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Report wants EU banks to ring-fence risky business

By Sarah Dilorenzo

Associated Press

Published: Tuesday, Oct. 2 2012 7:35 a.m. MDT

European Commissioner for Internal Market and Services Michel Barnier, right, and Erkki Liikanen, Member of the Governing Council of the European Central Bank and Chairman of the High-level Expert Group, address the media on possible reforms to the structure of the EU banking sector, at the European Commission headquarters in Brussels, Tuesday, Oct. 2, 2012.

Yves Logghe, Associated Press

Enlarge photo»

BRUSSELS — Europe's fragile banking system should be protected by building a firewall between a lender's retail operations and its more risky trading activities and forcing executives to take losses when their banks fail, according to an expert report.

The recommendations are one part of the European Union's efforts to figure out how to right troubled banks and prevent a similar crisis in the future. A committee led by Erkki Liikanen, the governor of the Bank of Finland, put together the report, which was requested by the European Commission, the EU's executive arm.

"In Europe, banking is critical," Liikanen told reporters. "It's more important in the European economy than any other area in the world."

Banks have played a big role in creating the financial crisis crippling the 17 countries that use the euro. The government debt bought by banks during the boom times of the eurozone are now no longer considered safe bets and the banks are struggling to unload them — usually at hefty losses. This has been made worse by real estate loans and assets that were turned toxic by a collapse the region's property markets.

In some cases, governments have been forced to step in to prop the lenders up. But rescuing banks is expensive and has added to investors' concerns that European countries are simply spending too much. Ireland's rescue of its banking sector pushed it to the edge of bankruptcy and into a bailout loan. Spain is now heading down the same path.

Meanwhile, many banks have retrenched into their home countries, lending to fewer and fewer companies and households and ditching investments made in other members of the eurozone — especially in Greece, Italy and Spain. That has undone much of the founding principles of the single currency — to allow money to flow freely and cheaply across borders.

As part of efforts to ensure these problems are never repeated, the European Union is trying to strengthen its banking oversight. It is considering making the European Central Bank a supervisor for all 6,000 banks in the 17 countries that use the euro, with wide-ranging powers. It is also pushing all European banks to hold more money as reserves against future economic shocks and looking at regulation that would force the creditors of failing banks to take losses — what's known as a "bail-in" rather than a taxpayer bailout.

The Liikanen report released Tuesday builds on these suggestions. Michel Barnier, a European commissioner charged with improving banking regulation, said the report would form the "cornerstone" of future regulation.

The report's most significant recommendation is that banks should separate their risky investment banking operations, like trading, from their more traditional retail operations, which lend to customers.

Regulators around the world are struggling to insulate the traditional lending operations of banks — which contribute to the economy by helping consumers to buy cars and houses and companies to expand their businesses — from the riskier and increasingly complex world of high finance, where billions of dollars can be lost in a single bad trade. During the financial crisis, the line between the two was blurred.

In Britain, where critics refer to such trading operations as "casino banking," a similar split is has been proposed. The U.S. has imposed the so-called Volcker rule, which restricts banks from trading for their own profit, where a lot of risk was taken.

In the Liikanen proposals, the two entities could still be part of one big bank holding company but would have to meet separate capital reserve requirements, put in place to make sure banks have enough money to cover losses in tough times. The retail banking arm would not be allowed to prop up the investment arm.

Small banks or banks with small trading operations would be exempt; the report suggested the regulation only apply to banks whose regularly traded assets make up 15 to 25 percent of total assets or total more than €100 billion.

The report also suggests that high-paid bank executives receive part of their compensation in the form of "bail-in instruments" — bonds or shares that would be used to rescue a bank if it were to fail.

The Liikanen group also recommends that failed executives could be banned from the profession for life and encourages bank supervisors to limit executive salaries and bonuses.

The report also encourages the EU to reassess what it considers to be a "safe" investment. That's important because one of the hallmarks of the crisis was that assets once considered safe — like government bonds — became risky. The report specifically mentions safeguards that would protect against bad real estate loans, which have done in Irish and Spanish banks — as well as American ones.

Barnier said he will study the report's conclusions and their impact on banks' lending and competitiveness. He will also seek out comments and criticism on the report from the banking industry before making his own recommendations.

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