Does Volcker + Vickers = Liikanen? EU proposal for a regulation on structural measures improving the resilience of EU credit institutions

1. On 29 January 2014 the European Commission  published a proposal for a regulation of the  European Parliament and of the Council “on  structural measures improving the resilience of  EU credit institutions” 1 .  This proposed legislation  is the EU’s equivalent of Volcker 2  and Vickers 3 .  It  was initiated by the Liikanen report 4  published on  2 October 2012 but the legislative proposal departs  in a number of ways from the report’s conclusions.   There are two significant departures: the legislative  proposal contains a Volcker-style prohibition, which  also departs from the individual EU Member States’  approach, and, although the proposal contains  provisions which mirror the Vickers ‘ring-fencing’  approach they are not, in direct contradiction to  Liikanen’s recommendation, mandatory. Background 2. Post financial crisis, various jurisdictions have  started to overhaul bank regulation and supervision.   Bank structural reform is part of that agenda and  involves separating retail and commercial banking  from wholesale and investment banking, as well as  outright prohibitions.  The objective is to protect  core banking activities and depositors from the  ‘riskier’ trading activities, which have been deemed  as ‘socially less important’, by reducing the risk  of contagion spreading from trading activities to  traditional retail banking and protecting the  1 See here http://ec.europa.eu/internal_market/bank/structural-reform/ index_en.htm 2 As implemented in section 619 of the Dodd-Frank Wall Street Reform  and Consumer Protection Act of 2010 which created a new section 13  of the US Bank Holding Company Act of 1956. 3 As implemented in section 4 of the Financial Services (Banking  Reform) Act 2013 which inserts Part 9B (sections 142A – 142Z1) into  the Financial Services and Markets Act 2000. 4 See here http://ec.europa.eu/internal_market/bank/docs/high-level_ expert_group/report_en.pdf deposits of individuals and small businesses in the  case of bank failure.  In addition, bank structural  changes are intended to reduce complexity and so  improve the resolvability of banking groups.  The  EU has been concerned about banks which it terms  “too big to fail”, “too big to save” and “too complex  to manage, supervise and resolve”.  It has been  concerned that failure of these banks would be  detrimental to the financial system in the EU as a  whole.  The EU also believes that these banks have  an unfair advantage over smaller banks: it believes  that the presumption that they would be bailed out  rather than be allowed to fail provides an implicit  guarantee which impacts their funding costs and  leads to moral hazard and excessive risk-taking.   These concerns and beliefs have led to a variety of  legislative proposals and legislation. 3. Different jurisdictions have taken different  approaches to bank structural reform.  Reference  has already been made to the UK and US legislation  but France 5  and Germany 6  have also adopted  legislation and the Belgian coalition government  reached a political agreement in December 2013 on  structural reform of its banking sector which it aims  to finalise before elections in May 2014 7 .  One of the  fundamental differences between the US and the  approaches of the individual EU Member States has  been the US preference for prohibition (or owner  5 French law no. 2013-672 of 26 July 2013 on the separation and  regulation of banking activities. 6 Trennbankengesetz (German Bank Separation Law) which is included  in Article 2 of the Gesetz zur Abschirmung von Risiken und zur Planung  der Sanierung und Abwicklung von Kreditinstituten und  Finanzgruppen (Law concerning Separation of Risks and  Restructuring and Winding-Up  of Credit Institutions and Financial  Groups), BGBl. 2013 I Nr. 47, 3090.  The law was announced on 7  August 2013 and Article 2 entered into force on 31 January 2014,  although most of  the rules in Article 2 are not applicable until 1 July  2015. 7 The text is not yet available but was approved in second reading on 14  February 2014 by the Belgian Federal Government.   Legal Update February 20142     mayer brown separation) as opposed to the EU Member States’  preference for ring-fencing (or functional separation  / subsidiarisation).  This difference means that the  activities which the US has prohibited cannot be  carried out within a banking group at all whereas  the activities on which the EU Member States  have focused can be carried out within a distinct  trading entity which is separate from the retail  and commercial bank entity.  The EU’s legislative  proposal, by including elements of both approaches,  blurs this distinction and creates a third approach  to bank structural reform which is consistent with  neither the US approach nor the approaches of the  individual EU Member States. 4. The second significant difference in the approaches  taken to date relates to the activities which the  different jurisdictions have regulated.  Broadly  speaking, the US approach has prohibited  proprietary trading, sponsoring private equity and  hedge funds (known as “covered funds”), investing  in covered funds and loans (known as “covered  transactions”) to covered funds with which the  banking group is involved.  Proprietary trading is  defined widely but there are a number of helpful  exclusions and exemptions which narrow the scope  of the prohibition, including a number of exclusions  and exemptions to reduce the extraterritorial  impact on non-EU banks, although, of course, there  are conditions with which compliance is necessary  before reliance can be placed on the exclusions  and exemptions.  There are similar exclusions  and exemptions relating to the prohibitions on  sponsoring and investing in covered funds and  on covered transactions with covered funds.  The  Volcker rule is examined in detail in our legal  reports “Final Regulation Implementing the Volcker  Rule” 8  and “The Volcker Rule – Application to  Securitization Transactions” 9 . 5. The UK approach (Vickers) focuses on a wider  range of investment and wholesale banking. By  prohibiting deposit-taking entities from ‘dealing in  investments as principal’ 10 , it requires most of the  derivative and trading activity currently carried out  8 See here http://www.mayerbrown.com/files/Publication/f95121f8- 0c01-40f8-b14b-46379c2b118d/Presentation/PublicationAttachment/ ddaf0395-d75d-4456-b143-6a026db6be71/Final-RegulationImplementing-the-Volcker-Rule.pdf 9 See here http://www.mayerbrown.com/files/Publication/b2ff45c7- 4252-4bb4-8bc0-899c2914b6a8/Presentation/ PublicationAttachment/9b7da3f6-47a6-4da5-8dfb-05f7f0893a0f/ UPDATE-VolckerRule-Application_131219.pdf 10Dealing in investments as principal includes buying, selling,  subscribing for or underwriting securities or contractually based  investments. by wholesale and investment banks to be carried out  by a trading entity wholly separate from the retail  bank.  The French and German approach follow the  ring-fencing approach of the UK but, like the US,  have a narrower focus.  