Stronger capital requirements and the legal separation of risky financial activities are among the key recommendations of the "High-Level Expert Group on Reforming the Structure of the E.U. Banking Sector," published in October 2012 at the behest of the European Commission, with the aim of reforming the troubled E.U. banking sector.
Erkki Liikanen, governor of the Bank of Finland, chaired the group, which counted José Manuel Campa, Spain's former secretary of state for the economy and now a finance professor at IESE, as an expert member.
The woes of the European banking sector are the result of problems not so much of the business model per se, but rather of excessive risk-taking behavior in trading activities and real-estate lending, as well as overreliance on short-term funding, notes the report.
Introducing stronger capital requirements would enhance banking resilience, repair dysfunctional incentives and reduce taxpayer liability in the event of a future crisis.
As such, the expert group made five key recommendations for structural improvements within the European banking sector.
1. Separate Risky Activities. Legally separating complex derivative instruments into an independent company, and separating risky trading and proprietary activities from deposit-taking banks, would enhance transparency and help to reduce some of the systemic risks inherent in today's highly interconnected banking sector.
One possible argument against separation is that it might threaten the universal European banking model and limit the range of financial services available to customers.
Yet, as the report notes, separating risky trading activities does not necessarily mean that some of these activities could not be offered as part of the same holding company; the point here is to separate these activities, in order to insulate the deposit bank from the risks.
2. Wind Down Risky Positions. To prevent another crisis and contagion effects, banks must have recovery and resolution plans. These plans must allow the institution to diminish its exposure to risky activities without damaging the stability of the financial system. Achieving this may again require greater separation of activities, especially when positions are large relative to overall market size, posing even greater difficulties during distressed market conditions.
3. Bail-in Instruments as a Resolution Tool. Bail-in instruments offer a promising way for distressed banks to use existing bondholders to recapitalize the institution before drawing upon public funding.
Done properly, this should increase stability, while reducing overall losses from slow responses and costly bankruptcy proceedings.
However, to be successful, bail-in instruments should be predictable and the circumstances in which a bail-in would occur need to be clearly defined, so that investors understand their exposure. In this regard, greater transparency would help.
Systemic risks could be reduced by restricting the holdings of bail-in instruments to parties outside of the banking sector, such as institutional investors and life insurance companies.
Inclusion of bail-in instruments within top management remuneration at banks could also help, by aligning decision-making with long-term performance.
4. New Capital Requirements for Trading Books and Real-Estate Exposure. Current methods to model capital requirements are vulnerable to modeling errors, since operational risks do not accurately reflect the volume of trading book assets.
Also, the treatment of real-estate lending within the capital requirements framework must be reconsidered, to prevent systemic banking crises, which have historically originated from excessive lending in real-estate markets, coupled with overreliance on wholesale funding.
Internal risk models must be better coordinated and harmonized. This would inspire confidence in the adequacy of capital requirements.
Assessment of large exposure limits should consider inter-institutional and intra-group exposures as well.
5. Strengthen Governance and Control. The recent financial crisis has revealed the dire failure and shortcomings of boards and management systems. For this reason, improving corporate governance is critical.
Measures need to be taken to control compensation and reform remuneration, in order to encourage sustainable performance. Supervisors need to be given sanctioning powers -- such as lifetime professional bans or clawback clauses -- to enforce responsible risk management.
Improvements in the quality, comparability and transparency of risk disclosures to the public should help to enhance market discipline, win back investor confidence and rebuild trust between the public and bankers.
"El camino de Don Quijote", La Mancha, central Spain, by M Moraleda, at flickr.com