a failure, thus reducing the severity of future financial crises.

Reducing Single Market fragmentation: Many of the banks that will be affected by structural reform legislation operate across borders and seek to benefit from the opportunities created by the single financial market. A common legislative framework on structural reform would prevent the fragmentation of the Internal Market and increase the effectiveness of the future SSM and SRM.

3.2. Specific or microeconomic objectives

The objectives of structural reform should be to address the problems highlighted in chapter 2. Accordingly, the different options outlined in chapter 4 will be assessed on the extent to which they achieve the following micro-economic objectives:

(1) Facilitate bank resolution and recovery;

(2) Facilitate management, monitoring and supervision;

(3) Reduce moral hazard;

(4) Reduce conflicts of interest, improve bank culture and standards;

(5) Reduce capital and resource misallocation; and

(6) Improve competition.

3.3. Operational objectives

On the basis of the above, the operational objectives of structural reform would be to reduce the magnitude of the problems currently encountered. The following set of quantifiable operational objectives would form the base of future evaluations:

(1) Reduce the size of implicit public subsidies, i.e. reduce the artificial funding cost advantage of TBTF banks (after controlling for bank characteristics such as size, risk-taking, etc.);

(2) Reduce excessive trading by TBTF banks; increase the lending to non-financial customers as a percentage of total assets.

4. Reform options

This chapter develops the policy options that will be subject to further assessment. In particular, sections 4.1, 4.2, 4.4, and 4.5 introduce options regarding (i) the scope of activities to be separated; (ii) the strength of separation; and, (iii) the institutional scope of separation, and considers the timeline for implementation. As each of the examined options may lead to a situation whereby certain banking activities may migrate away from regulated banking groups towards “shadow banks”, the structural reform options must necessarily be accompanied by measures improving transparency and data reporting of the shadow banking activities (section 4.3).

4.1. Activities to be separated

The Single Market has brought significant benefits to EU Member States. It contributes to solid economic growth and supports employment (ECB (2012)). Integration in the markets for banking and other financial services is one key element of the Single Market. Among other benefits, financial integration has contributed to the convergence of and decline in financing costs for corporations and households and the opening up of investment and diversification opportunities across Europe.

Financial integration in Europe had progressed significantly in the years prior to the crisis, in particular in the wholesale markets. The adoption of the euro and, shortly afterwards, the Financial Services Action Plan were major milestones in this integration process.

Financial institutions and banks in particular have adapted to this new economic reality by expanding in scale, reach and scope of activities. This has led to the emergence of large financial "one-stop shops" combining within one entity or group the provision of a diverse set of services. Moreover, in their quest for economies of scale and scope, banks have also consolidated; first within national borders, then beyond. This process has allowed banks both to provide a broader range of services to their clients, as well as serving clients operating across borders. This process was particularly pronounced in the EU, given the Single Market and enshrined treaty freedoms. This has enabled banks to respond to the increasingly sophisticated needs of their global clients. The financial crisis has clearly illustrated the impact on financial stability arising from an ever more global and integrated financial system with ever larger units of financial service providers.

As a result, the banking activities undertaken by large EU banking groups today range from retail and commercial banking (RCB) activities to wholesale and investment banking (WIB) activities. Examples of RCB activities include, amongst others, insured deposit taking, lending to households and SMEs, and the provision of payment system services. Examples of WIB include, amongst others, underwriting, market making, brokerage services, and proprietary trading.

Notwithstanding the benefits highlighted above, the financial crisis has clearly illustrated the impact on financial stability arising from an ever more global and integrated financial system with ever larger units of financial service providers. Therefore, the basic rationale of structural reform is to separate certain risky trading activities in order to facilitate the resolvability of banks and to ensure that these activities do not endanger bank activities that are regarded as critically important for the real economy. In the national structural reform efforts to date, the separation has been applied at different “locations” between and within the range of RCB and WIB activities. Depending on the strength of separation and the scope of targeted activities, separation leads to different degrees of restrictions on some banks’ ability to provide certain services.

