Following the Independent Commission on Banking's ("ICB") recommendations on banking reform in September last year, the Government has now set out how it plans to implement them in its White Paper on Banking Reform.
The ICB had recommended proposals in three key areas: a retail ring-fence, capital requirements, and competition in retail banking. These were intended to insulate critical banking services from shocks elsewhere in the financial system and to make it easier to preserve continuity of essential payment services while resolving financial institutions in an orderly manner without the need for taxpayers' funds.
The Government had previously indicated its support for the ICB's recommendations. The White Paper sets out in detail its vision of the structural changes that would be needed in practice to achieve the outcomes recommended. The proposals, in particular the de minimis threshold for ring-fence banks, mean that the reforms will have the biggest direct impact on the largest UK banks but the whole banking sector will be affected indirectly.
There have been a number of developments at the European ("EU") and International level which the Government will use to implement many of the changes. It has also stated its intention to use primary legislation only where necessary and otherwise empower regulators to make required rules. The Government is aiming to complete the legislative process this parliamentary term, with the majority of reforms being implemented in 2019.
Structural Reform - The Retail Ring-Fence
The restructuring of 'universal banks' has been confirmed with a ring-fence around retail banking operations. The ring-fence bank is to operate as a clearly independent, separate entity from other members of the corporate group. The proposals do seem to allow some flexibility about the business within the ring-fence, although they will still require significant restructuring for the largest UK banks. The relaxation of some ICB proposals comes at the cost of potentially more demanding monitoring for both banks and regulators.
Significantly, building societies are largely excluded from the ring-fence proposals although the Government is going to amend the Building Societies Act 1986 to bring it into line with ring-fence requirements (it is planning to publish proposals shortly). In addition, it is suggesting a de minimus of £25 billion of mandated deposits before requiring a ring-fence, this would cover 87% of deposits but in effect 8-9 banks and building societies.
Scope of the Ring-Fence:
- "Mandated (or protected) services" – these are services that may only be provided by ring-fence banks. Currently the Government is proposing that only the acceptance of deposits from individuals and small and medium enterprises ("SMEs") will be protected. This means it will only be possible for ring-fenced banks to provide overdrafts to these depositors. The Government is going to include a power to provide exceptions or additional mandated activities in secondary legislation.
- SMEs – the current threshold for inclusion in the ring-fence is based on the definitions in the Companies Act 2006, so would be somewhere between £6.5 million and £25.9 million in turnover over a given period to reduce fluctuation effects. Firms above this threshold could still choose to place deposits in a ring-fence bank.
- High net worth customers – these will also be exempt from the ring-fence if they meet the appropriate threshold, currently proposed as between £250,000 and £750,000 of "free and investable assets" with a single bank over a certain period of time. Customers will need to make the decision to place deposits outside ring-fence in full knowledge of risk so the Government is proposing a similar process to treating individual investors as professional investors under the Market in Financial Instruments Directive.
This suggests that some institutions outside of the ring-fence are going to need to have processes and structures in place to monitor and move customers if they no longer meet the exemption thresholds, although it is not clear from the White Paper whether this would just be limited to institutions providing "prohibited services" (described below).
- "Prohibited services" – these are services that a ring-fence bank will not be able to provide on the basis that it would impede resolution and/or increase its exposure to shocks. The Government's focus is on the carrying on of international and wholesale and investment banking services, in particular dealing in investments as a principal. Examples provided in the White Paper include: origination, trading, lending or making markets in securities (including structured investment products) or derivatives, secondary market purchases of loans and other financial instruments, conduit financing or securitisation of assets that originated outside the ring-fence bank (this would still allow the securitisation of mortgages and other assets which originated on the ring-fence bank's balance sheet). There would also be limits on the extent to which a ring-fence bank could enter into a transaction with a financial institution which results in an economic exposure to that institution. Although these institutions would still be able to access the ring-fence bank for payment services.
The Government is proposing allowing ring-fence banks to sell some 'simple' derivatives, although it is still considering what this might mean in practice. This is good news for banks within a ring-fence as it will allow them to provide their customers with a wider range of services.
- "Ancillary services" - these would include exemptions to prohibited activities to allow ring-fence banks to manage balance sheet risks, liquidity and the raising of funding.
The ring-fence bank would also be subject to geographical restrictions. The Government is proposing that it would not be able to carry out any banking activities through non-European Economic Area ("EEA") subsidiaries or branches. Instead, such operations would need to be undertaken by separate subsidiaries of the group. Within the EEA, legislation such as the Credit Institutions Wind-up Directive and the proposed Recovery and Resolution Directive (RRD) will facilitate an orderly resolution in the event of the failure of a ring-fenced bank. The Government has indicated it is already working with Guernsey, Jersey and the Isle of Man to establish conditions under which branches or subsidiaries within those jurisdictions would be treated consistently with EEA branches and subsidiaries. Of note, the Government is intending that all major service and credit contracts will need to be written under the laws of an EEA member state with limited exceptions.
'Height' of the ring-fence
For the ring-fence to function as designed, the ring-fence bank will need to be operationally separate from other entities in the group. This will include the following limits on intra-group relationships:
- Legal independence - the ring-fence bank will need to be a separate legal entity from others in the group and regulators will have the power to restrict the subsidiaries it might own or hold capital in.
- Operational independence - banks will generally be free to arrange their operations as they choose unless the regulator believes it presents a barrier to the separation of the ring-fence bank and continuous provision of its services.
- Payment services - ring-fence banks should not be permitted to use non-ring-fence banks to access business critical payment systems. Provision by ring-fence banks of payment services to non-ring-fence banks will be subject to approval.