Their approaches reflect  the agreement reached by the two countries to push  forward arrangements in the EU for the separation  of “speculative activities” from deposit- related and  customer-orientated activities.  Thus the French  legislation provides that proprietary trading and  unsecured financing to alternative investment funds  (“AIFs”) above a certain threshold (the “speculative  activities”) must be carried out by a trading  subsidiary separate from the retail banking entity.   Similarly, the German legislation specifies certain  high-risk activities (above a certain threshold  in terms of overall trading activity), including  proprietary trading, credit and guarantee business  with certain AIFS (or equivalent funds which are  high leveraged or engaged in short selling) and  certain forms of trading in one’s own name with the  exception of market-making that must be ringfenced and transferred to a separate trading entity. 6. Finally and amongst those jurisdictions that have  chosen the ring-fencing approach, there is some  difference in the strength of the ring-fence or the  degree of functional separation required.  The UK  requires the ring-fenced body (“RFB”) to be legally,  economically and operationally independent, to  interact with the rest of the banking group on an  arm’s length basis and to have its own capital and  liquidity resources.  The Prudential Regulation  Authority (“PRA”) will make additional rules to  ensure the integrity of the ring-fence and the  independence of the RFB.   The German legislation  requires the RFB to be legally, economically and  operationally independent, to interact with the rest  of the banking group on an arm’s length basis and to  have its own capital and liquidity resources, but does  not give any guidance on how this should be achieved  or should interact with German corporate law. Liikanen...but not as we knew it 7. At the same time as individual jurisdictions were  considering bank structural reform to deal with  the issues summarised at paragraph 2 above,  the EU was considering action, believing that  inconsistent national legislation increases the  possibility of distortions of capital movements and  investment decisions, serves to make the structure  and operation of cross-border banks more complex mayer brown     3 and increases fragmentation.  In February 2012, the  Commission established a High-level Expert Group to  examine possible reforms to the structure of the EU’s  banking sector, appointing Erkki Liikanen, Governor  of the Bank of Finland and a former member of the  European Commission, as the chairman.  The Group  presented its final report to the Commission on 2  October 2012, the Commission examined the possible  reform options and their implications and, on 29  January 2014, it adopted a proposal for a regulation  on structural measures improving the resilience of EU  credit institutions plus a proposal on transparency of  securities financing transactions aimed at increasing  transparency in the shadow banking sector.  This note  focuses on the former proposal. 8. The UK government had considered adding a  Volcker-style prohibition to the Vickers ringfence established in the Banking Reform Act 2013  but rejected it because of concerns that defining  proprietary trading as opposed to activities such as  market-making was too problematic, the “technical  challenges” that the US was experiencing in  implementation and the fear that it would distract  regulatory attention from the ring-fence.  The EU,  however, clearly did not share these concerns as  their proposal departs from the approach taken  by individual EU Member States and contains a  Volcker-style prohibition, as well as provisions on  ring-fencing.  The main points of note are set out in  the table below. The main provisions of the EU proposal Scope (a) It is proposed that the Volcker-style rule will apply to: (i) EU G-SIIs (and all their branches and subsidiaries  regardless of their location); and (ii) banks that for 3 years have total assets of at least 30  billion euro and trading assets of 70 billion euro or  10% of total assets.  (b) The proposal does not make ring-fencing mandatory but  requires national regulators to consider the possibility in  relation to each individual deposit-taking bank (termed  “core credit institution”) depending upon its risk profile.   There is a wide definition of core credit institution. (c) The EU proposal intends to have extraterritorial effect  and apply to non-EU subsidiaries of EU banks, as  well as effectively to non-EU banking groups with EU  branches, unless the Commission deems the relevant  non-EU jurisdiction equivalent to the EU regime but,  although the stated intention is to create a level playing  field in the EU, these provisions raise questions of legality  and enforcement. National regulators may exempt a  non-EU subsidiary of an EU bank from the ring-fencing  requirements of the EU proposal in the absence of an  equivalence decision if the relevant national regulator is  satisfied that the subsidiary’s resolution strategy has no  adverse effect on the financial stability of the Member  State(s) where the parent and other group entities are  established.  There is no such additional exemption  for EU branches of non-EU banks or in respect of the  Volcker-style prohibition. The rules (d) The EU Volcker-style rule prohibits proprietary trading  (which is said to be narrowly defined), investments in  AIFs save for closed-ended and unleveraged AIFs and  investments in other entities which themselves engage in  proprietary trading or investment in AIFs.  This rule is  considered in more detail at paragraphs 9 - 19 below. (e) Unlike Liikanen, the EU proposal does not make  separation of trading activities from retail and commercial  banking mandatory. Instead it provides that national  regulators must consider separation of trading activities  (which is very widely defined to include almost all activities  save those related to retail and commercial banking) from  retail and commercial banking depending on the risk each  individual core credit institution presents. The assessment  of risk will be carried out on the basis of metrics set out  in further legislation drafted by the European Banking  Authority (“EBA”) and the Commission. Where the risk  levels are exceeded and the national regulator determines  that there is a threat to financial stability then the national  regulator must impose a ring-fence on that particular  bank, unless the bank can demonstrate that the regulator’s  conclusions are not justified.  These provisions are  considered in more detail at paragraphs 20 - 39 below. Individual Member State derogations (f ) The Commission may grant individual deposit-taking  banks within Member States (not individual Member  States) a derogation from the ring-fencing requirements  set out in the proposal where national legislation is  equivalent to the EU legislation.  