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How EU Rules Could Scupper UK Banking Reforms

European Union “passporting” rules allow banks from across the EU to operate in each other’s markets as “branches” subject to regulations in their home country, rather than full-blown subsidiaries that would have to play by UK rules.

“This is a big worry,” said one person close to the Independent Commission on Banking, chaired by Sir John Vickers. “We recognise there is a loophole but ... we can’t change EU law.”

The Commission recommended a series of measures last week to make Britain’s banks safer and the market more competitive.

The central proposal on safety would see big “universal” groups such as Barclays , HSBC and Royal Bank of Scotland – which combine retail banking and higher-risk investment banking under one roof – forced to ringfence their UK high street operations and buttress them with additional capital.

Sir John said the ringfenced subsidiaries should hold top-notch core tier one capital equivalent to at least 10 percent of their risk-weighted assets, compared with a 7 percent minimum set by new Basel III global capital standards.

Banks such as France’s BNP Paribas, Germany’s Deutsche Bank and BBVA of Spain, which might be tempted to enter the UK retail banking market, would only be subject to their home market capital rules, likely to be in the 7-8 percent range.

“Freedom of establishment is a fundamental right under the European treaty,” said Bob Penn, a partner at Allen & Overy in London.

“There is nothing that the [Vickers] commission or the government can do about it.”

The loophole could be exploited by a European bank interested in buying branches from Lloyds, the part-nationalised bank that is the UK’s biggest high-street lender.

Lloyds has been ordered by EU state aid authorities to sell 600 branches as punishment for its government bailout. In addition, the Vickers Commission said Lloyds should sell “substantially more” branches to make the market more competitive.

But European banks have argued a lower capital requirement would not be enough of an incentive to enter the market.

“The challenge for banks is the cost of effectively setting up from scratch,” said Andrew Gray, a banking expert at PwC. “Capital levels ... are not going to be the defining factor.”

Commission officials, too, believe the capital advantage is insufficiently big to have a large-scale effect on the competitive landscape.

The reverse risk – of British banks moving headquarters to another European country and then passporting back into the UK – would be caught by anti-arbitrage rules in the Banking Consolidation Directive, officials said.

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