With this ring, I thee fence: how Europe's ringfencing proposal compares with U.S. ringfencing measures.

Author:Brown, Winthrop N.
Position:Credit institution structural resilience measures
 
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  1. INTRODUCTION II. EU PROPOSAL A. EU Ringfencing Measures 1. Activities Prohibited for a Depository Institution and Its Affiliates 2. Activities Prohibited Only for a Depository Institution B. EU Reinforcement Measures C. Determination of Equivalence III. U.S. BANKING LAW A. U.S. Ringfencing Measures 1. Underwriting and Dealing in Securities 2. Activities Not "Necessary to Carry On the Business of Banking" 3. The Securities Push-out Requirement 4. The Swaps Push-out Requirement 5. Non-banking Activities of a Bank Holding Company 6. The Proprietary Trading Prohibition 7. Transactions with Covered Funds B. U.S. Reinforcement Measures IV. COMPARISON OF THE EU PROPOSAL TO U.S. RINGFENCING MEASURES A. Who Is Subject to Fencing B. Where to Place the Fence C. What Activities Fall on Either Side of the Fence D. The Height of the Fence V. CONCLUSION I. INTRODUCTION

    A number of European countries have adopted or are considering proposals to regulate the structure under which banking institutions conduct a wide variety of activities. (1) These proposals are primarily grounded in the belief that certain activities are too risky to be conducted by a depository institution (2) and, in some cases, even by an affiliate (3) of a depository institution. The concern is that these activities could cause a depository institution to fail, which would lead to bailouts by taxpayers of the kind that proved so expensive and controversial during the recent financial crisis. (4) To prevent this, the proposals use ringfencing measures, which prohibit a depository institution from engaging in risky activities by requiring either that they be transferred to a separate entity within the depository institution's banking group (5) or that they be banned from the banking group altogether. In this way, either the depository institution or the separate entity to which the activities are transferred would be "ringfenced," thereby protecting the depository institution or isolating the risky activities within the separate entity, or both.

    In January 2014, the European Commission released a proposed regulation (EU Proposal) on "structural measures improving the resilience of EU credit institutions." (6) The EU Proposal is the product of extensive consideration of recommendations contained in a report released by a commission chaired by Erkki Liikanen, the Governor of the Bank of Finland (Liikanen Report). (7) In its preamble, the EU Proposal notes that variations of these ringfencing recommendations are being considered by some EU member states and urges them to adopt its recommended regulation in order to ensure consistency. (8) In that regard, the EU Proposal states:

    Harmonisation at Union level envisaged in this Regulation can ensure that Union banking groups, many of which operate in several Member States, are regulated by a common framework of structural requirements thereby ensuring a level playing field, reducing regulatory complexity, avoiding unwarranted compliance costs for cross-border activities, promoting further integration in the Union market place and contributing to the elimination of regulatory arbitrage opportunities. (9) As European governments debate the merits of the EU Proposal, they may find it instructive to note how these issues have been resolved in the United States--a jurisdiction that has had a long experience with ringfencing the activities of its depository institutions. (10) Although American legislators and regulators do not generally use the term "ringfencing," a number of measures in U.S. banking law in fact produce the same result, which is to insulate a depository institution from activities considered too risky. (11) Nor, as current commentary so often suggests, (12) are these measures confined to the Volcker Rule, a provision enacted following the 2008 financial crisis as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd Frank). (13) Rather, as discussed in Part III of this Article below, they have been key features of U.S. law since at least 1933. (14)

    Part II of this Article first briefly describes the key features of the EU Proposal. These features consist of two principal measures that govern which entities may engage in certain activities within a banking group (ringfencing measures) and several additional measures that reinforce these requirements (reinforcement measures). Part III then reviews seven features of U.S. banking law that can fairly be described as ringfencing measures and other features that operate as reinforcement measures. Part IV then compares the EU Proposal to U.S. banking law. The hope is that these comparisons will make the United States' experience with ringfencing helpful to those considering the EU Proposal. The analysis should also prove useful to those U.S. banking institutions and U.S. subsidiaries of EU banking institutions that will want a determination under Article 27 of the EU Proposal that U.S. laws contain requirements that are "equivalent" to those in the EU Proposal. Such a determination, if granted, would relieve the EU branches of U.S. depository institutions and the U.S. subsidiaries of EU banking institutions of the obligation to comply with the EU Proposal.