At the time of writing,  it appears that only the UK legislation is likely to meet  the requirements of equivalence but that may depend  on secondary legislation, which the UK has yet to adopt,  which will provide the technical detail of the Vickers rule. Timing (g) On the basis that the final text of the Regulation is  adopted by the European Parliament and Council by  June 2015, it is proposed that the provisions will be  phased in over a number of years: the Volcker-style  prohibition will come into effect on 1 January 2017 and  the provisions on ring-fencing will come into effect on 1  July 2018.4     mayer brown The Volcker-style prohibition 9. The introduction of a prohibition on proprietary  trading, investment in AIFs and certain other  entities is a major departure from the Liikanen  recommendations.  As noted above, none of  the EU Member States which have introduced  legislation to address bank structural reforms have  adopted a Volcker-style prohibition.  Although the  US legislation is clearly the influence behind the  provisions, the Commission has not taken exactly  the same approach as Volcker. Scope 10. The first thing to note is that, unlike the US rule, the  EU Volcker-style rule is not intended to apply to all  deposit-taking institutions.  It is intended to apply  to around 30 of the largest banks in the EU, those  being: (a) EU G-SIIs (and all their branches and  subsidiaries regardless of their location); and (b) banks that for 3 consecutive years have had total  assets of at least 30 billion euro and trading  assets of 70 billion euro or 10% of total assets.  The rule is intended to apply to the following  entities within category (b): (i) EU banks which are neither parent institutions  nor subsidiaries, plus all their branches  regardless of their location; (ii) EU parent institutions, plus all their  subsidiaries and branches regardless of their  location, when one of the group entities is an  EU banks; and (iii) EU branches of non-EU banks. The intention appears to be that the assessment of  total assets and trading assets is made at each  individual entity level, including at branch level 11 ,  rather than that an assessment should be made on a  consolidated basis.  It appears that the presence of  an EU bank within a group could bring entities  whose assets would not otherwise have to be  assessed within the scope of the EU prohibition.   The proposal contains some detail on how trading  activities are to be calculated and the EBA shall be  mandated to draft legislation to set out the exact  methodology.   11 As a strict matter of law, a branch does not have a legal identity  separate to its parent but, although the drafting is not wholly clear, it  does not appear to be the intention that branch assets are consolidated with those of its parent.   11. The EU prohibition will not apply to non-EU  subsidiaries of EU banks and to EU branches  of non-EU banks if the Commission deems the  relevant non-EU jurisdiction equivalent to the  EU regime.  In considering equivalence, however,  the Commission will look at whether the non-EU  jurisdiction has requirements equivalent to both  the Volcker-style and ring-fencing provisions.   It is questionable whether any jurisdiction has  requirements equivalent to both these provisions  in the draft EU legislation.  Like the Volcker rule,  the effect of the EU rule is to prevent the prohibited  activities being carried out within the banking  group in its entirety.  Thus bringing EU branches  of non-EU banks within the scope of the EU  prohibition is an attempt to bring the entire non-EU  banking group within scope, unless it has equivalent  legislation which is not currently likely.  Whereas  the objective is sensible – to create a level playing  field in the EU and not give non-EU banking groups  a competitive advantage – this raises questions and  could precipitate a clash with the US, particularly  if the EU rule imposes additional or different  prohibitions to the Volcker rule. 12. Without an equivalent decision, the draft EU  legislation provides that its Volcker-style prohibition  will apply to non-EU subsidiaries of EU banks, and  effectively to non-EU banking groups that have  an EU branch, within scope but such purported  extraterritorial application raises questions as  to its legality and enforcement.  In order for the  prohibition to be effective, it, like the US Volcker  prohibition, must apply throughout the whole  banking group.  How this will be applied to banking  groups headquartered outside the EU and, arguably,  subsidiaries established outside the EU is far from  clear, particularly if there are significant differences  with Volcker.  It is also worth noting that the UK  and the Council Legal Services have questioned  the purported extraterritorial application of  other recent pieces of EU legislation.  In its legal  challenge to the remuneration provisions of CRD  IV12 , the UK has alleged that, to the extent that the  cap on bankers’ bonuses is required to be applied  to employees of institutions outside the EU, it  infringes Article 3(5) of the Treaty on European  Union and the principle of territoriality  12 The Fourth Capital Requirement Directive which consists of a  directive (2013/36/EU) and a regulation (575/2013).mayer brown     5 found in customary international law13 .  A similar  issue is currently being debated in the context of  the financial transaction tax.  The UK has issued  proceedings arguing the decision permitting  the adoption of the tax by a subset of the EU is  unlawful because it authorises the adoption of an  FTT with extraterritorial effects for which there is  no justification in customary international law14 and the Council Legal Services has supported this  argument.  Thus the question of extraterritorial  application is likely to be a contentious issue in the  context of this dossier also. The prohibitions: proprietary trading 13. Chapter II of the proposal prohibits the largest  banks and entities within their group from carrying  out the following : (a) proprietary trading, which is defined as using  own capital or borrowed money to purchase,  sell or otherwise acquire or dispose of a  financial instrument or commodity “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 a result of actual or anticipated  client activity” through specifically dedicated  desks, units, divisions or individual traders; (b) with their own capital or borrowed money and  for the sole purpose of making a profit for own  account: (i) acquiring or retaining units or shares in  AIFs; (ii) investing in financial instruments the  performance of which is linked to shares or  units in AIFs; and (iii) holding any units or shares in an entity that  engages in proprietary trading or acquires  units or shares in AIFs. There are some very limited exemptions to both the  prohibitions at (a) and (b) above. 14. The Commission has indicated that it has learned  from the US experience of implementing the  Volcker rule.  Rather than adopting a wide  definition of proprietary trading with a number  of specific exclusions and exemptions, it claims to  have opted for a narrow definition with limited  13 Case C-507/13 United Kingdom of Great Britain and Northern Ireland v  European Parliament, Council of the European Union 14 Case C-209/13 United Kingdom of Great Britain and Northern Ireland v  Council of the European Union exclusions.  