Accordingly, concrete options to separate banking activities logically end up between, at one end of the spectrum, a narrow trading entity and a correspondingly broad deposit-taking entity and, at the other end, a broad trading entity and a correspondingly narrow deposit entity. In the first case, relatively few activities are being separated from the deposit entity (funded by guaranteed deposits in contrast to the trading entity), and it accordingly remains relatively free to provide a broad set of trading and capital market activities. In the latter case, a much broader set of activities is separated, and the deposit entity is accordingly much more constrained in the activities it can engage in.

· “Narrow” trading entity and “broad” deposit entity: A first polar case is that in which only relatively few trading activities are being separated from a broad deposit entity, namely those types of trading activities where traders are speculating on markets using the bank’s capital and borrowed money, for no purpose other than to make a profit and without any connection to trading on behalf of customers (i.e., proprietary trading). Proprietary trading is the purchase and sale of financial instruments for own account with the intent to profit from subsequent price changes. The importance of dedicated proprietary trading desks has decreased over time and currently appears to be of relatively limited importance for many large EU banking groups. Internal hedge funds are similar in spirit. This would also involve trading in physical commodities.[40] In this polar case, the set of activities to be separated from the deposit entity would roughly correspond to the French banking law and the German law (where the separation largely takes place within the group), as well as the Volcker rule in the US (where the separation amounts to a prohibition and a banning of the activity from the group altogether). See Annex A1.

· “Medium” trading entity and “medium” deposit entity: A second case is one in which market making (and possibly more) is added to the above set of activities to be separated from the deposit entity. Separating customer-related market-making, proprietary trading and selected similar activities is roughly aligned with the proposals made by the HLEG.

In general terms, market making is the purchase and sale of financial instruments (government bonds, corporate bonds, equities, derivatives, etc.) for own account at prices defined by the market maker, on the basis of a commitment to provide market liquidity on a regular and on-going basis. Market makers provide "immediacy" to clients and investors by facilitating their requests to buy and sell quickly and, arguably, in a cost-effective way for them. For example, an investor anxious to sell an asset relies on a market maker's standing ability to buy the asset for itself immediately. Likewise, an investor who wishes to buy an asset often can call on a market maker to sell the asset out of its inventory. By doing so, market makers can instil greater investor confidence in the functioning of financial markets and encourage investors to trade confidently. Market making makes up a significant part of large banking groups' trading revenues. Without market makers, customers would face higher transaction costs, and security prices would be more volatile. However, from a legal and economic point of view, market making (and the securities inventory used to facilitate customer trading) is difficult to distinguish from proprietary trading, in particular for “outsiders”. A market maker acquires a position at one price and then lays off the position over time at an uncertain average price by providing liquidity to customers. The ultimate goal is to "buy low, sell high". In order to accomplish this goal on average over many trades, with an acceptable level of risk for the expected profit, a market maker relies on its expectation of investors’ needs and the future path of market prices. Although traders involved in the actual trade are able to identify any given transaction as being of a market making or proprietary trading nature, such a distinction no longer is simple from the perspective of an outsider such as a manager, regulator, supervisor, creditor, or judge. Indeed, a market maker might legitimately choose to take a long position in an asset either in anticipation of client demand to allow the order to be fulfilled quickly or to facilitate a quick sale by a client of an illiquid asset.

While it is possible for institutions other than banks (such as funds) to take on a similar role to market makers, banks do have a natural advantage in acting as market makers because of the fact that banks have a variety of other relationships with the clients who want to make trades and the fact that acting as a market maker for a security is often a natural follow-on activity for securities underwritten by the banking group.

The most active market makers in financial markets today are high frequency traders, many of whom trade as voluntary market makers with no obligations to maintain markets. According to several academic studies, high frequency market making is a profitable enterprise and, more importantly, market quality has improved alongside the growth in algorithmic trading. These results are frequently interpreted as support for a structure where participants supply liquidity because it is a profitable and viable activity on its own (see Anand and Vankatamaran (2013) for a more in-depth analysis). Several important market makers are not taking any deposits, suggesting that market making is a viable activity on its own.

