A new set of proposals aimed at banks operating in the EU could potentially hit Wall Street banks and add pressure on balance sheets.
The European Commission has unveiled a new set of proposals aimed at banks operating in the European Union (EU) that could potentially add further pressure on balance sheets that are already facing a challenging environment of low interest rates.
The key aspect of the proposed reforms – released Wednesday morning - is the implementation of a caveat that is designed to deal with the "too-big-to-fail" problem at an international level. Known as the total loss-absorbing capacity (TLAC), this part of the proposals is expected to tackle risks linked to globally and systemically important banks.
It would require banks to hold sufficient amounts of readily liquid capital in order to safeguard financial stability and public funds. The rules could affect big Wall Street banks as well as other non-EU banks which have operations in the region.
In a speech earlier this month, European Commission Vice President Valdis Dombrovskis said up to 13 banking groups would have to comply with the TLAC standard in the EU. This could have a big impact on U.S. banks that top the list of Globally Systemically Important Banks (G-SIBs). Earlier this week, Citi joined JP Morgan at the top of global regulators' list of systemically important banks replacing HSBC. Under the proposals, these U.S. banks operating in the region would have to hold 16 percent of risk-weighted assets (RWAs) from 2019 to help preserve financial stability.
This could, however, become more challenging as the U.K.'s Brexit negotiations with the European Union progress. Banks, in the future, may be expected to hold additional liquidity pools both for operating in the U.K. and in the European Union once Britain formally leaves the EU.
Banks across the globe are operating in a tough environment with low or even negative interest rates adding pressure on their profitability. Meanwhile, the uncertainty around Brexit is impacting long-term strategies for financial institutions operating in the EU.
The comprehensive set of plans, aimed at further strengthening the resilience of EU banks, builds on existing EU banking rules by adding a few extra levels of regulatory requirements to ensure banks are not dependent on taxpayers' money in times of crisis. The Commission is the legislative arm of the EU and, as with most proposals, it needs to be approved by heads of state from each member country and could be ratified by the European Parliament.
"Europe needs a strong and diverse banking sector to finance the economy. We need bank lending for companies to invest, remain competitive and sell into bigger markets and for households to plan ahead. Today, we have put forward new risk reduction proposals that build on the agreed global standards while taking into account the specificities of the European banking sector," Dombrovskis, responsible for financial stability, financial services and the capital markets union, said in a press statement on Wednesday.
The proposal aims to amend several existing pieces of regulation including the Capital Requirements Regulation (CRR) and Directive (CRD), which were adopted in 2013 and spell out the required capital that financial institutions should hold in their reserves. It also builds on the Banking Recovery and Resolution Directive (BRRD), that came into force earlier this year – which requires an 8 percent "bail-in" of a bank's creditors, including very large foreign banks and hedge funds, which would be applied before taxpayer money is used to aid the banks.
Other key elements of the proposal include a binding 3 percent leverage ratio which would prevent institutions from excessively increasing lending when they do not have enough capital. "Cheap credit can give rise to excessive leverage building up in the financial system. Banks have learnt that lesson from the financial crisis. To avoid repeating past mistakes, we will add the leverage ratio alongside risk-based own funds requirement in the CRR," Drombovskis explained in a speech earlier this month.
The reforms also include a detailed net stable funding ratio (NSFR) which will require banks to finance their long-term activities with stable sources of funding and handle periods of market stress more ably – such as the U.K. referendum or the Greek debt crisis. The proposed reform package also includes measures to improve banks' lending capacity to support the European economy by lending to small- and medium-sized enterprises and to fund infrastructure projects.