Iain Morse asks whether European banking reforms will have an adverse impact on securities services providers

It may not be obvious that the UK Vickers Report will have many consequences for securities services in the UK or Europe. Due for implementation in 2019, the report recommends the effective separation of clearing and investment banking in UK domiciled banks. The only UK bank with substantial domestic custody business, HSBC, is already well positioned to meet these recommendations. Otherwise, the market is dominated by a group of US originated custodian banks.

But what about Europe? Michel Barnier, the EU commissioner for the internal market, has formed a ‘high level’ group of experts to investigate structural reform of Europe’s banking industry. The group has been mandated to determine whether, on top of the regulatory changes in the pipeline, further ‘structural reforms’ would ‘strengthen financial stability and improve efficiency and consumer protection.’

The group has started work; Erkki Liikanen, governor of the Bank of Finland, and previously a European Commissioner, is chairman. Measures to be considered include “prohibiting banks from carrying out some activities or requiring banks to put certain activities (eg, taking deposits from retail customers) into separate legal entities”, according to an EU communiqué. Regulation of this kind is already controversal in the US, where banks have criticised plans by regulators to ban commercial banks from proprietary trading, arguing that the Volcker rule will increase risks and costs for investors.

Barnier has stated that the Volcker rule will be considered by Liikanen’s group. It is due to report by the end of summer 2012. “This report may come to similar conclusions to those of the Vickers Report,” says David Strachan, former director of financial stability at the UK Financial Services Authority (FSA), now co-head of the Deloitte centre for regulatory strategy. “There are two agendas at work here, the G20 agenda is to strengthen balance sheets, while the European agenda is that checks have to be placed on the extent of financial markets freedom.”

The continental European securities services industry is far from being as efficient as those of the US or the UK. European depositary and custody services are often run within banking and wider financial services groups on captive assets. A large number of small depo-banks also survive, not to mention practices such as private and local investment banks offering in-house custody to private clients, forms of business little known in the US and UK. If Liikanen follows Vickers, the consequences will be far greater in Europe than in the UK .

The notion of ring-fencing sits at the core of the Vickers Report. The emphasis is not on ring fencing ‘casino banking’ but protecting retail and SME deposit-taking in separate, financially independent legal entities, subject to higher prudential requirements. The principles behind this fence are to first mandate services for encirclement; these comprise retail and SME deposits, overdrafts and other forms of credit. Next there are services that are to be excluded. Finally, activities within the ring fence that would not otherwise be permitted are allowed if ancillary to the provision of mandated, fenced-in services.

We can expect the term ‘ancillary’ to be the subject of much debate. It certainly excludes proprietary trading. Many desks have already closed; banks like the troubled RBS are withdrawing from these activities. Meanwhile, the aim of the report is to isolate and insulate those banking activities where continuous provision is vital to the economy. Activities that are deemed incidental to this core and might threaten its continuity are due to be moved outside the ring fence.

The main motives have nothing to do with the improvement of investment banking, or securities servicing. They are intended to make it easier to deal with banks in crisis and make it easier to decide whether other banks can be allowed to fail, in both cases without the provision of taxpayer funded support. In addition, after the massive cost of recent bank bailouts, to allow the curtailment of government guarantees and thereby the risk to public finances.

To this end, the report places emphasis on those services prohibited to banks within the ring fence. Prohibited services include making it harder and/or more costly to ‘resolve’ the ring-fenced bank and those which directly increase the exposure of the ring-fenced bank to global financial markets. Another criteria for prohibition is that services are not integral to the provision of payment services to customers or the direct intermediation of funds between savers and borrowers. Finally, there is a prohibition on any services which threaten the objectives of the ring fenced bank. There is going to be much debate over what all this means and how far the definition of words like ‘integral’ or ‘threaten’ can be stretched.

One key area of risk likely to be prohibited is that of acting as, or being exposed to any, counterparty risk. The UK government has also responded to Vickers with the intention to undertake further analysis of the characteristics of any entities potentially acting as counterparties to ring-fenced banks. They have also promised to look in detail at the characteristics of products prohibited by reference to their function. Here derivatives and trading book assets get a special mention; it seems likely that ‘simple’ contracts will be allowed within the fence insofar as they are integral to core functions but not otherwise.

The report also recommends change to the capital reserves of banks, At present a universal bank will have 3.5% non-equity capital, a 5% equity buffer, and 4.5% Basel III hard equity minimum. Post Vickers, a ring-fenced bank would add a layer of long-term unsecured debt equal to at least 3.5% with the equity buffer increasing from 5% to 5.5%. Banks outside the ring fence would have a substantially increased layer of long term unsecured debt, twice that of a ring fenced bank at 7%, with the other bands at 3.5%, 5% and 4.8%.

“This will put up costs as extra capital is required. If the costs of non-UK banks do not rise then Vickers will raise costs for UK banks, particularly those banks outside the fence,” notes Andrew Gray, banking partner at PWC. On the other hand, it can be argued that UK banks with less risk on their balance sheets will find capital raising less expensive.

If the European Commission were to adopt similar recommendations, a ring fence and capital requirements that would prevent local custodians from being embedded in universal banks, this would change the entire environment. “Custody and depositary services are widely dispersed in Europe. Vickers in Europe would change the game, sparking off further merger and consolidation,” adds Gray.

Elsewhere, we have yet to see the final version of the Volcker Rule, intended to weaken the link between clearing and investment banks in the US. “Whether and how far this constrains US bank activities remains to be seen. This is an important part of the jigsaw,” adds Strachan.