· “Broad” trading entity and “narrow” deposit entity: This case corresponds to a relatively broad range of activities being separated from the deposit entity and is one in which all wholesale and investment banking activities are to be separated. In this stylised option, trading entities would perform activities such as underwriting[41], advisory services, brokerage services, derivatives transactions, investing, sponsoring and structuring activities related to certain securitisation activity[42], in addition to proprietary trading and market making (See Annex A6 for a more elaborate description and assessment of these additional WIB activities). Separating a broad range of investment banking activities will result from the UK structural reform. The US also organises banking groups as bank holding companies that perform core banking activities and other banking activities through different affiliates.

In determining which activities should be subject to separation, the Commission services have considered: (i) the extent to which losses related to an activity would impact a bank’s balance sheet; (ii) the extent to which an activity gives rise to market or counterparty risk; (iii) the importance and potential impact of the activity on systemic risk; (iv) the customer-oriented nature and usefulness of an activity for financing the real economy, and (v) the extent to which the banking activity resolves a market failure (such as asymmetric information) in the economy. The application of these criteria leaves a narrow range of wholesale and investment banking activities that require further analysis, e.g. proprietary trading, market making, underwriting, investing, sponsoring and structuring activities related to certain securitisation activity, and derivatives transactions. The focus on wholesale and investment bank activity is consistent with the significant increase in trading and market-based activities, documented in Chapter 2.

There are certain activities, however, that are critically important for the continuity of a banking group (i.e. the taking of deposits and provision of retail payment services). Those activities would under any of the options outlined above always reside with the deposit-taking entity.

4.2. Strength of separation

When determining the strength of separation, a starting point is to consider three broad forms of separation: (i) accounting separation; (ii) subsidiarisation; and (iii) ownership separation, i.e. prohibition of certain business lines. These forms of separation display a varying degree of severity and intrusiveness in banks’ business structure. They are not mutually exclusive but build on each other. For example, subsidiarisation presupposes a degree of accounting separation. Furthermore, subsidiarisation can coexist with prohibition (ownership separation) of certain activities.

(a) Accounting separation: The lightest degree of intervention is accounting separation. This would require banks that provide integrated financial services to make separate reports for their different business units and make them publicly available. A certain degree of accounting separation already exists in the EU. Accounting separation would increase transparency, as it would lead to banks having to put more information in the public domain, thus in theory facilitating market monitoring and supervision. However, it would not significantly affect economic incentives. For example, it would not impose any restrictions on intra-group legal and economic links, and it is thus unlikely to be sufficient to address the major policy objective of this exercise. Accordingly, it would not contribute to addressing the TBTF problem. Even so, while insufficient to address the main objectives, a degree of stronger separation of accounts by business lines would, by construction, follow from – and be necessary for – more ambitious forms of separation.

(b) Subsidiarisation: A second form of separation is to require subsidiarisation, i.e. to require banking groups to separate the activities of different business units into separate legal entities ("subsidiarisation"). Subsidiarisation could also require these entities to maintain separate capital structures, i.e. for the business units to become “ring-fenced” subsidiaries with their own capital and funding and with rules on how the different subsidiaries deal with each other (e.g. limits on intra-group capital flows and arm's length pricing).

Importantly, under subsidiarisation, universal banking groups could continue to provide their clients with a diverse set of banking services. However, they would have to structure their group differently with some of the services provided in legal entities separated from the other parts of the group (“structured universal banking”).