Careful analysis will be required to  assess both whether the definition is as narrow  as the Commission claims and whether the EU  approach achieves the same result as the more  detailed Volcker rule.   15. The narrow definition of proprietary trading is  intended to satisfy France and Germany who were  concerned to ensure that market-making was  not restricted.  It appears that both underwriting  market making and it would fall outwith the  definition of proprietary trading as it will be argued  that they are connected to client activity and does  not have the sole purpose of making a profit for the  bank.  Trading in EU sovereign debt is expressly  permitted 15 .  Entities can also trade in cash or  defined cash equivalent assets (money market  instruments) if they use their own capital as part  of their cash management processes but concerns  have been expressed that it does not seem that  securities transactions for the purpose of liquidity  management and riskless principal transactions  will be permitted.  Hedging for own purposes is  permitted but only as set out in the definition of  proprietary trading and so is limited to hedging as a  result of actual or anticipated client activity.   16. The differences in approach between the US and  EU rules are marked.  The US approach is more  sophisticated and consists of detailed and lengthy  rules setting out exclusions and exemptions  individually tailored to specific activities and  situations, as well as the conditions with which  there needs to be compliance in order to rely on  the exclusions and exemptions. Setting out so  much detail has been both challenging and time  consuming.  It has also led to some unforeseen,  and perhaps unintended, consequences.  The EU  approach is the diametric opposite: it consists  of about a page and a half of relevant rules.   Interestingly, there is no provision in the draft for  significant level 2 legislation to add further detail to  the high-level prohibitions set out in the proposal.   17. It could be said that the EU has taken a more  pragmatic approach, opting for a principle-based,  as opposed to the US rule-based, approach.  It could  be argued that a vast range of activities which could  otherwise  fall under the heading of ‘proprietary  trading’, including securities transactions for  15 The Commission may adopt further secondary legislation to exempt  trading in the sovereign debt of third countries which have equivalent  supervisory and regulatory requirements, exposures to which have  0% risk weighting under the Capital Requirements Regulation. 6     mayer brown the purpose of liquidity management, riskless  principal transactions and hedging activities, are  ultimately connected to actual or anticipated client  activity, even if indirectly.  The lack of specified  exemptions and exclusions in the EU rule could  be said to create uncertainty and the possibility  of regulatory arbitrage, as much will depend on  individual national regulator’s interpretation of the  provisions, and to require individual consideration  of each bank’s different activities but it does give  banks a degree of latitude and flexibility by not  setting out a finite set of permitted activities.  This  lack of certainty may make it difficult to draw exact  comparisons with the Volcker rule in the abstract  and in the absence of some indication as to how  broadly – or narrowly – the national regulators will  enforce the EU prohibitions.     The prohibitions: investment in AIFs and other specified  entities 18. In order to prevent evasion of the prohibition on  proprietary trading, the proposal also provides that  banks subject to the prohibition are prohibited from  using their own capital or borrowed money to invest  in or hold shares in AIFs (or certificates/derivatives  linked to such shares) or entities that themselves  engage in proprietary trading or invest in AIFs.  The  sole purpose of the banks’ activity must be to make  a profit for their own account: this provision may  give some additional flexibility.  Unleveraged and closed-ended AIFs established in the EU or, if not  established in the EU, marketed in the EU (arguably  mainly private equity funds), venture capital funds,  social entrepreneurship funds and the proposed  European Long Term Investment Funds are  exempted from this prohibition as they are regarded  as supporting the financing of the real economy.  The  Commission has stated that this provision is targeted  at hedge funds but, as drafted, it has a far wider  application as it would capture all leveraged and  open-ended AIFs (plus AIFs which are unleveraged  but not closed-ended) which could include, for  example, a real estate fund, a fine art or wine fund,  a retail investment fund or an investment company  which is established or marketed in the EU.  Banks  to which these EU prohibitions apply will be able to  continue providing banking/custody services to the  AIFs within the scope of the prohibition.   19. Although the second prohibition again appears to  have been mirrored on Volcker, there are disparities.   The potential exemption of private equity funds  from the prohibition is in direct contrast to the  Volcker rule which prohibits investment in private  equity and hedge funds.  There is no equivalent in  the EU rule to the Volcker prohibition on covered  transactions with covered funds with which the  banking group has other relationships.  Further, the  EU legislation does not, unlike earlier drafts and the  Volcker rule, prohibit the sponsorship of AIFs.  On  the other hand, the limited exclusions as opposed to  the myriad US exclusions and exemptions, means  that this investment prohibition appears to go  further than the Volcker rule in certain respects.   In addition, and in a broader fashion than the  Volcker rule, the EU rule has an indirect effect: it  prohibits investment in any entity that itself engages  in proprietary trading or invests in AIFs.  This  provision is exceptionally wide and its practical  effect is questionable: it is not clear whether the  Commission expects banks to carry out extensive  due diligence of all entities into which they have  already invested or into which they are considering  investing. These disparities will be of particular  concern to those banks – for example, EU branches  and subsidiaries of US banks and US branches  and subsidiaries of EU banks but also other third  country banks with a presence in both the EU and  US – which are likely to have to comply with both  Volcker and the EU prohibitions.      The ring-fencing provisions 20. The discretionary nature of the ring-fencing provisions  is another departure from the Liikanen Report.   Chapter III of the proposal only mandates national  regulators to review the trading activities of each  individual deposit-taking bank (termed “core credit  institution”) in the EU and decide whether those  activities create a threat to the financial stability  of the core credit institution (“CCI”) itself or to the  EU financial system as a whole 16 .  If so, the national  regulator must prohibit the CCI from carrying  out the specific risky trading activities, unless that  institution convinces the regulator that such a decision  is not justified.  Such a decision would not prevent  the identified trading activities being carried out  elsewhere within the banking group.     16 The drafting of Chapter III is currently ambiguous.  