NA PŘÍKOPĚ 28
115 03 PRAHA 1
CZECH REPUBLIC

November 13, 2012

Opinion of the Czech National Bank on the consultation on the recommendations of the High-level Expert Group on Reforming the Structure of the EU Banking Sector

(“Final Report of the High-level Expert Group on Reforming the Structure of the EU Banking Sector Chaired by Erkki Liikanen”)

The Czech National Bank’s general position on the report

The Czech National Bank generally welcomes the publication of the reportof the High-level Expert Group and the opportunity to comment on the recommendations contained therein in this consultation. We trust that the responses to the consultation and any subsequent measures proposed by the Commission will be carefully analysed, especially at a time when the entire European financial sector, and particularly the banking sector, is going through a period of excessive regulation that will ultimately lead to growth in costs throughout the financial system and the economies of EU Member States and to a reduction in the international competitiveness of the EU. Moreover, the existing regulatory measures in the EU are causing structural changes that will lead to further restructuring of the European banking sector. To this we also need to add measures which have yet to enter into force (such asthe CRDIV/CRR and the MiFID/MiFIR). The Czech National Bank regards it as important to defer further structural reforms, since it is first necessary to assess the impact of all the regulatory actions that have been taken so far in the EU and around the world.

In the opinion of the Czech National Bank, a suitably calibrated and rigorously implemented structural reform could contribute to strengthening the stability of the banking sector and to mitigating the risk of activation of deposit guarantee schemes. That said, structural reform is not necessarilya cure-all for the trends undermining banks’ focus on sustainable profit growth, investor and public confidence in self-regulation by banks, and the ability of banks to cover losses from their own funds. Structural reform cannot substitute for measures to fundamentally improve bank governance – in particular risk management and internal control – or for effective banking supervision.[1]

The Czech National Bank’s opinions on individual recommendations

Opinionon the separation of a bank’s activities:

First and foremost, it is important to emphasise that the financial crisis has not proved that the universal banking model is a failure or performs worse than the specialised banking model. We believe that the crisis has merely revealed that there are clear differences in its impacts on banks with conservative business models and on banks with aggressive business strategies. The Czech National Bank believes that thanks to broad diversification of banking activities the universal banking model leads generally to a more stable banking sector than the specialised banking model. We do not consider investment banking by definition to be more risky than lending to non-financial corporations, households and general government.

We do not doubt that the proposed separation could contribute to making individual business lines more transparent within financial groups, to making activities more transparent, to making institutions easier to manage and to making supervision on a solo basis easier to perform. On the other hand, one could argue that it will generate increased costs due to the operation of two legal entities instead of one, reduce diversification effects and increase the costs of consolidated supervision.

The declared objectives of separation areto a) limit the exposure of insured deposits to excessive risks, b) prevent the coverage of losses incurred from trading activities by the funds of the deposit bank, c) limit the funding of trading activities from thedeposit bank, d) reduce the interconnectedness between banks and the shadow banking system, and e) level the playing field for trading activities between standalone investment banks and investment banks operating within financial groups.

We doubt that all these objectives can be achieved by separating banks into two parts. One could argue, for example, that aggressive lending to low-income groups is perhaps more risky than prudent investmentactivityor that it is virtually impossible to prevent funding of trading activities from the deposit bank and interconnectednessbetween the deposit bank and the shadow banking system.

We wish to point out that the separation recommendation must also be assessed in connection with the recommendations on corporate governance, risk management, disclosure and sanctioning. To stop companies circumventing the regulation by moving activities from the deposit bank to, for example, the holding-company level, the rules need to be applied not only to both new entities, but also to the entire financial group, or at least to the holding company.

The separation requirement might be sensible and justifiable in some individual cases, but for the reasons given above, universal application of this recommendation seems debatable, costly and inconclusive. The Czech National Bank therefore does not support the first recommendation of the Expert Group to separate the activities of banks.

Opinion on additional separation of a bank’s activities into separate legal entities conditional on the recovery and resolution plan:

The Czech National Bank generally agrees that to draw up a realistic recovery and resolution plan it may be necessary to separate certain activities of a bank into separate legal entities. Supervisory and resolution authorities should have the power to require such separation. The need to make such an intervention in the operation of a bank must always be assessed in detail on a case-by-case basis and take into account a whole range of circumstances, including the specifics of national markets.