Subsidiarisation can take many forms. Under subsidiarisation, there will still be links of legal, economic, operational and governance nature between the banking group and the functionally separate legal entities. As a result, choices need to be made as regards the degree of independence of the subsidiary. More specifically:

· As regards legal separation, one could limit oneself to requiring the setting-up of a separate legal entity to which the relevant activities could be separated for banks that fall under the institutional scope of the regulation. Given the activities under consideration, that entity would most likely be an investment firm. Or, one could consider options that would provide a stronger degree of legal separation by governing also the ownership links between this new entity and the rest of the group. For example, one could consider rules limiting certain parent-subsidiary ownership structures (e.g. whereas the group could continue engaging in a universal set of activities, the trading entity of the group could not own the group’s deposit bank); or rules prohibiting direct ownership links between deposit banks and trading entities, thus calling for a group holding company on top;

· As regards economic separation, the separate legal entity would normally have to respect the CRD/CRR requirements related to capital, liquidity, leverage, and large exposures on an individual basis. To provide a stronger degree of economic separation, further rules could be considered for the relations between the separated entities and other group entities, such that intra-group transactions could be on arm's length basis; whether certain restrictions on exposures, funding pattern and activities should be introduced to further isolate the deposit taking entity from (international and financial-system originated) shocks. In addition, one could consider whether the subsidiary would have to raise funds separately;

· As regards governance separation, one could consider the degree of independence of the board of the separated entities (e.g. degree to which directors should be independent from rest of group), as well as whether or not the separated entities should have their own risk management structures even if currently reserved for “significant” institutions by CRD. Also one could require the management body to uphold the objectives of structural reform;

· As regards operational separation, one could consider the degree to which infrastructure related to payment systems and IT and data could be shared among group entities, or whether it would also need to be separated.

The reforms pursued to date have chosen different combinations along these separation dimensions, even though there is a large degree of complementarity (see Annex A1).

(c) Ownership separation: The most intrusive degree of structural intervention is ownership separation. Under this form of separation, there would be separate ultimate ownership of assets supporting different activities. Accordingly, those services would have to be provided by different firms with different owners that are not in any way affiliated with each other.

This was the approach followed by the 1933 Glass-Steagall Act.[43] The justifications for this strong type of separation were to: (i) prevent inherent conflicts of interest; (ii) reduce the financial power of depository institutions; (iii) reduce depository institutions' ability to engage in risky securities activities; and (iv) prevent managers of depository institutions – focused on prudence – to enter markets that are focused on risk-taking.

For the reasons stated under point A) above, accounting separation will not be subjected to further assessment in this Impact Assessment.

Three degrees of separation will be subject to consideration in the remainder of this Impact Assessment, two based on different forms of subsidiarisation (given the wide range of specific subsidiarisation rules) and one based on ownership separation. A first separation option would contain a limited degree of subsidiarisation in legal and economic terms. It would require the creation of a separate legal entity, but would limit itself to the degree of economic and governance separation that currently follows automatically from such an obligation. A second “moderate separation” option would include an additional, stricter degree of legal, economic, and governance separation, whereas a final “complete separation” option would be equivalent to full ownership separation, as described above, i.e. effective prohibition of certain activities. More specifically:

(1) Subsidiarisation with intra-group links restricted according to current rules (“SUB”): in terms of legal separation, this option would require a separate legal entity. In terms of economic separation, it would restrict itself to the economic and governance requirements that currently result from this degree of legal separation. That entity should be subject to the CRD/CRR prudential requirements in terms of capital, liquidity, leverage and large exposures on an individual basis. This would result in a degree of economic and governance separation, depending on whether these requirements would be waived or not;

(2) Subsidiarisation with tighter restrictions on intra-group links (“SUB+”): in order to more effectively address intra-group funding subsidies, this option would require a more significant degree of subsidiarisation in legal and/or economic terms. In terms of legal separation, it may include rules on ownership links between separated entities within the group. This option may also require a stricter degree of economic separation, such as separate funding for the two entities. It also includes stricter economic separation, notably by considering rules on intra-group relations (e.g. requirements that intra-group transactions be on third party, commercial terms; ensuring that current large exposure restrictions are not waived and possibly apply stricter requirements; providing limits on intra-group guarantees (deposit-taking entity would not support trading entity); and, stipulating a higher degree of governance separation (e.g. limits on cross-use of board directors within the group); or

(3) Ownership separation: under this option, banking groups would not be allowed to engage in certain activities. They would accordingly have to divest or wind down any such activities that they currently engage in.

