BRUSSELS - Banks in the must split their most risky activities into legally separate units to safeguard the financial system and avoid future bailouts of lenders at taxpayers' expense, a group of financial experts said on Tuesday.
The recommendations, by a group led by Erkki Liikanen, the governor of the Bank of Finland, echoed the of the 1930s that split investment banking from retail lending in the wake of the stock market crash in the United States. That makes the recommendations another measure of how seriously policymakers have taken recent bank failures in countries from Britain to Spain that have left European governments with huge debts, stymied growth, and helped perpetuate the region's lingering .
Mr. Liikanen acknowledged that some members of his group wanted to recommend far less aggressive forms of regulation, such as requiring banks with investment banking arms to put extra money aside in the form of so-called capital buffers.
But Mr. Liikanen said that structural reform including legal separation would be the best way to protect the “socially most vital parts†of banks, including everyday deposit taking and the kinds of lending that keep businesses and economies ticking over.
“The Group's recommendations regarding separation concern businesses which are considered to represent the riskiest parts of trading activities and where risk positions can change most rapidly,†Mr. Liikanen wrote in a letter to summarize the conclusions. “Separation of these activities into separate legal entities within a group is the most direct way of tackling banks' complexity and interconnectedness,†he insisted.
The group of 10 people included former bankers, economists, regulatory experts, and a representative from a consumer group. José Manual Barroso, the president of the European Commission, and Michel Barnier, the E.U. commissioner for financial services, named Mr. Liikanen to head the group in January this year.
The recommendations are likely to encounter fierce opposition from investment bankers who had wanted the group to avoid recommending mandatory rules on legal separation, and Mr. Barnier still must decide whether to come forward with legislative proposals.
“This report will feed our reflections on the need for further action,†Mr. Barnier said in a statement on Tuesday.
The activities that should be separated would include proprietary trading of securities and derivatives, and other closely linked activities, according to the report. Many of the banks conducting these forms of risky trading would need to place those activities in units that are funded and capitalized separately, the report said.
The separation could be carried out using a single holding company, and it would only be mandatory if the risky activities amounted to a significant share of a bank's business, the report said.
To qualify for mandatory separation, the bank would need to have assets for trading and available-for-sale that amounted to between 15 percent and 25 percent of total assets, or those assets would need be valued at "100 billion or more. The European Commission would then conduct an additional review to determine the precise terms of the separation.
The recommendations, if adopted, should not spell the end of so-called universal banks, the kind of soup-to-nuts institutions that combine trading with large retail arms and are well established in countries like France, according to the group. The form of separation “aims to maintain banks' ability efficiently to provide a wide range of financial services†so that “the same marketing organization can be used to meet the various customer needs,†the group said in a summary of its findings.
But the group offered a stinging indictment the way that modern investment banking had become so elaborate and impenetrable that many supervisors and participants in the markets no longer have an adequate understanding of its workings.
“The difficulties of governance and control have been exacerbated by the shift of bank activity towards more trading and market-related activities,†the group concluded. “This has made banks more complex and opaque and, by extension, more difficult to manage. It has also made them more difficult for external parties to monitor, be they market participants or supervisors.â€
The group blamed excessive risk taking, often in trading highly complex instruments or real estate-related lending, and excessive reliance on short-term funding, for helping create the financial crisis.
To help remedy those failings, the group recommended a bevy of new rules for the way banks should be run, including the introduction of so-called “fit-and-proper tests†to evaluate the suitability of management and board candidates.
The group also recommended additional limits how bankers should be compensated, including making the overall amount of bonuses less than what banks pay in dividends.
To punish wrongdoers, banking supervisors “must have effective sanctioning powers to enforce risk management responsibilities, including sanctions against the executives concerned, such as lifetime professional ban and claw-back on deferred compensation,†the group said.
