The report for European commissioner Michel Barnier also recommends a "legal separation" of risky financial activities from banks holding deposits for retail customers but insists that it is not trying to break up 'universal' banks which unite investment banking and retail banking.
"The central objectives of the separation are to make banking groups, especially their socially most vital parts (mainly deposit-taking and providing financial services to the non-financial sectors in the economy), safer and less connected to high-risk trading activities and to limit the implicit or explicit stake of taxpayer in the trading parts of banking groups," the report by Finnish central bank governor Erkki Liikanen said.
With regards to bankers' pay, Liikanen recommends that bankers are paid in 'bail-in' bonds - which are intended to prop up banks as a last resort – and restrictions put on the size of bonuses relative to salaries.
"Furthermore, a regulatory approach to remuneration should be considered that could stipulate more absolute levels to overall compensation (for example that the overall amount paid out in bonuses cannot exceed paid-out dividends)," the report said.
The report by Liikanen follows moves in the US and the UK to push forward reforms to restructure the banking industry which needed taxpayer support on both sides of the Atlantic during the 2008 crisis.
In the US, the Volcker rule – named after the former chairman of the Federal Reserve Paul Volcker – limits the way banks used their own resources to bet on market movements through what is known as proprietary trading. Banks are expected to comply with the rule by 2014. In the UK, the government is pledging to adopt recommendations by Sir John Vickers, who chaired the Independent Commission on Banking, to force banks to erect a ringfence between their high street businesses and "casino" investment banks.
Liikanen's group in some ways builds upon the Volcker rule by calling for legal separation of proprietary trading of securities and derivatives. But separation would only be mandatory if the activities amount to 15 to 25% of a bank's business.
Among the other suggestions by the Liikanen report is that loans to property companies should have different rules about the amount of capital that banks must hold to support the lending. "History has shown that many systemic banking crises resulting in large commitments of public support have originated from excessive lending in real estate markets," his report said.
It also calls for "more attention" to be given to ability of management and boards to run large, complex banks with "fit and proper" tests for board candidates.
"The group has found that no particular business model fared particularly well, or particularly poorly, in the financial crisis. Rather, the analysis conducted revealed excessive risk-taking – often in trading highly-complex instruments or real estate-related lending – and excessive reliance on short-term funding in the run-up to the financial crisis. The risk- taking was not matched with adequate capital protection and high level of systemic risk was caused by strong linkages between financial institutions," Liikanen's group said.
Barnier now needs to decide whether to implement the five key recommendations which require:
• Manadatory separation of proprietary trading and other high-risk activities.
• A requirement by banks to have a recovery and resolution plan if they run into financial difficulty.
• Bail-in bonds should be used as a way to bolster bank capital during times of crisis.
• Potential new rules for lending to property companies.
• A "fit and proper" test for top bankers to strengthen control of banks.
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