4.3. Preventing the risks emanating from shadow banking

As each of the examined options may lead to a situation whereby certain banking activities may migrate away from regulated banking groups towards shadow banks where there may be less scope for control by supervisors (whether or not located with the EU). To that end, each of these options must necessarily be accompanied by measures improving transparency and data reporting of the shadow banking activities.

The work done by the FSB has highlighted that the disorderly failure of shadow banking entities can carry systemic risk, both directly and through their interconnectedness, with the regular banking system. The FSB has also suggested that, as long as such entities remain subject to a lower level of regulation and supervision than the rest of the financial sector, reinforced banking regulation could drive a part of banking activities beyond the boundaries of traditional banking and towards shadow banking. The European Commission has recently adopted a Communication setting-out a roadmap for tackling the risks inherent in shadow banking. In line with the 2013 FSB Recommendations endorsed at the St-Petersburg G20 Summit, the measures foreseen in this roadmap include, among others, measures aimed at strengthening transparency and data availability in the shadow banking area.

Because of its size and close links to the regular banking sector, the shadow banking sector poses a systemic risk. The first factor is size. The latest studies indicate that the aggregate shadow banking assets are about half the size of the regulated banking system. Despite the fact that shadow banking assets have decreased slightly since 2008, the global figure at the end of 2012 was €53 trillion[44]. In terms of geographical distribution, the biggest share is concentrated in the United States (around €19.3 trillion) and in Europe (Eurozone with €16.3 trillion and the United Kingdom with around €6.7 trillion). The second factor which increases risks is the high level of interconnectedness between the shadow banking system and the regulated sector, particularly the regulated banking system. Any weakness that is mismanaged or the destabilisation of an important factor in the shadow banking system could trigger a wave of contagion that would affect the sectors subject to the highest prudential standards.

To prevent that banks shift parts of their activity in the less regulated shadow banking sector, it is necessary to ensure that any structural separation measure be accompanied by measures improving the transparency of shadow banking. Due to their size and close links with the banking sector securities financing transactions (SFTs) such as repurchase agreements, securities lending, other equivalent financing structures and re-hypothecation are a particularly relevant issue to address. SFTs display structural similarities with banking activities as they can lead to maturity and liquidity transformation and increased leverage, including short-term financing of longer-term assets.

As explained in detail in Annex A13, when assessing the transparency of the SFTs markets and rehypothecation, three main themes emerge: (1) the monitoring of the build-up of systemic risks related to SFT transactions in the financial system; (2) the disclosure of the information on such transactions to the investors whose assets are employed in these transactions; and (3) reducing the uncertainty about the extent to which assets have been rehypothecated. EU regulatory authorities lack the necessary data to better monitor the use of SFTs and the risks and the vulnerabilities for the stability of the financial system that they imply. At the same time the investors are not properly informed whether and to what extent the investment fund, in which they have invested or plan to invest in, has encumbered or intends to encumber investment assets by means of engaging in SFTs and other financing structures that would create additional risks for the investors. Finally, there is a lack of transparency about the extent to which clients' and counterparties' assets can be rehypothecated, or about the risks posed by rehypothecation.

Because the risks resulting from a migration from the banking sector toward the shadow banking sector are not directly related to the decision that is retained as regards the degree of the structural separation, the options aimed at increasing the transparency of the shadow banking sector will be assessed separately. The assessment of the impacts for the structural separation is not linked to the assessment of the impacts for the shadow banking transparency, and inversely. However every decision that is taken on the structural separation aspect will have an impact on the shadow banking sector, therefore Annex A13 analyses the potential response to that threat for the financial stability.

