The Regulation of Banking in the EU

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The Regulation of Banking in the EU

• Professor Joseph A. McCahery
• Tilburg University

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Outline of Lecture

• IntroductionSummary of Key Elements of ISD
• Part I European banking Dutch market
• Part II New Approach to Banking Regulation
• Part III The Second Banking Directive
• Conclusion

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SummaryKey Articles of ISD

• 1. Rules of conduct (ISD art 11(1)) which
  support both investor protection and the
  stability and integrity of financial markets
  (rules of conduct limit abuse through
  pre-contractual conduct of investment firms
  (advertising, door to door selling, cold calls)
• 2. Concentration and access (ISD art 14(3(4))
  allows MS to require that transactions satisfy
  certain criteria be carried out on a regulated
  markettransaction carried out on more than one
  exchange comply with concentration requirement

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ISD

• Brokers-(Art 15) investment firms authorized by
  one state to provides services are allowed to
  offer servicesdirectly/indirectly to other
  markets clearing services
• Transparency (Art 21) a compromise which is
  minimum standard for post-trade transparency
  trend is immediate reporting

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European Banking Overall Market

• Banks at the center of European financial market
• 1. European banks mostly lend to firms (small
  SMEs global)
• 2. Most of their income is derived from spread
  between lending and borrowing rates
• 3. Fee income (services that banks sell to
  clients) constitutes a small share of their
  revenue/US banks (higher share of revenue)
• 4. Main activities include retail, private
  banking, corporate and real estate, investment
  banking, asset management

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Disintermediation and the Transformation of
Banking

• Since 1980s, banks have lost large part of
  business to other financial intermediaries (US
  decline from 1970s when banks controlled more
  than 45 of all assets to 1990s when it fell to
  just 30 for Europe volume shirking to 40 of
  total assetslate 1990s)
• Reason for decline securitization of commercial
  loans (increasing) banks now pursue other
  business than deposit-takingwhich has led to
  decline in total assets under management

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European Banking Markets

• Cross-border activity increasing although most
  banking remains strictly national (charts)
• Market is still segmented with increasing
  reliance on international capital markets
  (international bondsbond issues have accelerated
  with advent of Euro.
• Domestic banks continue to dominate fixed income
  business (lack of competition in book running
  business)

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Competition in European banking industry

• Limited competition until recentlydue to barrier
  to high barriers to entry
• Lack of competition reflected in industry-wide
  concentration (market share of top banks for
  deposit taking above 50 in UK, Spain, Belgium,
  France, etc.
• Increased competition in 90s evidenced in
  decrease in interest margins decrease in size of
  branching and reduction in operating expenses

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Dutch Banking Market

• Dominated by four banks limited foreign
  competition (Deutsche, BNP, Chase, Citibank)
• Loan pricing increasingly formulaic (regardless
  of size of loan)
• Banks relying on RAROC (risk adjusted return on
  capital) to calculate ratio of return on loan
  (which includes the BIS 8 risk-based capital
  requirement) as the fees received plus a spread
  minus operating costs minus expected loan losses
• Rates on loans Euribor plus markup (bank spread)

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Loan Pricing

• RAROC the amount has to be larger than a cost of
  equity (ROE) benchmark for the loan to be granted
  (value will be created)
• Benchmarks (net of taxes)12-15 depending
  whether it is net measure or not.
• RAROC pricing stimulated by BIS capital
  requirements (8 risk capital, 1992 rules)
• Loan price base rate, mark-up and credit spread
  (depends on borrowers history) sometimes an
  add on feewhich large firms avoid

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Collateral

• Collateral or security are crucial for Euro
  bankshigh collateral requirements
• Collateral requirement is influenced by Dutch
  bankruptcy priority rulesbanks claims are often
  secondary to tax authority
• Covenants large firms are subject to covenants
  (protection of conversion rights).

