Guest blog: The Liikanen Report and the proposal for a resolution framework – 10 years on
It is now a decade since the Liikanen Report was published. While the proposal for structural reform in the banking sector was not implemented in the EU, many of the ideas brought forward by the high-level expert group can be found in other regulatory initiatives. The task to assess the need for separation of business lines, legal entities or assets and liabilities to ensure the resolvability of every bank is now in the hand of the resolution authorities.
Proposals for structural reform in the banking sector
Published in October 2012, the Liikanen Report outlined the work by the high-level expert group commissioned by Commissioner Michel Barnier to assess the need for structural reform in the banking sector. Former governor of Bank of Finland Erkki Liikanen chaired the group. The thinking of the high-level expert group was structured along two different avenues. One was based on the notion that that resolution authorities will make the needed tough decisions to ensure resolvability based on the assessment done during the annual resolution planning process. Hence, a one-size-fits-all structural reform ex-ante, which possibly would reduce the diversity in banking business models, would not be needed. The other saw the need for a separation of significant trading activity ex-ante to make resolution manageable at the time of crisis. This would also reduce risk of contagion within large, multi-business line banks and make bank easier to manage, supervise and monitor, thus further reducing the room for excessive risk taking.
The final proposal for structural reform was a combination of the two avenues. Proprietary trading and other high-risk trading were to be separated from the socially most vital parts of deposit-taking and lending, while bank-level specificities were to be accounted for by conditioning further separation of, for example, market-making activity on the credibility of recovery and resolution plans. The separation was to be done within the group in terms of legal and operational barriers, and so acknowledges the benefits of the universal banking model. The implementation of the proposed structural reform was to be mandatory only for banks with significant trading activity.
The legislative proposal on bank structural reform drafted based on the work of the high-level expert group was withdrawn by the EU Commission in 2018. While the high-level expert group was working on its proposals, the Commission made the proposal for the Bank Recovery and Resolution Directive (BRRD). At the same time, the European Council asked for a roadmap to create the Banking Union. The BRRD was adopted in spring 2014, while the Single Resolution Mechanism Regulation (SRMR), creating the second pillar of the Banking Union, was adopted in July 2014. The Single Resolution Board (SRB) with responsibility for significant institutions in the Banking Union and the national resolution authorities (including in Finland the Finnish Financial Stability Authority (FFSA)) with the responsibility for less-significant institutions were established in 2015. Now it is up to us resolution authorities to show that we will, as needed, take the tough decisions based on a bank specific assessment along the lines of the first avenue in the Liikanen Report.
Resolvability assessment rather than ex-ante separation of operations
Since 2015, the EU resolution authorities have been mandated to ask for substantial changes from banks in order to ensure resolvability. The SRB is working in close cooperation with the banks to ensure that the significant institutions in its remit are resolvable by the end of 2023. Similarly and with the same deadline, the FFSA and the other national resolution authorities are working with the less-significant institutions to ensure that those earmarked for resolution are resolvable.
Ensuring resolvability is a complex task touching almost every part of a bank. The issues are grouped along seven dimensions: governance, loss-absorbing and recapitalisation capacity, liquidity and funding in resolution, operational continuity and access to financial market infrastructure (FMI) services, information systems and data requirements, communication, and separability and restructuring. Of these, separability and restructuring, covering the need to push for organisational changes or a split of assets and liabilities ex-ante to ensure resolvability, is closest in nature to the bank structural reform proposed in the Liikanen Report.
Ensuring separability is most relevant for banks for which the sale of business tool is foreseen in the preferred or the variant strategy, entailing partial transfers of assets and liabilities. The SRB expects significant institutions to make a separability analysis and a transfer playbook outlining how the separation would be done in practice by the end of 2023. This will provide resolution authorities with the sufficient flexibility to, for example, transfer some parts of a failing bank to a potential buyer, transfer non-performing loans to an asset management vehicle, i.e. a bad bank, and transfer relatively healthy parts to a bridge bank while awaiting a suitable buyer.
Even though the preferred resolution strategy for many of the banks entails implementation of the bail-in tool, insights into the possibility to separate business lines or asset classes are needed. Bail-in is followed by a reorganisation of the bank to ensure that it has a healthy business model going forward. It is the task of the bank to outline a business reorganisation plan after it has been resolved. The SRB expects significant institutions to demonstrate restructuring and re-organisation capabilities needed to implement the business reorganisation plan by the end of 2022. Banks with significant trading book activities have already taken measures to ensure that trading activities can be wound down in an orderly way in resolution. The FFSA expects that the less-significant institutions progress in this area by the end of the year 2023.