Whereas the  majority of Articles in Chapter III (for example Articles 10(2), 10 (3), 11  and 12) refer to the subject of a ring-fencing decision being the EU  core credit institution, Article 9(1) currently mandates the national  regulator to assess the trading activities of a far wider group of  entities, including the EU parent and all branches and subsidiaries in a  group which contains a core credit institution, as well as EU branches  of all credit institutions established in third countries.mayer brown     7 Scope 21. A significant difference between the EU rules on  ring-fencing and the UK legislation is that the EU  rules are generally intended to apply to all banks that  take deposits eligible under the Deposit Guarantee  Scheme as provided for in the Deposit Guarantee  Schemes Directive 17 .  This includes all deposits  held by individuals and small, medium and large  businesses but not financial institutions and public  authorities.  The UK approach has been to apply its  ring-fencing legislation to deposit-taking banks but  it intends to exempt the deposits of specified types of  depositors in secondary legislation, as well as provide  for a de minimis exemption.  The draft secondary  legislation provides that deposits of high net worth  individuals who have chosen to deposit outside  the ring-fence, deposits of large organisations and  deposits of other financial institutions are not ‘core  deposits’.  The EU approach is, therefore, to protect  a wider range of deposits than the UK which may  cause a problem when the UK seeks to apply for a  derogation – see paragraphs 35 - 39 below. 22. As with the Volcker-style prohibitions, these  provisions have extraterritorial effect.  In the  same way as set out at paragraph 10 above, they  are intended to apply to an EU parent, and all  its branches and subsidiaries regardless of their  location, of a CCI, as well as to an EU branch of a  non-EU bank 18 .  Thus the same issues as described  in paragraph 11 and 12 above apply.   Non-EU  subsidiaries of EU banks and EU branches of  non-EU banks will be exempt from the ringfencing provisions if the Commission has made  an equivalence decision regarding the nonEU jurisdiction: we have already commented  (at paragraph 0 above) on the likelihood of an  equivalence decision given that it demands  equivalence as to Chapter II (the EU Volcker-style  prohibition) and Chapter III (the ring-fencing  provisions).  There is an additional option, however,  for non-EU subsidiaries of EU banks: a national  regulator may exempt the subsidiary if it is satisfied  that there is a group-level resolution strategy agreed  between the EU group level resolution authority  and the third country authority and that strategy for  the subsidiary does not have an adverse effect on the  17 Directive 94/19/EC. 18 There is no requirement for the branch or the non-EU bank to fall  within the definition of a CCI.  Thus it appears that EU branches of a  non-EU bank may be within the scope of this provision when they  would not be (because they would not fall within the definition of a  CCI) if they were established in the EU as a subsidiary. financial stability of the Member State(s) where the  EU parent and other group entities are established.   This exemption, therefore, necessitates the  cooperation of the relevant EU resolution authority,  although it does not make clear which authority  ought to make the discretionary decision as to the  effectiveness of the resolution strategy.   The potential ring-fencing of certain trading activities 23. National regulators appear to be given a significant  degree of discretion in Chapter III.  This does  raise the issue of inconsistent approaches 19  but the  discretion conferred on regulators is not as wide as  it initially appears.  National regulators are required  to assess the trading activities of CCIs.  A wide  definition of “trading activities” is given so that it  essentially means all activities other than taking  deposits eligible for deposit insurance, lending,  retail payment services and a number of other retail  and commercial banking activities.  Trading in EU  sovereign debt is exempt from the obligation to  review (and thus the power to separate) and the  Commission has the same power as described in  footnote 15 to adopt further secondary legislation  to exempt trading in the sovereign debt of third  countries.  The regulators are directed to give  specific attention to market-making (as it is closely  related to proprietary trading), investing and  sponsoring securitisations and trading in derivatives  other than those that are specifically permitted for  the purpose of prudent risk management (as the  Commission believes that these latter activities  played a key role during the financial crisis).   24. The national regulator must carry out its assessment  of individual CCIs at least yearly and must use  prescribed metrics when doing so.  These metrics are: (a) relative size and leverage of trading assets; (b) relative levels of counterparty credit risk and  market risk; (c) relative complexity of trading derivatives; (d) relative profitability of trading income; (e) interconnectedness; and (f ) credit and liquidity risk arising from commitments  and guarantees provided by the CCI. 19 Although the ECB will assume its full supervisory tasks from 4  November 2014 and would thus be the relevant prudential regulator  for the purposes of this proposal, national regulators will be  responsible for the direct supervision of “less significant” banks and  will assist the ECB in the on-going day-to-day supervision of  “significant supervised” banks.  As a result, the possibility of  inconsistent national approaches must remain.8     mayer brown The EBA will draft secondary legislation specifying  how the metrics should be measured, giving further  detail of the metrics and setting out a methodology  for consistent measurement and application of the  metrics.  The Commission will also specify a limit  for each metric above which the risk level of the  relevant trading activity is deemed “individually  significant” and set out the conditions which will  trigger the exercise of the national regulator’s power  to separate.  Finally, the Commission will also draft  legislation specifying certain types of securitisations  which are not considered a threat to the financial  stability of the CCI or the EU as a whole.  It is,  therefore, important that the proposal contains  metrics which accurately measure the risks associated with trading activities and also takes into  account risk mitigation techniques.  The proposal  does not, however, currently have regard to risk  mitigation techniques such as netting, offsetting,  diversification and portfolio compression nor  prudent risk management and hedging techniques.   It is also important that the Commission sets the  limits and conditions at the correct level as these  will determine the application of ring-fencing. 25. When the national regulator has carried out its  assessment and concludes that the limits and  conditions set out in the secondary legislation have  been surpassed, a threat to the financial stability  of the CCI or the financial system of the EU is  deemed to exist and the regulator must commence  the process whereby the CCI would be prohibited  from carrying out the trading activities in respect of  which the limits and conditions have been exceeded.   