  2. EU PROPOSAL

    The EU Proposal has three principal parts: (1) a prohibition on certain activities being conducted either by a depository institution or any of its affiliates; (2) a requirement that certain additional activities be reviewed by a national regulator to determine whether they must or should be transferred from a depository institution to a separate ringfenced entity within the banking group; and (3) reinforcement measures to strengthen the ringfence by ensuring the independence of the ringfenced entity and by regulating transactions between it and the depository institution. In addition, the EU Proposal establishes an equivalence regime under which an EU member state or third country may be relieved of its obligation to comply with the EU Proposal by demonstrating that its national laws provide measures equivalent to those in the EU Proposal.

    As a preliminary matter, the EU Proposal applies to two categories of depository institutions (Covered EU Institutions). In the first category is any depository institution or its parent, including all of its branches and subsidiaries wherever located, which has been identified as a "global systemically important institution." (15) Second, the EU Proposal covers any of the following three entities that have, for three consecutive years, both total assets over 30 billion [euro] ($41.4 billion) and total trading assets and liabilities over 70 billion [euro] ($96.6 billion) or ten percent of its total assets: (1) an EU depository institution that is neither a parent nor a subsidiary, including all of its branches wherever located; (2) an EU parent of an EU depository institution, including all of its branches and subsidiaries wherever located; and (3) an EU branch of a depository institution established in a third country. (16)

    1. EU Ringfencing Measures

      The EU Proposal imposes two ringfencing measures. The first bans activities for both a depository institution and its affiliates; the second bans activities only for the depository institution.

      1. Activities Prohibited for a Depository Institution and Its Affiliates

        The first ringfencing measure of the EU Proposal would ban a Covered EU Institution from engaging in two activities: proprietary trading (or investing in interests issued by any company that engages in proprietary trading) and investing in certain investment funds for its own account (or investing in companies that acquire interests in such funds, or in instruments the performance of which is tied to such funds). (17)

        The EU Proposal defines proprietary trading as:

        [U]sing own capital or borrowed money to take positions in any type of transaction to purchase, sell or otherwise acquire or dispose of any financial instrument or commodities for the sole purpose of making a profit for own account, and without any connection to actual or anticipated client activity or for the purpose of hedging the entity's risk as result of actual or anticipated client activity, through the use of desks, units, divisions or individual traders specifically dedicated to such position taking and profit making, including through dedicated web-based proprietary trading platforms.... (18) The ban on proprietary trading does not apply to investments in government securities issued by member states or the use of an entity's capital as part of the cash management process. (19)

        The ban on investing in investment funds applies to units or shares of private funds, which the preamble to the EU Proposal refers to as "hedge funds," and the text of the regulation refers to as "AIFs as defined by Article 4(1) (a) of Directive 2011/61/EU." (20) The ban does not apply to investments in certain "closed-ended and unleveraged" funds as defined under other EU directives, including private equity and venture capital funds. (21) The purpose of this exception is "to ensure that the entities subject to the ban on proprietary trading can continue to contribute toward the financing of the economy." (22)

      2. Activities Prohibited Only for a Depository Institution

        The second major ringfencing measure in the EU Proposal requires that a depository institution's regulator review certain other "trading activities" conducted by the depository institution. (23) The regulator must review "in particular" three activities: (1) market making; (2) investing in and acting as a sponsor of securitizations; and (3) trading in derivatives (other than certain derivatives used to hedge customers' or the institution's own risk) to which a Covered EU Institution is a party. (24) If the regulator concludes that the depository institution meets certain "limits and conditions" linked to eight specified "metrics" (25) in the EU Proposal, it will "therefore deem[] that there is a...

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