The following section presents the nine reform options for the structural separation whereas the Annex A13 presents and assesses the potential options aimed at increasing the transparency of SFTs. For each of the three main themes that have been identified, a series of policy options have been identified and assessed. The reform options on the structural separation are aimed at credit institutions whereas the options on shadow banking are aimed at each financial counterparty that performs SFT activity. This difference in scope is necessary because the entities acting in the shadow banking universe are diverse in nature. A targeted approach would not have achieved a level playing field between all actors.

These elements will notably allow supervisors to better identify interconnectedness between deposit taking entities and some shadow banking entities and will shed more light on some of their funding operations. It will also allow both market participants and supervisors to better evaluate possible risk exposures of shadow baking entities, leading to better-informed investment decisions by the former and better-targeted and timely actions by the latter. Annex A13 provides for details about the impact of introducing more transparency in securities financing transactions.

4.4. Structural reform options

The combination of the different range of trading and capital markets activities to be separated and strengths of separation (see sections 4.1 and 4.2) yields nine stylised reform options, as visualised in matrix form in Table 2. In the remainder of this Impact Assessment, we will refer to the different reform options, according to the labels in Table 2 (reform option A, reform option B, etc.). To the extent possible and for illustration purposes only, the Commission services have mapped the different national and expert group structural reform proposals and/or legislative initiatives into the matrix of stylised reform options. See also Annex A1 for a more elaborate discussion of these reform initiatives.

Table 2: Overview of options

Activities strength || Functional separation 1 (SUB) Current requirements || Functional separation 2 (SUB+) Stricter requirements || Ownership separation Ownership separation

Narrow trading entity/ broad deposit entity E.g. Proprietary trading + exposures to HF (PT ) || Option A || Option B [≈ FR, DE baseline, BE] || Option C [≈ US Volcker]

Medium trading entity/ medium deposit entity E.g. PT + market-making (MM) || Option D || Option E [≈ HLEG; ≈ FR, DE if wider separation activated] || Option F

Broad trading entity/ narrow deposit entity E.g. all investment banking activities || Option G || Option H [≈ US BHC; ≈ UK] || Option I [≈ Glass-Steagall]

The reform options listed in the first column (A, D and G) all have in common that they require setting up separate subsidiaries for trading and deposit entities (“subsidiarisation” requirement) without strengthening the regulatory rules and requirements that are currently in place. The effectiveness of all three of these options thus depends on whether the social benefits are effectively achieved with a separation according to current rules. However, under current rules and regulations, some of the above prudential requirements can be waived in certain circumstances, notably upon approval from the domestic supervisor. Moreover, the current regulatory framework does not regulate legal, economic and governance links and interconnections between separate entities within a group to a significant extent. For example, large exposure rules for intra-group entities are optional (can be waived) and Member States have discretion on their level. Implicit public subsidies arising from the public safety net could accordingly continue to flow freely within integrated groups. Taken together, these options have a very limited effectiveness. The Commission services will therefore not further assess these reform options.

Selected structural reform initiatives have been mapped into Table 2 for illustration purposes only and according to the understanding of Commission Services of the latest proposals and (draft) laws. The conceptual mapping inevitably is a simplification of reality. National initiatives differ from the stylised options and the mapping does not necessarily do justice to the different national initiatives. See Annex A1 for more details on the respective national initiatives.

4.5. Issues related to implementation

The social benefits and costs of the options outlined in table 2 will be compared against each other and against the “no policy change” scenario in the next chapter. Irrespective of the preferred options that will arise as a result of that comparison, there are three more specific implementation issues that need to be addressed in any structural reform option. The first implementation issue concerns the scope of banks that would be subject to structural reform. The second implementation issue concerns the role of supervisors in structural reform implementation, and the third implementation issue relates to the structural reform implementation timeline.

4.5.1. Institutional scope

Irrespective of choices related to activities and strength, given the focus on TBTF banks identified in chapter 2, a structural reform initiative in principle targets large banks only. Hence, it only applies to a small subset of the more than 8000 banks incorporated in the EU. It would in particular not concern the vast majority of local and regional banks, such as small cooperative and savings banks, which put relatively large proportions of their balance sheet at risk to serve the local real economy as well as the banks that primarily focus on customer-related lending. The latter banks are more likely to be resolvable than larger and more trading intensive and interconnected banks.