Indeed even where the limits and conditions are not  exceeded, the national regulator may commence to  consider such a prohibition if its assessment leads  it to conclude that any trading activity, save trading  in those derivatives that are specifically permitted  for the purpose of prudent risk management,  poses the threat outlined above.  The regulator  must consult with the EBA and communicate its  conclusions to the relevant CCI, which is given 2  months to comment.  Unless the CCI demonstrates  that the conclusions are not justified, the national  regulator shall prohibit the CCI from carrying out  the specified trading activities.   26. The drafting of the provisions gives the national  regulators little discretion to do other than make  a decision to ring-fence the relevant trading  activities away from the CCI when the limits and  conditions set out in the secondary legislation  are surpassed.  The regulators do, however,  appear to have considerable discretion as to  whether they are satisfied by the representations  of the CCI concerned.  This could lead to further  inconsistencies of approach across different  jurisdictions and even across banking groups.  Once  a decision to ring-fence any trading activity has  been made by a national regulator, however, further  provisions are triggered which mean that any CCI  which has been subject to a ring-fencing decision,  regardless of which or how many trading activities  are ring-fenced or the extent to which the limits  and conditions have been exceeded, can only use or  sell derivatives to manage its own risk or to provide  risk management services to customers as set out  in the proposal.  These provisions seem to render  a national regulator’s decision to ring-fence only  certain trading activities nugatory. 27. The proposal provides that a CCI that has been  subject to a ring-fencing decision by a national  regulator may use only credit, FX and interest  rate derivatives 20  which are eligible for clearing to  hedge its overall balance sheet risk.  This seems  to link the derivatives that a ring-fenced CCI can  use or sell to ESMA’s decision under EMIR on  which class of derivatives are subject to the clearing  obligation.  Given that ESMA’s decision cannot be  anticipated and that it is not clear that the clearing  obligation will apply to any FX derivatives, this  cross-reference appears peculiar.  The CCI must  also demonstrate to the national regulator that  such hedging demonstrably reduces or significantly  mitigates specific identifiable risks of its individual  or aggregated positions.  This wording mirrors the  wording found in the Volcker rule and does not per  se prohibit portfolio hedging.   28. A CCI that has been subject to a ring-fencing  decision is permitted to use a slightly wider range  of derivatives when selling them to clients for their  risk management purposes.  It can use credit,  FX, interest rate and commodities (including  emissions allowances) derivatives (but again only  those eligible for clearing) provided that the sole  purpose of the sale is to hedge credit, FX, interest  rate or commodity risk and subject to caps on the  resulting position risk which the Commission will  set out in further secondary legislation.  There  are also restrictions on the range of types of ‘real  economy’ clients that could benefit from such risk  management services. 20The Commission may adopt secondary legislation adding to these  classes of derivatives, including those that are not cleared.  mayer brown     9 29. The intention behind these provisions is not entirely  clear but the drafting provides that using derivatives  for their own risk management purposes and selling  derivatives to clients for their risk management  purposes are the only trading activities that can  be carried out by a CCI subject to a ring-fencing  decision.  Article 11(1) provides that “A core credit  institution that has been subject to a [ring-fencing]  decision ... may carry out trading activities to the  extent that the purpose is limited to only prudently  managing its capital, liquidity and funding.”  The  following article, which provides for the provision  of risk management services to clients, is arguably  inconsistent with the word “only” in Article 11(1) but  it does appear that CCIs which have been subject  to a ring-fencing decision cannot engage in any  other trading activities save those specifically set out  in Articles 11 and 12.  For the avoidance of doubt,  this would mean that those CCIs could not engage  in market-making, underwriting, securitisation  activities and trading in derivatives other than those  set out in Articles 11 and 12 of the proposal.  As  a result, irrespective of the decision taken by the  national regulator who may decide to separate only  certain trading activities, the effect of Article 11(1)  is to prevent the CCI subject to the ring-fencing  decision from carrying out any trading activity other  than the use of certain derivatives for the specified  risk management purposes.  This restriction  is consistent with the UK approach to ringfencing, which prohibits the RFB from dealing in  investments as principal which means that it cannot  engage in market-making, underwriting and most  of the derivative and trading activity currently being  carried out by wholesale and investment banks.   30. The synergies with the UK legislation become even  more apparent when consideration is given to the  UK draft legislation published for consultation in  July 2013 that permits RFBs to deal in derivatives  to hedge their own balance sheet risks and to sell  simple derivatives as risk management products  to customers subject to safeguards.  It ought to  be noted, however, that the UK draft legislation  includes additional exemptions from the excluded  activity of dealing in investments as principal: these  permit own asset securitisation and acquiring and  selling shares in companies through debt-equity  swaps.  The EU draft legislation does not currently  go so far.  31. France and Germany have not taken the same  approach as the UK, however, but have focussed  more specifically on prohibiting their RFBs from  proprietary trading, trading for own account in  certain circumstances and lending to certain AIFs.  The German law also provides for a number of  exceptions, including hedging and market making.   Rules on ring-fencing 32. Unlike the Volcker-style prohibition, the effect of a  ring-fencing decision does not prevent the trading  activities that have been separated being carried  out elsewhere in the banking group.  Under the  EU proposal, the separated trading activities may  be carried out by a trading entity which is legally,  economically and operationally separate from the  CCI.  