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Single Market in Banking Regulation

• Banking regulation and supervision conducted in
  accordance with Single Market legislation
  promulgated by EC (creation of single market in
  financial services in 1987, planned for
  completion by end of 92, but only completed by
  96).
• Rationale cost savings resulting from
  barrier-free EU (estimated at EU22bn) financial
  sector (lower budget costs, non-inflationary
  growth, etc.)
• Basic concepts delivery of single market in
  financial services via single passport under
  which financial intermediaries are able to branch
  into other EU member statesmarkets based on
  prior home country authoritization (ie., no
  further authoritizations required)
• Mutual recognition this concept was required (in
  light of single passport concept) in order to
  allow home country acceptance of authoritization
  procedures of supervisory authorities of member
  states

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Legislative Programme

• Avoding a race to the bottom In this regard, EU
  member states agreed on essential mimimum
  standards prior to the establisment of the
  single passport, including minimum capital
  requirements fitness and properness test for
  shareholders, managers, etc agreeing to regulate
  banks based on BIS standards, etc.
• Legislation Single Market
• promulgated through use of Directives, notably
  the Second Banking Directive Deposit Guarantee
  Directive Investment Services Directive and the
  capital adequacy directives (which are addressed
  later in course)
• Second Banking Directive (December 1989, taking
  effect 1993) established the single passport
  concept. The Directive establishes further the
  minimum standards of authoritization and
  prudential supervision to be carried out by all
  MSs.

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Aim of SBD

• Designed to overcome the obstacles to banking
  integration
• 1) by abandoning prior harmonization and
  standardization of all credit institutions 2)
  introducing the mutual recognition principle 3)
  introducing a single license valid throughout the
  communityconditioned upon holder being a credit
  institution, and license not limited to two
  activities which define credit institution

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2nd Banking Directive

• Directive permits banks to establish branches and
  services in other states Annex provides a broad
  range of services (dealing in shares, debentures,
  portfolio management, deposit taking, LCs,
  etc)(list reflects universal bank model)
• Universal bank is permitted to engage in carrying
  out commercial and investment banking activities
  across the EU subject to a single regime of
  financial regulation applied by the regulator in
  its home state (some think this may lead to
  distortion of competition through reverse
  discrimination)
• Minimum capital control article 4 provides that
  authoritizations are permitted only where a bank
  has at least 5 million EURO
• Disclosure of larger shareholders article 5
  requires that a bank disclose all qualified
  holdings (more than 10 of capital/voting)

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License

• License permits
• Licensed banks permitted to carry out activities
  listed in Annex A (commercial banking activities
  mortgage, commercial credit, factoring, trade
  finance, credit cards, guarantees, securities
  trading, futures, options, etc.)
• But some banks may be restricted (under their own
  laws) from carrying out activities listed in the
  Annex (eg., leasing)
• And some banks may permitted to pursue activities
  not covered in the Annex, but cf general
  provisions of Treaty

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Directive (contd)

• Continuing capital requirement Article 10
  requires that banks not fall under the 5 m EURO
  requirement during the period licensed (article
  10 exemption grandfathering institutions whose
  capital was less at time of passage of SBD
  article 10, para 3 limits abuses) banks which
  fall below threshold may be permitted time to
  comply with the requirement.
• Controlling conflicts of interest due to
  cross-shareholdings article 11 (1) requires
  disclosure of size of holding notification of
  increases in holdings (3 mo period for regulator
  to respond) art. 11 (3) disposal notification
  req.

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Directive contd

• Segregation of financial and other business
  concerns article 12 requires that no bank have
  more than 15 from a business that is not related
  to banking or financial services (rationale
  harmonization of sector requires that supervisory
  laws apply to those firms that operate in the
  sector (ring-fence risk))
• Limit non-bank capital must not exceed 60 of
  qualifying capital
• Exception Art 12 (3)allows MSs to vary the
  ceilings on total insurance holdings and if
  holding limit is exceeded, art. 12 (1) (2)
  requires banks to increase its capital base.