In case a bank does not make sufficient progress and the preparations ensuring that legal entities, business lines or assets and liabilities can be separated at short notice are not credible, decisions requiring the bank to remove the identified substantive impediment will be taken by the SRB or any of the national resolution authorities. To underpin such an intrusive decision, the SRB is closely monitoring the progress made by the banks as part of the annual resolution planning cycle.
Variations of bank structural changes
To date, we have not in the EU seen structural separation of traditional banking activity and other banking activity as envisaged by the high-level expert group. But we have seen other structural changes. In Ireland, the largest banks have been asked by resolution authorities to create holding companies, from which bail-inable debt is issued. This separates this activity from operational entities to facilitate the implementation of the bail-in tool. We have also seen branchification of operations, which improves resolvability in that it facilitates the implementation of the single point of entry strategy, which foresees resolution action at the level of the consolidating parent entity. This trend, visible in the Nordics, has, however, been driven by business decisions of banks rather than interventions by authorities.
Going forward, it is possible that we will see a separation of traditional banking activity from other banking activity, either to ensure resolvability ex-ante or as implemented during resolution. The economic functions of deposit-taking and payments system services are frequently assessed to be critical by resolution authorities, given that customers cannot be without these banking services for a long time. Lending to companies is crucial for the real economy. A healthy loan portfolio also makes a bank more attractive for a potential buyer. If the attractive loan portfolio includes mortgage loans and the bank uses these in pools enabling issuance of covered bonds, this type of funding needs to be included in the package to be separated. Separating, for example, trading and asset management activity to another package ex-ante so that they can be sold to buyers, which might find synergies, or preparing to separate non-performing loans to an asset management vehicle might well facilitate the job of resolution authorities during the hectic hours of resolution.
But we might also see other variations of ways to implement structural changes in banks. In some banks, resolution authorities might see the need to push the bank to centralise activity to support a single point of entry strategy. In other banks it might be beneficial to strengthen the independence of different sub-groups along, for example, geographical lines to facilitate the implementation of a multiple point of entry strategy, where resolution measures would be addressed to several entities rather than only to the parent entity. In some banks, organisational changes related to support functions might be needed to ensure the operational continuity of critical economic functions.
We have come a long way in ensuring that banks are resolvable, reducing the implicit government guarantee attached to banks previously regarded as too big to fail. The uplifts in credit ratings are smaller than before the great financial crisis, credit rating agencies assume that public money will not be used in most European countries in case failure of a bank and the pricing of bank funding depends on the likelihood of default, or more specifically on the likelihood of bail-in reaching the particular debt class.
The SRB heat map on the progress towards resolvability published in July 2022 also indicate that we have come rather far in making banks resolvable. There is, however, still significant amount of work to be done. With the deadline of 2023 coming closer, we might see more concrete changes in the banking sector driven by the assessment of resolution authorities. We are ready to make the tough decisions as needed.
Chief Economist Hanna Westman, the assistant to the chairman of the high-level expert group at the time
 The high-level expert group also made recommendations related to bail-inable instruments, capital requirements for trading activities and real estate related loans as well as governance and control of banks. The recommendations related to bail-inable instruments have been incorporated in the resolution framework. A new insolvency hierarchy has been created through legislator changes in 2018. So called senior non-preferred debt would bear losses after own funds, but before unsecured debt to which it is subordinated. The largest banks are to hold a minimum level of subordinated debt in their balance sheet at all time. Cross-holdings of TLAC instruments are already prevented among G-SIIs, while EBA is currently investigating the extent of cross-holdings among other banks. Resolution authorities are accounting for the implications of bail-in on investors and the potential risk of contagion in the public interest assessment. The authorities have the possibility to make discretionary exclusions of debt from bail-in to maintain financial stability. The other recommendations of the high-level expert group can be found in other legislative initiatives. The capital requirements for trading activities have been refined in the fundamental review of the trading book, macroprudential measures has been taken to mitigate risks from real estate loans, while the governance and control of banks are under increased scrutiny by supervisors, and in particularly the SSM established in 2014.
 Structural reform was implemented in the USA, where proprietary trading was to be separated according to the rule named by the former Chairman of the Federal Reserve Paul Volcker and in the UK, where domestic retail banking operations were to be separated based on the proposals of the independent commission for banking chaired by Sir John Vickers.
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About the author
Hanna Westman works as Chief Economist at the Finnish Financial Stability Authority. Previously she has worked with questions related to banking and bank regulation both in the private and public sector. Westman obtained her doctoral degree (Ph.D., economics) in 2009 from Hanken School of Economics, Helsinki, with a thesis on corporate governance in European banks. During her time at the Bank of Finland, Westman...