In light of the focus on TBTF banks, an approach should be found to limit the scope for structural reform to banks that either are very large and/or engage in significant trading activity. To that effect, the HLEG recommended that only banks with significant trading activities should be subject to structural separation. However, the definition of trading activities underpinning the thresholds recommended by the HLEG, which is based on the aggregation of broad accounting categories and includes available for sale assets, has been criticised for being a poor proxy of risky trading activities.

Many financial institutions, as well as public authorities, that responded to the Commission’s public consultation about the options considered in this Impact Assessment also favoured the use of a risk-based threshold to determine the appropriate scope of banks for structural reform (See annex A2). Under a risk-based approach, the threshold would be based on a measure of banks’ trading risk. A risk-based threshold would accordingly have the benefit of clearly linking structural separation to existing measures of the risk associated with trading. The most logical source for such a risk-based threshold would be the risk-weighted assets for market and counterparty credit risk, as these are the prudential measure of banks’ trading books. However, such a risk-based approach has certain drawbacks. First, risk-weighted data is not always publicly available. In the absence of verifiable and consistent public data, the delineation of the appropriate threshold and hence scope becomes less transparent. Second, there are concerns about risk-based approaches that would rely on risk weighted assets given the reported inconsistencies between banks when presented identical stylised portfolios of assets. Furthermore, both European and international standard setters are currently reviewing the RWA approach. Both concerns led the HLEG to reject using such measures for threshold and initial scope delineation purposes.

Another alternative is to apply structural separation to banks that are designated as systemically important by competent authorities. This was also highlighted as an alternative by some respondents to the stakeholder consultation. This approach would have the advantage of linking separation to one of the main drivers of implicit public subsidies. It also has the operational advantage of linking it to a readily available measure of systemic risk that has been translated into European law by the CRDIV. Moreover, analysis by the Commission services (Annex A8) indicates that nearly all banks that are of global systemic importance engage in significant trading activity. However, the systemic risk measure may not be a perfect proxy for significant levels of trading activities, as the analysis carried out by the Commission services also highlight that banks beyond the current G-SII list engage in significant trading activity. So, whereas the list of G-SII may be useful as a starting point, it may not necessarily include all banking groups that may require closer scrutiny. Also, while the provisions related to systemically important institutions have been laid down in the CRDIV, the definitive list of G-SIIs has not yet been finalised. Accordingly, using this approach as a sole base for determining the banks subject to separation would not yield clarity in the short term.

For the above reasons, the Commission services on balance recommend retaining the HLEG recommendation for an accounting-based approach. It is likely to be more effective than the other two alternatives referred to immediately above. It would be transparent and would provide for a higher degree of legal certainty for banks and market participants as regards the scope of banks subject to structural reform. While the Commission services do not consider risk-weighted assets to be an appropriate base for setting the institutional scope, they consider that the systemically important institution-approach should be included explicitly in the sample of banking groups that require further examination. Thresholds should further identify banks with significant trading activities. Accordingly, in addition to banks designated as G-SIIs should, banks that are captured by the accounting-based trading activity threshold, in principle should be subject to the provisions of the reform..

The Commission services have therefore assessed and reviewed the recommendations of the HLEG with a view to consider in particular the suggested examination threshold levels and definition of trading activity to be taken into account (see Annex A8). The Commission services have assessed four options in that respect:

(1) Using the HLEG definition (Assets held for trading and available for sale);

(2) A more narrow definition that account for the current reform agenda by excluding securities held for liquidity purposes under Basel III, and/or a share of derivative assets that are likely to become cleared by Central Counterparties (CCPs);

(3) A definition focused on the gross volume of trading activities, as this is likely to focus on proprietary traders and market-makers; or

(4) A definition focused on net volumes, which is likely to only capture those that have a higher share of unbalanced risk trading (proprietary traders).

