Ring Around the Rules

Nothing in finance is certain, but this statement’s as close as it gets: After a big crisis, regulators will do their darnedest to prevent a repeat ... and usually miss the target. After 2008’s financial crisis, a regulatory backlash was assured. But the specifics were anything but—regulators took years to create the new rules, and in many respects, they still aren’t done. They’re close in the US—last month’s Volcker Rule completion filled in one of Dodd-Frank’s biggest remaining gaps. The UK is close behind, having finalized the Financial Services Reform Bill—including the so-called Vickers Rule on separating retail and investment banking—in December. The EU, however, is mostly just getting started. Progress on the eurozone regulatory and bank resolution regime continues slowly, but the question of EU-wide bank restructuring—its own version of Vickers and Volcker—remains unanswered. An early draft of the European Commission’s proposed rules, leaked over the weekend, didn’t help matters—it lays out some guidelines but leaves major decisions to national governments, potentially pulling the rule in 28 different directions. But this could change again by the time the final proposal hits next month, and change further still when the European Parliament gets ahold of it. In short, eurozone regulatory uncertainty likely won’t clear any time soon—a headwind for eurozone Financials stocks.

The eurozone has lagged the US and UK in this department since day one. The Volcker Rule entered US debate in 2010, and the Vickers Rule entered the UK conversation in autumn 2011. That’s about when the European Commission started its own exploration, tapping Finnish central bank chief Erkki Liikanen to lead an EU banking review and recommend changes to theoretically make the system less bailout-prone. Liikanen returned in October 2012 with a recommendation to separate (aka ring-fence) financial institutions’ investment and retail banking operations, with a full ban on trading within the retail arm. Then came 13 months of public comment and internal deliberations as the Commission—led by market commissioner Michel Barnier—decided which provisions of Liikanen’s recommendation to adopt.

Now it seems they’re winding down. The leak of Barnier’s draft suggests the Commission has abandoned a full EU-wide ring-fence, leaving that decision to national regulators. Member states would decide for themselves whether certain practices should be ring-fenced in a separately capitalized business unit (read: separate from customers’ deposits), based on risk-assessment “metrics” from the European Banking Authority. The Commission would, however, ban proprietary trading—trading in their own account for a profit—at the EU’s 30 biggest banks.

It’s just a draft, though, and even if Barnier’s final proposal doesn’t deviate, the final law might be different. The European Parliament must pass legislation. They break for elections in two months, and polls indicate the next Parliament could be more fragmented and euroskeptic than the current one, making centralized regulation that much more difficult to pass (even if euroskeptical MEPs appreciate their home countries’ having more say in bank restructuring). The Commission doesn’t expect a final law before December 2015, and even that could be optimistic, depending on how the election goes. Compounding matters, the European Commission’s current term expires in October 2014, with the new guard possibly favoring something other than Barnier’s proposal. This leaves a lot of room for debate to continue and new details to be written in or provisions to be watered down, just as they were in the US and UK.

Even if Barnier’s proposal is wildly popular and becomes EU law by December 2015 as planned, uncertainty persists. At that point national regulators will likely have to adopt their own rules on bank restructuring or prop trading. That means 28 different regulatory proposals, parliamentary battles and final rules. One is settled—the UK’s system is in the books. It’s a full ring-fence, but with trading exemptions for hedging and underwriting within the deposit-taking portion. France and Germany, too, have already started pursuing their own versions, which closely resemble the British model—allowances for market-making, underwriting and other practices that would “hurt the financing of the economy and the functioning of capital markets through a decrease in liquidity” if they were banned. But that’s about it in terms of low-hanging fruit, especially when you consider how fragile some national governments are. The stability of Italy’s and Portugal’s governments, for example, is hit or miss.

In short, European banking uncertainty probably won’t clear up any time soon. That any changes likely take a while has plusses and minuses. On one side, long timelines and lots of debate give markets plenty of time to digest potential changes. By the time these rules take effect—whether in 2018 as planned or later—they’ll likely have no surprise power. But prolonged debate keeps banks in a holding pattern, likely discouraging them from doing much until they know what the rules will be. Until then, uncertainty remains. Combine that headwind with the ECB’s upcoming stress tests, which encourage banks to continue deleveraging, and regulators appear likely a damper on continental European Financials stocks for the foreseeable future.