ECB finds merit in separating risky bank activities

The ECB "sees merit" in separating some high-risk trading operations from banks' mainstream business but has stopped short of fully backing splitting deposit-taking arms from riskier investment banking.

In a document released on Monday, the European Central Bank also supported proposals to impose losses on bondholders at insolvent banks but wanted a closer examination of the practical implications of such "bail-in" provisions.

The ECB's views on banking carry weight because from next year it will have new powers that will give it automatic oversight of around 150 of the euro zone's 6,000-odd banks, and the authority to intervene in smaller banks if there are signs of trouble.

An EU advisory group, led by Bank of Finland chief Erkki Liikanen, proposed last October that banks separate their deposit-taking arms from proprietary trading and other risky investment banking work to shield taxpayers from further bailouts and protect savers.

The proposal is a response to concerns that rose during the financial crisis that retail banking is vulnerable to troubles that hit the investment banks.

"In general, the Eurosystem (of euro zone central banks) sees merit in separating certain high risk activities of financial institutions that are not associated to the provision of client-related services," the ECB said in the document on the Liikanen Report.

But it added that "further analysis is warranted on the possible scope for allowing market-making to be carried out by the deposit taking entity, subject to certain limits."

The European Commission is due to make proposals on changing the structure of banks in the coming months based on the Liikanen Report but is uncertain how far it will go in recommending a break-up of Europe's biggest banks.

The Liikanen proposals provide steps towards strengthening the resilience of the financial system, the ECB said, adding:

"The Eurosystem is of the view that an impact assessment needs to be carried out as a matter of priority in order to gauge the possible impact of the proposals in the EU."

Even mandatory separation of banks' activities may still be unable to avoid taxpayers facing a bill "if the trading entity is too systemic, large and interconnected", the ECB said.

"This should be avoided," it added in the document. "In this context, further research is warranted to understand and assess the implications of size and interconnectedness."

The "bail-in" proposal "is seen as providing legal certainty and incentives for investors to better monitor banks and reduces the implicit government subsidy for the too-big-to-fail entities," the ECB said.

But just as with bank structures, it added the caveat that further analysis should be carried out on the "practical and operational implications of bail-in."

(Writing by Paul Carrel)