The Czech National Bank wishes to point out, however, that the proposed BRR, to which the report of the Expert Group refers, contains numerous very problematic provisions both in the part relating to recovery and resolution plans and in its other parts.

As regards the preparation of recovery and resolution plans and the assessment of resolvability, transferring decision-making powers to the national supervisory authority of the parent company (or the authority responsible for the resolution of the parent company) and to the EBA must be considered unacceptable, as it would limit the ability of some Member States (including the Czech Republic) to maintain the stability of their own financial systems. In our opinion, recovery and resolution plans should always be drawn up at the level of individual legal entities, not at group levelonly, and group plans should be approved in the form of unanimous joint decisions within the relevant colleges. Binding mediation by the EBA in matters of crisis management is not acceptable to the Czech National Bank. The financial stability of each state is closely bound up with its fiscal accountability, so in our opinion intervention byEBA in this area is inadmissible.

The Czech National Bank has numerous other objections to individual provisions of the BRR. However, we do not present them here, as they are outside the scope of this consultation.

Opinion on bail-in instruments:

The Czech National Bank generally prefers to safeguard the solvency of a bank with quality Tier 1 capital rather than with bail-in debt instruments, because there are many legal questions relating to the application of bail-in instruments that have yet to be clarified. At the same time, it is currently impossible to predict the reaction of market participants to this instrument and therefore also the future applicability of this mode of financing by European banks. Problems could also arise as a result of differences between the position of bailed-in creditors in case of resolution and their position in case of insolvency.

Given that application of the bail-in tool represents significant interference in ownership rights, it can be expected that the decisions of resolution authorities to apply it will be the subject of lawsuits. We therefore regard it as vital to conduct thorough analyses and simulations in advance in order to clarify all the conditions and possible consequences of introducing and applying this instrument. The Czech National Bank does not agree with incorporating bail-in “generally” into the regulations and only subsequently elaborating it in more detail. The exact definition of bail-inable liabilities, the relationship to the jurisdictions of third countries, the avoidance of conflict with existing regulations (for example in the conversion of liabilities to equity instruments) and other problem areas need to be sufficiently analysed in advance and regulated in appropriate detail so that this tool is fully usable in real crisis situations.

As regards the specific recommendations of the Expert Group on the bail-in tool, we should begin by saying that limiting it to a certain category of financial instruments is not in accordance with the proposals of the European Commission contained in theBRR, which envisages the bail-in tool being applied to all liabilities of the bank, with some explicit exceptions. Certain advantages and disadvantages can already be identified for both these approaches. The proposal of the Expert Group would, in our opinion, lead to a greater degree of legal certainty for bank creditors (by comparison with the proposal of the European Commission). On the other hand, it would mean that a smaller stock of liabilities would be available to offset losses and recapitalise the bank in case of resolution. There is also uncertainty, among other things, about how effective the write-down or conversion of liabilities subject to the law of a third state would be and whether in such case a conflict could arise with the Member States’ international commitments, for example,under investment protection treaties.[2] This applies both to the proposal of the Expert Group and to the proposal of the European Commission.

For this and other reasons, the Czech National Bank considers it necessary for the Commission to draw up an analysis of the two approaches and to compare them with respect to their applicability and consequences.

Opinion on a review of capital requirements and on macro-prudential supervision:

As regards models and risk weights, effective micro-supervision of capital adequacymustplay a role alongside regulation in limiting the manipulation of risk weights in banks’ internal models and preventingexcessive risk-taking. Regulation cannot be effectivewithout enforcement through supervision. It is probably a good idea to discuss harmonising the techniques for determining risk-weighted assets, or at least setting rules for checking the adequacy of weights. At the same time, attention should be paid not only to the methodology of the models, but also to the data entered into them.

