Banks should separate deposit banking from trading and other high-risk investment to shield taxpayers from further bailouts and protect savers, an EU advisory group said on Tuesday (2 October).
The advisers also single out the risks of property lending and said it should be underpinned with larger capital reserves. The European Commission set up the group of experts, led by Bank of Finland Governor Erkki Liikanen, to examine bank structures.
The report will reignite a debate in Europe about reforming banks but it is unlikely that the EU's executive, the European Commission, will respond soon with new regulation.
It is more focused on winning backing for its separate banking union plans to make the European Central Bank the main supervisor for euro zone lenders, a step which non-euro zone states have deep concerns about.
"The group has concluded that it is necessary to require legal separation of certain particularly risky financial activities from deposit taking banks within the banking group," said the report.
"The activities to be separated would include proprietary trading of securities and derivatives, and certain other activities closely linked with securities and derivatives markets."
The recommendations borrow from policies already being implemented in Britain to ring-fence retail banking and in the United States to curb banks' proprietary trading or taking bets with own money.
The report also backs the idea of bail-in debt, a mechanism to impose losses on bondholders in the case of a banks' bailout or collapse. The Liikanen group suggests that bankers should accept this type of bond as part of their bonus.
Legally separating or ring-fencing investment banking would make it easier for the part of the bank that holds savers' deposits and lends to businesses to keep running even if other parts of the group collapsed, some banking experts say.
It would affect European banks such as Britain's Barclays, Germany's Deutsche Bank and France's BNP Paribas, which engage in high street banking alongside riskier trading in stocks, debt and other securities.
With property crashes in Spain, Ireland and elsewhere having triggered problems for banks, there is also a recommendation to consider specific capital charges to cover risks from property loans on a bank's books.
But European policymakers, struggling to contain the regional debt crisis and associated banking troubles, are set to give priority to creating a banking union that would eventually allow euro zone countries to jointly support banks.
"This report will feed our reflections on the need for further action," said Michel Barnier, the European Commissioner in charge of regulating the banking sector.
"I will now consider the next steps, in which the Commission will look at the impact of these recommendations both on growth and on the safety and integrity of financial services."
Brussels is expected to pursue safeguards such as larger capital reserves for risky business or rely on new powers to be granted to the European Central Bank to keep banks in check.
Setting aside capital by holding back profits, for example, makes banks less risky for shareholders and taxpayers.
The United States is pursuing its own structural reforms through the introduction of curbs on proprietary trading, where banks trade for their own benefit and in doing so take on risk.
Britain chose safeguards for depositors by shielding that part of a bank's business after Royal Bank of Scotland's rush to extend its investment arm resulted in the largest state bailout of the crisis in Europe.
A panel of experts headed by John Vickers, a former chief economist at the Bank of England, recommended that the retail arms of banks be "ring-fenced" by a cushion of extra capital beyond the international norm.
Monique Goyens, Director General of BEUC, the European consumers' organisation, applauded the recommendations of the Liikanen report – to which she contributed – to split investment from retail banking.
"Banks too big or too interconnected to fail relied heavily on taxpayers to help out in cases of financial disruption, whether caused or not by the banks’ risky activities," Goyens said. "This was not only totally unfair – the risk should be borne by the risk taker – but also a distortion of competition among those banks that did not benefit from these implicit guarantees."
She said it was now up to the Commission to take ownership of these recommendations and engage in the process of translating them into legislation.
The Liikanen report was hailed by the Greens political group in the European Parliament.
"Ringfencing trading activities in banks would play a vital role in limiting contagion within and between banks and ensuring retail banking customers are not damaged by losses from investment banking activities in their bank, which have nothing to do with them," said Green finance spokesperson Philippe Lamberts MEP in a statement.
But the Greens felt the proposal could have gone further by requiring "a total separation of retail and investment banking".
According to Lamberts, the proposals in the Liikanen report also fell short of what was needed to end the 'too big too fail' conundrum. "Further measures – such as cap limits on the size of assets that a bank can hold – are needed to reduce the systemic footprint of the banking industry. Exemptions for certain trading activities within retail banking open significant loopholes that would potentially nullify the effect of the ringfencing. This is a major shortcoming."