Following the successful passage of the US’ financial regulatory reform bill through the Senate last week, the European Commission has proposed that each of the EU’s member states should introduce a levy on banks to establish a dedicated bank resolution fund. The key aim of the proposal – which also underpinned the US Senate’s recent financial regulation reform bill and is shared by the G20 – is that “taxpayers’ money should not be used again to cover bank losses”. The Commission believes that this aim can be achieved in two complementary ways: by reducing the probability of a bank failure in the first place (to which end the Basel Committee will release new capital and liquidity requirements, as well as other measures, in December); and by ensuring that, in the event of a bank failure, “sufficient resources are available for orderly and timely resolution”. It is the second objective that the Commission’s proposal aims to address.

The key features of the Commission’s proposal are that:

- A levy should be imposed on banks to establish an ex-ante (i.e. pre-emptive) crisis resolution fund. The size of the fund each country should build up has not yet been decided, but the Commission notes that the IMF recommended in April that funds raised should equate to 2-4% of GDP.

- It must be made clear to shareholders and creditors (excluding insured depositors) that they must be the first to face the consequences of a bank failure and, crucially, that resolution funds must not be used to bail out a failing bank. Their sole purpose should be to facilitate an orderly failure.

- The kind of measures that a resolution fund might be expected to take in the event of a bank failure include providing bridge financing to the distressed institution, financing a total or partial transfer of assets and/or liabilities from a failing bank to a third party, financing a good bank/bad bank split, and covering administrative, legal and advisory costs.

- The Commission believes that, in principle, its aims would best be met by pooling resources into a single pan-EU fund. However, it recognises that this is not possible without an integrated EU crisis management framework. It is therefore recommending the establishment of a harmonised network of national funds linked to a set of coordinated national crisis management arrangements. However, this would be just the first step. The Commission would like these arrangements to be reviewed by 2014 with the aim of creating a pan-EU crisis management and supervisory mechanism.

The Commission will put its proposals to the European Council meeting on 17 June 2010, ask the Council to endorse them and invite the EU’s representatives in the G20 to advocate them in forthcoming meetings. In October 2010, the Commission will set out broader and more detailed plans for the development of a new crisis management framework, which should specifically include tools to ensure that creditors contribute to bank failure resolutions at an early stage. The Commission plans to adopt legislative proposals for crisis management and resolution funds in early 2011.

What do these proposals mean for European banks? That depends on the details of the levy’s implementation, which are yet to be agreed. How much money would the resolution funds seek to raise? On what basis would banks be taxed? Would the money raised be channelled into a bespoke resolution fund or be allocated for general government spending? Is an ex-ante fund a good idea, or would it lead to moral hazard?

Plenty of disagreement remains on each point. In terms of how much money should be raised, current proposals vary from €1bn per year in Germany to $90bn over ten years in the US. The UK’s Liberal Democrats’ manifesto suggested that up to £3bn per year could be raised from British banks, while Sweden plans to raise 2.5% of GDP over the next fifteen years. There has also been little agreement on how to tax the banks, with the US and Swedish models targeting wholesale liabilities, while some UK politicians and the IMF incline towards taxing profits and remuneration. Size is another measure on which banks could be charged. But the immediate political discussion following the Commission’s proposal focused on whether funds raised by the levy should be earmarked specifically for future crises. The UK and French governments have made it clear that they would prefer the funds to be treated as general government revenue, to be spent in whatever way they see fit. They also believe that this would neutralise the moral hazard issue, as banks would not feel that there was a ready pool of money waiting to prop them up following any future crises.

Plenty of issues therefore need to be ironed out. However, we draw two key conclusions from the Commission’s announcement. First, some sort of levy on banks, which had already appeared highly likely following tax proposals in the US, the UK, Germany and Sweden, now seems inevitable. Second, any levy would not seriously impact the credit quality of Europe’s major lenders. For instance, to put possible annual levies of €1bn and £3bn on German and British banks in perspective, we would point out that Deutsche Bank and Barclays alone made net profits of €5bn and £9.4bn respectively in 2009. So any European bank levy should be comfortably manageable. There is no doubt that news of the Commission’s announcement has made headlines across the continent. However, we remain convinced that the measures that will have the greatest impact on the financial industry will be those to be announced by the Basel Committee in December.

Nick Smallwood - Credit Analyst

Disclaimer:

This research report is produced by Daiwa Securities Capital Markets Co., Ltd and/or its affiliates and is distributed by Daiwa Capital Markets Europe Limited in the European Union, Iceland, Liechtenstein, Norway and Switzerland. Daiwa Capital Markets Europe Limited is authorised and regulated by The Financial Services Authority and is a member of the London Stock Exchange, Chi-X, Eurex and NYSE Liffe. Daiwa Capital Markets Europe Limited and its affiliates may, from time to time, to the extent permitted by law, participate or invest in other financing transactions with the issuers of the securities referred to herein (the “Securities”), perform services for or solicit business from such issuers, and/or have a position or effect transactions in the Securities or options thereof and/or may have acted as an underwriter during the past twelve months for the issuer of such securities. In addition, employees of Daiwa Capital Markets Europe Limited and its affiliates may have positions and effect transactions in such securities or options and may serve as Directors of such issuers. Daiwa Capital Markets Europe Limited may, to the extent permitted by applicable UK law and other applicable law or regulation, effect transactions in the Securities before this material is published to recipients.

This publication is intended for investors who are not Retail Clients in the United Kingdom within the meaning of the Rules of the FSA and should not therefore be distributed to such Retail Clients in the United Kingdom. Should you enter into investment business with Daiwa Capital Markets Europe’s affiliates outside the United Kingdom, we are obliged to advise that the protection afforded by the United Kingdom regulatory system may not apply; in particular, the benefits of the Financial Services Compensation Scheme may not be available.

Daiwa Capital Markets Europe Limited has in place organisational arrangements for the prevention and avoidance of conflicts of interest. Our conflict management policy is available at http://www.uk.daiwacm.com/about-us/corporate-governance-and-regulatory. Regulatory disclosures of investment banking relationships are available at http://www.us.daiwacm.com/.

Investment Banking Relationships; Daiwa Capital Markets Europe Limited or an affiliate has managed or co-managed a public offering of securities in the past 12 months, or has received compensation for investment banking services in the past 12 months: no exceptions.

The statements in the preceding paragraphs are made as of May 2010.

For more details, please contact:

Nick Smallwood, Research Division
Daiwa Capital Markets Europe Limited
5 King William Street, London, EC4N 7AX

+44 (0)20 7597 8383

nicholas.smallwood@uk.daiwacm.com

For up to date Research analysis, see our blog site here.

Sign up for news/events alerts