Preference for either of these approaches accordingly depends on which of the reform option outlined in Table 2 is being pursued. The assessment of the reform options carried out in Chapter 5 is accordingly done on the assumption that any structural reform would apply to a limited subset of TBTF banks only. A comparison of the alternatives for a threshold stated above will accordingly be carried out following the comparison of the options in Table 2.

4.5.2. Role of supervisors

Irrespective of the choice of threshold, a separate issue is whether supervisors should retain some discretion in reviewing the scope of institutions, the activities subject to potential separation as well as whether separation would need to materialise. As regards the institutional scope, any threshold may not always capture the right institutions. As regards the activity scope, there may be a case for allowing flexibility for supervisors in how to address particular activities in light of e.g. local market circumstances (e.g. market-making provisions by banks may be regarded as more useful where public markets are particularly illiquid). Finally, as regards the decision of whether separation would automatically materialise, specific characteristics of banks may be such that the objectives of structural reform are not put at risk or that diseconomies of scale and scope do not arise. Therefore supervisors may want to exempt them from separation requirements. There is therefore an a priori case for a degree of supervisory discretion.

However, this needs to be constrained for both practical and legal reasons. First, structural separation decisions go beyond simple prudential matters and ultimately reflect societal and economic choices as regards the reach of the public safety net. Such policy decisions accordingly need to be taken at political level. Second, supervisory discretion cannot be unlimited if the intention is to ensure consistent outcomes across the Internal Market. Third, unconstrained supervisory discretion reduces legal certainty. For all those reasons, structural separation decisions should be anchored at political level with only a degree of carefully framed powers granted to supervisors.

The ways of designing and framing supervisory powers will be assessed after the comparison of the different reform options as outlined in Table 2.

4.5.3. Timeline for implementation

The HLEG called on the Commission to consider a sufficiently long implementation and transition period. There are a number of rationales for considering the time dimension. First, structural separation, no matter how beneficial to society, will yield private costs. Imposing restrictions on the structure of a banking group will by construction limit bank flexibility to freely allocate capital and liquidity within the banking group. Moreover, improved market discipline and more credible resolution will get reflected in higher funding costs at unchanged balance sheet size, in particular for the trading entity. To the extent that bank shareholders and/or bank employees do not shoulder this cost, banks may pass the costs on to borrowers or may not provide the activity at all, which in principle could reduce economic growth depending on whether other alternative actors step in (see section 5.2 for a more in-depth discussion of the social costs and benefits of structural reform). Furthermore, the transfer of existing assets and liabilities to a potentially new separate legal entity requires time and involves one-off costs, the level of which would depend on the timeline available for implementation. The implementation will also depend on the role of supervisors in reviewing the scope of institutions as well as the activities subject to potential separation. Finally, the EU has adopted or will soon adopt several initiatives in related areas, including Basel III, BRRD and the SRM that will not become fully applicable until 2018 or 2019. Accordingly, in order to allow institutions subject to these related legislative initiatives to implement them in a coordinated manner and to gradually absorb related transition costs, it is appropriate to provide for a similar transition period to implement a future structural reform initiative. The latter should not become applicable before 2019.

5. Impact and comparison of reform options

The previous chapters list the problems with respect to the current corporate structure of the large, complex and trading-intensive EU banking groups (Chapter 2), describe the corresponding objectives of structural bank reform in trying to resolve the identified problems (Chapter 3), and outline the range of policy options under consideration to achieve the stated objectives (Chapter 4).

This chapter assesses and compares in qualitative terms the relevant reform options under consideration (the two last columns of Table 2). The chapter should allow understanding the rationale, objectives and viability of the preferred structural reform options. The benefits and costs of the different structural reform options will be compared, qualitatively and where possible quantitatively.

Stakeholder views on different reform options will be considered, bearing in mind the clear divergence of opinion between the responses of the banks on the one hand (against any separation and especially any option going beyond separating proprietary trading) and consumer associations and individuals on the other hand (in favour of full ownership separation, and s