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Supervisory Control

• Home country control direct through
  authoritization of license (art. 18 (1)) article
  6 eliminates foreign authoritization for setting
  up a branch
• Authoritization means bank is permitted to carry
  on activities listed in Annex throughout EU (so
  long as authorized by terms of host country)
• unlisted activities if bank wishes to pursue
  unlisted activities provided for by home but not
  home country supervisor, additional requirements
  may be put in place by host regulator (eg., host
  country control and supervision)

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Mutual recognition of authorization

• Article 18(1) states that MS shall provide that
  the activities listed in the annex may be carried
  on within their territory by any credit
  institution authorized provided such activities
  are covered by the authorization
• Activities not listed in Annex are excluded from
  mutual recognition of authorization
• Host state has right to prohibit the activities
  of foreign bank not authorized

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Branching Activities of Banks

• Article 19 permits location of branches in
  another MS if authoritization has been received
• Art 19 (2) sets forth the procedure for opening
  up a branch notification of home country
  authority which is required to ensure that
  information is supplied (eg.,location of branch
  program of operation (business plan, etc)
  management, address of branch))
• Home country supervisor must communicate
  information to host country regulator (along with
  solvency ratio capitalization of bank deposit
  insurance, etc.)
• Two month processing period to prepare for
  supervision of branch activities in host country
  (Art. 21)

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Subsidiaries

• Home country supervision applies only to
  branches
• Sub has own legal identity (nb separate
  authoritization required)
• Regulated by Second Consolidated Supervision
  Directive (April 6, 1992, effective 1993) which
  provides that a company that has a subsidiary is
  subject to supervision on a consolidated basis
  (applies to solvency, adequacy of funds to deal
  with large exposures etc.)
• Supervision of subsidiary is required of national
  regulator (Art. 3(8)) so as to ensure flow of
  information to other national supervisors

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Subsidiaries

• Financial institutions which are subs of credit
  institutions are permitted to carry on activities
  listed in Annex (trading of securities, leasing,
  securitization, etc.)
• Art 18 (2) allows subs to carry out services
  either through a branch or by way of provision of
  services only if parent is authorized as credit
  instit activities are carried out within MS
  parent satisfied home country control, sub is
  included in consolidated supervision.

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Subsidiary function

• Firms that wish to function as subs must fulfill
  a number of requirements
• 1) parent must be authorized in MS by the law of
  which the sub is governed 2) parent shall
  control more than 90 of the subs voting rights
  3) parent satisfies the requirements of
  supervisory authority (guarantees activities of
  its sub) 4) included within the consolidated
  banking activities of the parent firm

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SBD Regulatory Arbitrage

• Regulators were concerned to limit the effects of
  regulatory arbitrage
• Recital 8 control authorizations where its clear
  that choice of legal system is based on avoiding
  rules (supervisory standards permitted
  activities)
• Article 7 prior consultation with authorities of
  other MS
• Question conflict between Treaty provisions and
  SBD

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More Competition in European Banking

• Cross-border mergersEuro should stimulate
  consolidation of markets (but has not so far)
• Way forward EU merger regulation allowing cross
  border consolidation
• EU Merger Regulation (Art 5.3a) stipulates
  specific turnover calculation for financial
  institutions only provision related to banks

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Competition Policy

• Main issue No banking market definition
• EC divides market into four components retail,
  corporate, investment markets
• EC view products not well developed so as to
  draw definition of market
• Alternativecluster markets (transactional
  complementary) v. product markets

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Problems

• Conflict over competition v. efficiency effects
  of merger which is related to market definition
• Art 21.3 exemption related to cross-border bank
  mergers limits power of EC by allowing parties
  to deploy defenses public security interests and
  prudential regulation concerns (see BSCH/A.
  Champalimaud)

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Solutions

• 1. More flexible definition of relevant bank
  market and efficiency exemption
• 2. Cluster-based products could provide way
  forward as basis for new market definition

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