- Economic links - ring-fence banks should meet capital and liquidity requirements on a stand-alone basis, although where there is a number of ring-fence banks in a single group, it may be appropriate to apply requirements as a sub-consolidated group. There will also be a limit on intra-group exposures and funding, for example lending across the ring-fence and the Government is also considering steps, to ensure intra-group transactions are undertaken under market conditions, restricting or prohibiting intra-group guarantees and cross-default clauses.
- Governance - at least half of the board (excluding the Chair) of the ring-fence bank will need to be independent. In addition, no more than one-third of the members of the board may be representatives of the rest of the group (although the restrictions would not apply to boards within a group of ring-fence banks). The Government also agrees with the ICB recommendation that there be an extra obligation on directors of both the ring-fence bank and its parent to protect the integrity of the ring-fence. Ring-fence banks will also have to have their own board committees to ensure the integrity of the ring-fence.
- Disclosure - it is likely that a ring-fence bank will need to make a number of public disclosures anyway under Pillar III, but the Government will give regulators a broad power to require additional disclosures where necessary to demonstrate independence.
The Government is also considering how the ring-fence bank could be independent for tax and pensions liabilities, but is currently thinking of requiring separated pension liabilities by 2025 (this is to allow banks time to deal with current deficits).
Since the ICB's final report there have been significant developments in the EU and internationally considering the appropriate levels of capital financial institutions should hold. Bearing these in mind, the Government is proposing:
- Loss absorbency – a primary loss-absorbing capacity (PLAC) of up to 17 % for UK headquartered global systemically important banks (G-SIBs) and ring-fence banks, although it is not going to specify how that requirement is met. The Government is going to seek to deliver the PLAC requirement through the RRD.
The Government agrees that a ring-fence bank should hold more equity than under Basel III (if it can be implemented in accordance with EU law), and has proposed a ring-fence buffer of up to 3% on top of Basel III, scaled depending on size and risks posed. A breach in this buffer should lead to restrictions on capital distributions, for example, dividends and bonuses, so that equity levels are rebuilt.
Notably, the Government is not currently considering that UK headquartered G-SIBs hold either equity or debt components of PLAC beyond international or local standards against risk weight assets held by overseas operations that do not pose a risk to UK and/or EEA financial stability.
- Bail-in – the Government believe a bail-in tool is required to ensure at least some unsecured non-capital liabilities can absorb losses without having to put a bank into insolvency, helping to remove any implied Government subsidy and so creditors bear the risk of loss. The Government is expecting to implement bail-in through the RRD and is seeking views on the scope, composition and process. It acknowledges that it will be a challenge to determine what bail-inable debt will look like as there is no current market. It has suggested that a transition may be necessary, as it will be important to ensure bail-inable debt can credibly absorb losses while allowing banks to manage funding costs and any market distortions that might occur when it is introduced.
- Leverage ratio – the Government is not proposing a leverage ratio (as recommended by the ICB) beyond the Basel II international standard.
- Depositor preference – the Government is investigating how it can change the creditor hierarchy so that deposits entitled to the Financial Services Compensation Scheme ("FSCS") protection are preferred. In its view, the preference would reduce the contagion if a failure meant other banks were unable to meet their FSCS responsibilities and incentivise other senior unsecured creditors to discipline banks' behaviour.
Subject to the outcome of the proposed RRD, the Government is planning to amend the Insolvency Act 1986 to provide that from 1 September 2019 insured deposits are made preferred debts. It is consulting on whether this protection should include non-EEA deposits up to the FSCS limit held in non-EEA branches of UK incorporated entities or any other types of deposits which are not currently eligible for the FSCS scheme, for example, charities and local authorities.
These proposals and the EU and international developments should alleviate to a certain extent, concerns caused by the ICB report that UK retail operations will be put at a competitive disadvantage in comparison to other jurisdictions.
Competition in the Retail Banking Sector
The ICB had expressed concerns with the concentration of the retail banking and SME markets following the financial crisis. Many of its recommendations are already in the process of being implemented, for example, the Government has amended the Financial Services Bill 2012-2013 to ensure the proposed Financial Conduct Authority ("FCA") has a strong competition agenda. This section of the White Paper therefore contained little in the way of additional requirements but equally little detail about how its competition concerns will be addressed by measures taken over the next year or so. Of note are the following:
- The Bank of England and the Financial Services Authority ("FSA") are currently considering how prudential requirements are causing barriers to entry for small banks and are expected to report on their views in the autumn.
- The Government confirmed that it is closely monitoring the implementation of the new switching service which the industry has committed to deliver by September 2013. It has not ruled out other options, including full account portability, if the service does not improve switching in practice.
- The Office of Fair Trading ("OFT") is planning to review the personal current account market in late 2012, following up its 2008 market study. It is also planning on holding a roundtable in October to take forward the ICB recommendations about the inclusion of interest foregone on banks' statements in annual summaries (which the OFT actually looked at as part of its 2008 market study).
- The FSA will publish the approach the FCA will take in addressing transparency within its regime in Quarter 1, 2013.
- The Government is going to press on with its plan to reform the Payments Council, following the unpopular (and later reversed) decision to abolish cheques. This is likely to be a new public body to set strategy, which is accountable to the FCA, and which will give payment users a stronger voice.
The White Paper includes a number of consultation questions to help the Government develop its thinking further, both to take forward these proposals and for its discussions at the EU and international level. The deadline for responding is 6 September. The Government then plans to publish a draft Bill for pre-legislative scrutiny in the autumn relating to ring-fencing, depositor preference and the application of PLAC.
The proposals will result in significant restructuring of the financial services industry. Although 2019 seems quite distant, particularly considering the current conditions the industry is facing, it is important that banks are clear about what the proposals will mean for them in practice so they can engage meaningfully with the Government now about the impacts.