The proposal contains provisions to achieve  this level of separation including the following: (a) a group which contains CCIs and trading  entities shall be structured so that on a subconsolidated basis 2 distinct sub-groups are  created, only one of which contains CCIs; (b) CCIs may only hold capital instruments or  voting rights in a trading entity in prescribed  circumstances and with the consent of the  national regulator; (c) CCIs and trading entities shall issue their own  debt, provided this is consistent with the group’s  resolution strategy; (d) contracts between CCIs and trading entities  shall be agreed on a third party basis; (e) requirements regarding members of the  management bodies of both types of entities; (f ) the names of CCIs and trading entities shall  make clear whether they are CCIs or trading  entities; (g) limits on the intra-group exposure a CCI has to  any entity outside its sub-group; and (h) limits on the extra-group exposure a CCI can  have to financial entities. The proposal also provides that the trading entity  may not carry out certain activities, those being  taking deposits eligible for protection under deposit  guarantee schemes and providing retail payment  services as defined in the Payment Services  Directive 21 .  It appears that, if an EU branch of a  non-EU banking group is within the scope of the EU  legislation, these provisions are intended to apply to  the non-EU banking group.   21 Directive 2007/64/EC.10     mayer brown 33. When a CCI has been subject to a ring-fencing  decision, or an entity has decided to separate  trading activities on its own initiative, it or its  EU parent must submit a separation plan to the  national regulator within 6 months of the ringfencing decision or at the start of the national  regulator’s assessment period.  The national  regulator has 6 months to approve the plan or  require changes to be made.  If a separation plan is  not submitted, the national regulator shall adopt its  own plan. 34. When consideration is given to the existing EU  domestic legislation, the UK requirements on ringfencing are most consistent with these provisions.   The Banking Reform Act 2013 is a framework  piece of legislation which sets out the key political  choices which will give effect to Vickers but much  of the technical detail will be found in subsequent  secondary legislation and regulatory rules.  Thus  the Act requires the PRA to make rules governing  the degree of separation between the RFB and the  rest of the group, including rules to limit the shares  and voting powers a RFB may have in another  company, to ensure independence of decisionmaking in the RFB, to ensure the RFB does not rely  on the provision of capital and liquidity resources  of other members of the group, to restrict payments  the RFB may make to other group members and to  enter contracts with other members of the group  on an arm’s length basis.  In addition, the UK  government has published draft legislation which  prohibits RFBs having exposures to certain financial  institutions.   Derogations from the ring-fencing provisions 35. The EU proposal provides for the possibility of the  Commission granting a derogation from the ringfencing provisions at the request of a Member State  which had in place on 29 January 2014 primary  legislation which fulfils the criteria set out on the  proposal.  This means that only the UK, France  and Germany would qualify for the derogation as  they are the only EU Member States which have  already adopted legislation.  The Belgian coalition  government has, however, committed to finalising  its legislation on bank structural reform before the  elections in May 2014 and other Member States  may want an opportunity to introduce their own  legislation.  The Commission’s choice of cut off date  may, therefore, be challenged. 36. The EU proposal provides that, in order to  qualify for a derogation, the aim of the domestic  legislation, its material scope and provisions  referring to the legal, economic and governance  separation of deposit-taking entities must have an  equivalent effect to the provisions of the draft EU  legislation.  For reasons set out above, it appears  that the UK legislation is most likely to satisfy  these requirements but, also as pointed out above,  not all of the UK’s draft secondary legislation is  consistent with the EU provisions.  In addition  to the exemptions mentioned at paragraph 30  above which permit RFBs to engage in own asset  securitisation and to acquire and sell shares in  companies through debt-equity swaps, the UK’s  draft legislation also provides for a de minimis  threshold below which institutions will be exempted  from ring-fencing and exemptions which will  permit the deposits of larger organisations and high  net worth individuals to be held outside the ringfence 22 .  It is not clear whether these exemptions  would prevent the UK’s legislation meeting the  criteria necessary for a derogation.  There is thus  a risk that the UK will have to change its draft  secondary legislation if it wishes to benefit from the  derogation.  37. Even within France and Germany, it is considered  that the French and German domestic legislation  is less likely than the UK’s legislation to qualify  for the derogation as the scope of the French and  German ring-fencing provisions is less extensive  than the EU proposal. The French banking market  is already expressing concern at the possibility that  UK banks may be the only banks which benefit from  a derogation. 38. There are 2 other points of controversy as regards  the derogation.  First, it appears the intention of the  Commission that, despite the fact that a Member  State must apply for it, any derogation should  be granted on an individual deposit-taking bank  basis not on a jurisdictional basis.  Article 21(1)  provides that a derogation may be granted “to a  credit institution taking deposits from individuals  and SMEs that are subject to national primary  legislation adopted before 29 January 2014  when the national legislation complies with the”  requirements set out within the Article.   22 The draft Order provides that banks whose ‘core deposits’ do not  exceed £25 billion will not be RFBs.  It also provides that deposits of  high net worth individuals who have chosen to deposit outside the  ring-fence, deposits of large organisations and deposits of other  financial institutions are not core deposits.mayer brown     11 Article 21(2) envisages a derogation being  withdrawn from a bank after the Commission  has decided that the national legislation is not  incompatible because that legislation no longer  applies to a particular credit institution.  Taking the  UK’s legislation as an example and supposing that  the exemptions referred to in the above paragraph  are maintained, it is not clear whether a deposittaking bank which takes advantage of the proposed  de minimis exemption, for example, would be  regarded as “subject to national primary legislation”  so as to qualify for the derogation.  It would be  argued, of course, that such a bank is subject to the  Banking Reform Act and is merely relying upon  an exemption granted in accordance with it but, if  that argument is valid, it is not clear why it would  be necessary for derogations to be granted on an  individual bank basis and not to all banks within a  jurisdiction which has adopted national legislation  having equivalent effect: the provision for a  derogation on an individual bank basis presupposes  that different decisions can be reached in respect  of different banks within the same jurisdiction.   