We recommend thinking about the growing complexity of the rules (including the further demands on models), which are being supplemented with a large set of technical standards[3] with the ambitious goal of achieving a single rule book. Another, very complex potential issue relates tothe CVA models (credit value adjustmentof derivatives expressing counterparty credit risk) andAVA models (prudential revaluation of instruments valued at fair value) introduced inthe CRDIV/CRR, which in the prudential regulation essentially remedy insufficient compliance with accounting regulations. Related to this is the Basel Committee on Banking Supervision’sproposal to fundamentally change the capital requirements for instruments in the trading book. This proposal oversteps the bounds of what regulated institutions and supervisory authorities can do. It exacerbates the lack of regulatory transparency, clarity and certainty and puts an excessive regulatory burden on regulated institutions. It is highly likely that these requirements (for example with their demands for growing numbers of model approvals and the hugely difficult/unrealistic task of assessing the models’ overall impact) will overload the supervisory authorities’ human, technical and financial resourcesso muchthat theirability to perform actual supervision will – counterproductively – be limited.

Turning to real estate-related lending, we have no fundamental objections to the introduction of additional mandatory ratios such asLTV or LTI. At the same time, we should point out that in the current capital regulation some risk weights are set to a large extent politically rather than prudentially. This applies not only to real estate loans, but also to exposures to sovereigns and exposures to small and medium-sized enterprises.

The CNB supports an assessment of the adequacy and setting of the leverage ratio. The proposed CRDIV/CRRassumes this in accordance withBasel III. We also support the proposal for an assessment of the adequacy of the large exposure limitsregarding inter-institution and intra-group exposures.

Opinion on governance and control:

The Czech National Bank has long stressed the unsuitability and harmfulness of detailed regulatory interference in governance. This is because responsibility for deciding on the specific internal configuration of decision-making, control and other processes should lie with the company and its shareholders, not with legislators or supervisory authorities. In the view of the Czech National Bank, for example, the differences between Anglo-Saxon law and Continental law, as well as the differences between the legal traditions of the individual Member States, make it very difficult to harmonise the regulation of governance within the EU, primarily due to differences in the corporate law of individual EU Member States. Any potentially adopted rules should only be in the form of recommendations (soft law). The Czech National Bank also highlights the fact that excessive regulation can have impacts on competitiveness and lead to regulatory arbitrage. In the case of unjustified and excessively burdening regulation of corporate governance there is a danger that companies will relocate their registered offices to more liberal jurisdictions. The Czech National Bank is convinced that the current regulatory measures proposed by the Commission in the area of governance are sufficient and also believes that that it is unclear from the report of the Expert Group whether further measures are necessary. Nevertheless, the Czech National Bank would like to emphasise that if the first recommendation is applied in the future, the recommendations proposed here must simultaneously be applied on a consolidated basis so as to prevent circumvention of the rules. In such case, however, enforcement of the governance requirements on a solo basis and the validity of national corporate law must not be weakened. Likewise, it is essential to retain host supervisory authorities’powers to enforce compliance with the governance requirements by subsidiaries that are separate legal entities.

In the opinion of the Czech National Bank, the main road towards enhancing bank governance (including risk management and internal control) and staff motivation runs via renewal of the proper functioning of the self-regulatory mechanisms of each bank at the initiative of its main shareholders and top management. Such initiative can be prompted and promoted by strengthened supervision of compliance with the current rules on bank regulation, in particular the CRD under Pillar 2.

The Czech National Bank is of the opinion that the risk disclosure recommendations could contribute to enhancing bank credibility. At the same time, we should point out that this is a complex problem in which the interests of many interested parties on the one hand, and regulatory principles with international accounting standards governed by EU law on the other hand, converge and conflict.

As for sanctions, there is no doubt that in those Member States where it has been shown that the national supervisory authority does not have sufficient sanctioning powers, those powers should bestrengthened through national legislation. The EBA can help improve the situation in this area by acting as a forum for exchanging experience in this area and as a coordinator for defining best practices.

1

[1] The BCBS Core Principles for Effective Banking Supervision.

[2]In this regard it would be appropriate to pay special attention to the method for calculating compensation for investors, as the method envisaged in the EU directive is not necessarily compatible with the procedures contained in investment protection treaties.

[3]However, it will still be impossible to apply these standards without expert supervisory judgement and without applying Pillar 2 methods for risks not covered explicitly by Pillar 1.