Similar to restrictions in the United State's controversial Volcker rule, which it drew upon, the European Commission on Wednesday proposed new rules to prohibit its biggest banks from engaging in proprietary trading. The rules empower supervisors to require banks to separate risky trading activities from their deposit-taking business if those activities could compromise financial stability.

"Today's proposals are the final cogs in the wheel to complete the regulatory overhaul of the European banking system,” said Michel Barnier, commissioner for internal market and services, in a statement. The legislation, he said, deals with “the small number of very large banks which otherwise might still be too-big-to-fail, too-costly-to save, too-complex-to-resolve.”

The proposal, which applies only to “the largest and most complex EU banks with significant trading activities," will ban proprietary trading in financial instruments and commodities. Exemptions are provided for financial instruments issued by sovereigns, multilateral development banks, and certain international organizations.

Bank supervisors will be empowered to require the transfer of other high-risk trading activities (such as market-making, complex derivatives and securitization operations) to separate legal trading entities within the group. This aims to avoid the risk that banks would get around prohibitions by engaging in hidden proprietary trading activities which become too significant or highly leveraged. Banks will have the possibility of not separating activities if they can show to the satisfaction of their supervisor that the risks generated are mitigated by other means.

To prevent banks from attempting to circumvent these rules by shifting parts of their activities to the less-regulated shadow banking sector, structural separation measures must be accompanied by provisions improving the transparency of shadow banking. The accompanying transparency proposal will provide a set of measures aiming to enhance regulators' and investors' understanding of securities financing transactions. “A better monitoring of these transactions is necessary to prevent the systemic risk inherent to their use,” a statement from the European Commission says.

The proposed rules were crafted through the work of a working group, established in November 2011, by Erkki Liikanen, governor of the Bank of Finland. The group delivered its initial report in October 2012, recommending mandatory separation of high-risk trading activities for banks whose trading activities exceeded certain thresholds

An initial analysis by the law firm Morrison & Foerster's London office takes note of those thresholds and how a bank will be designated as “too big to fail.” Among the criteria is designation as a global systemically important institution under the EU's Capital Requirements Directive IV, or if, for a period of three consecutive years, an entity maintains total assets of at least €30 billion and trading activities of at least €70 billion, or 10 percent of total assets. This makes the scope of the prohibition more targeted and limited than the Volcker rule, which also applies to mid-tier, small, and community banks.Barnier, however, said the substance of the rule is intended to be tougher than the similar mandates of the U.S. Dodd-Frank Act and similar rules crafted in the UK, Germany, and France.

EU branches of non-EU entities will also fall under the regulation if they meet the established thresholds. Although the draft lacked clarity, the asset/trading activity test likely centers on the EU branch, not the larger entity, the firm says. In accompanying FAQs, the Commission says the Regulation would currently cover approximately 30 banking groups, but does do not specify them or indicate how many are EU branches of non-EU entities.

The current proposal is for the proprietary trading ban to apply as of Jan. 1, 2017 and the requirement for separation of other trading activities would begin in January 2018.

Morrison & Foerster's analysts note that “this is just the start of the EU legislative process and negotiations with the EU Commission and EU Parliament could be lengthy.” The likelihood of significant opposition means the proposed timetable is likely to be extended.

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