Subsequent drafting does suggest that a Member  State can apply for derogations in respect of a  number of deposit-taking banks at the same time  and that one single derogation would be granted.   Further, if domestic legislation is to be regarded  as equivalent to the EU legislation, it would seem  inconsistent for a decision to be reached that it is  only equivalent for certain banks but the drafting  and intent requires clarification to ensure certainty. 39. The second point of controversy is that the draft  EU legislation gives the Commission a discretion to  decide whether or not to grant the derogation.  It is  for the Commission to decide whether the domestic  legislation is compatible with the EU legislation and  it also appears that the Commission is required to  consider the potential impact of a derogation on the  financial stability of the EU and the functioning of  the internal market.  Conferring such a discretion  on the Commission will raise political and legal  questions concerning whether and how the  Commission can be given such a power.   40. The effect of the provision on derogations is that an  EU cross-border banking group with a number of  CCIs in different Member States (or potentially a  number of CCIs in the same Member State) could  obtain a derogation for some of those CCIs but  could still be required to develop a separation plan  that applies across its group if a derogation is not  granted to all its CCIs. What happens next? 41. The proposal must be adopted by the European  Parliament and Council under the ordinary  legislative procedure.  Under this procedure the  Council and the Parliament are placed on an equal  footing as the co-legislature. Both institutions will  consider the Commission’s proposed text and reach  an internal agreement as to a version that they can  accept.  Once they have reached this agreement,  they and the Commission enter a process known as  trialogues in an attempt to reach an agreed text for  adoption as legislation.  The agreed text must be  adopted by a qualified majority of the Council and a  simple majority of the Parliament. 42. The process for adopting EU legislation is thus  both complex and lengthy.  France, Germany and  Italy have already made clear their objection to  the proposal as a whole and the UK is likely to be  concerned both at the Volcker-style prohibition  it contains and the process necessary to obtain a  derogation from the ring-fencing provisions.  Given  these concerns, significant amendments to the  proposal, in Council at least, are to be expected.  It  is less clear how the new Parliament will view the  proposal. 43. Agreement on a final version of the legislation is  not expected before June 2015 and, on this basis,  the Commission’s proposed timetable would see the  prohibition on proprietary trading applying from  1 January 2017 and the provisions on separation of  the trading activity applying from 1 July 2018.  This  timetable is not dissimilar to that which is expected  to apply in the UK but is significantly behind the  Volcker timetable: the Volcker conformance period  ends on 21 July 2015 and banking entities must  make good faith efforts to be in compliance by that  date.   44.When considering the operational changes  required by Volcker, Vickers, the French law on  the separation and regulation of banking activities  and the Trennbankengesetz, it would be prudent  to bear in mind the likelihood of additional EU  requirements, although there is as yet no certainty  as to exactly what those requirements may be.  In  addition, banks which expect to be within the scope  of the EU’s proposal should commence lobbying  their own governments, the Commission and,  after elections, the new European Parliament if,  as appears likely, they are concerned by the EU  proposal.  0416ldr February 2014 Mayer Brown is a global legal services organisation advising many of the world’s largest companies, including a significant portion of the  Fortune 100, FTSE 100, DAX and Hang Seng Index companies and more than half of the world’s largest banks. Our legal services include  banking and finance; corporate and securities; litigation and dispute resolution; antitrust and competition; US Supreme Court and appellate  matters; employment and benefits; environmental; financial services regulatory & enforcement; government and global trade; intellectual  property; real estate; tax; restructuring, bankruptcy and insolvency; and wealth management. OFFICE LOCATIONS AMERICAS:  Charlotte,  Chicago,  Houston,  Los  Angeles,  New  York,  Palo  Alto,  Washing ton  DC ASIA: Bangkok, Beijing, Guangzhou, Hanoi, Ho Chi Minh City, Hong Kong, Shanghai, Singapore EUROPE: Brussels, Düsseldorf, Frankfurt, London, Paris TAUIL & CHEQUER ADVOGADOS in association with Mayer Brown LLP: São Paulo, Rio de Janeiro Please visit our website for comprehensive contact information for all Mayer Brown offices. www.mayerbrown.com Mayer Brown is a global legal services provider comprising legal practices that are separate entities (the “Mayer Brown Practices”).  The Mayer Brown Practices are: Mayer Brown LLP and  Mayer Brown Europe–Brussels LLP, both limited liability partnerships established in Illinois USA; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales  (authorised and regulated by the Solicitors Regulation Authority and registered in England and Wales number OC 303359); Mayer Brown, a SELAS established in France; Mayer Brown JSM, a Hong  Kong partnership and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. “Mayer Brown” and the Mayer Brown logo are  the trademarks of the Mayer Brown Practices in their respective jurisdictions. © 2014. The Mayer Brown Practices. All rights reserved.  45. As currently drafted the EU proposal is not  consistent with any of the existing domestic  legislation on bank structural reform, in the EU  or in the US.  The possibility of duplicative and  conflicting requirements will be a concern for  banks which are active cross-border as it raises  the question whether a single banking model can  be designed that complies with the legislative  requirements in all relevant jurisdictions.  If a  single model is not possible, the cost of banking,  and thus bank lending, could be increased and this  will impact on the real economy and EU’s economic  recovery.  The EU’s legislative proposal could,  therefore, adversely affect the very people who it  is designed to protect.  It is also hard to see how  the EU’s proposal addresses the problem that the  Commission itself identified of inconsistent national  legislation.  The EU legislation could itself increase  the possibility of distortions of capital movements  and investment decisions, make the structure and  operation of cross-border banks more complex and  increase fragmentation.  In these circumstances, the  necessity for this legislation may well be questioned:  is EU legislation for bank structural reform  necessary and proportionate in addition to banking  union, CRD IV, the soon-to-be-adopted bank  recovery and resolution directive and the domestic  legislation already in place?  A