The Parliamentary Commission on Banking Standards (Commission) has published (on 19 June) its Final Report entitled "Changing banking for good". The report identifies various reforms the Commission considers necessary to improve standards across the banking industry. The recommendations cover several areas including: making senior bankers personally responsible, reforming bank governance, creating better functioning and more diverse markets, reinforcing the powers of regulators.
The Commission's recommendations aim to:
- restore public trust and confidence in the UK banking system;
- make individual responsibility in banking a reality and ensure that risk and reward are appropriately aligned;
- reform governance in banks to reinforce each bank's responsibility for its own safety and soundness; and
- reinforce the responsibilities of Government and regulators in the exercise of judgment in deploying their current and proposed new powers.
- A new Senior Persons Regime, replacing the Approved Persons Regime, to ensure that the most important responsibilities within banks are assigned to specific, senior individuals so they can be held fully accountable for their decisions and the standards of their banks in these areas;
- A new Licensing Regime underpinned by Banking Standards Rules to ensure those who can do serious harm are subject to the full range of enforcement powers;
- A new remuneration code to better align risks taken and rewards received in remuneration, with much more remuneration to be deferred and for much longer;
- A new power for the regulator to cancel all outstanding deferred remuneration, along with unvested pension rights and loss of office or change of control payments, for senior bank employees in the event of their banks needing taxpayer support, creating a major new incentive on bankers to avoid such risks; and
- A new criminal offence for Senior Persons of reckless misconduct in the management of a bank, carrying a custodial sentence.
The Commission's recommendations are not binding on the Government, regulators, banks or individuals. The Government has indicated that it will publish its response to the Commission's Final Report by 18 July 2013. The Commission recommends that the Government's response sets out a timetable for implementing each of the proposals.
The Commission calls on the Government to implement those recommendations that require primary legislation through amendments to the Financial Services (Banking Reform) Bill 2013-14 (Banking Reform Bill) currently going through Parliament. In addition, where the Government does not propose to implement a recommendation requiring legislative action through the Banking Reform Bill, the Commission proposes that the Government sets out plans for implementing such legislation.
In addition, the Commission recommends that the:
- Government examines the merits of requiring large banks to relinquish ownership of the payments system and reports to Parliament on its conclusions before the end of 2013;
- Government immediately announce a process for considering alternative strategies for the future of the Royal Bank of Scotland (RBS) and report to Parliament by September 2013;
- HMS Treasury (Treasury) should establish an independent panel of experts to assess means of enabling much greater personal bank account portability, which should report within 6 months on switching bank accounts and 12 months on other issues;
- Treasury Committee undertake an inquiry in three years' time into the supervisory and regulatory approach of the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA);
- Competition and Markets Authority should immediately commence a full market study of competition in the retail and SME banking sectors, to be completed on a timetable consistent with a market investigation reference by the end of 2015;
- PRA and FCA report to the Treasury Committee about the risk that they appear to be acting as shadow directors within six months;
- PRA and FCA be required to publish a joint review of the working of the enforcement arrangements for the banking sector in 2018;
- Financial Policy Committee (FPC) should be given the duty of setting the "leverage ratio" from Spring 2013; and
- FPC should consider and publicise a report on whether the "leverage ratio" should act as a regulatory front-stop as opposed to a back-stop, by the end of 2013.
The current FCA/authorised person Remuneration Code is expected to be revised in accordance with the changes being introduced by the Capital Requirements Directive IV (CRD IV), which is expected to come into force on 1 January 2014. The Commission recommends that their proposals for a new Remuneration Code be considered at the same time.
A summary of the Commission's recommendations is set out below.
1. New framework for individuals
The Commission concludes that the existing Approved Persons Regime is a "complex and confused mess", which has failed to perform its role adequately as the primary framework for regulators to engage with individual bankers. Senior bankers have operated in an environment characterised by insufficient personal responsibility and little prospect of financial penalties or effective enforcement action, even in the most severe banking failures. Therefore the Commission has determined that an entirely new framework for individuals within banking is urgently needed.
The Commission recommends that this new framework should consist of three main pillars:
A Senior Persons Regime
- This new regime would replace the Significant Influence Function element of the Approved Persons Regime. It would apply to all banks and bank holding companies operating in the UK.
- It would assign key responsibilities within banks to specific individuals who formally accept them, and are made fully and unambiguously aware of those responsibilities and made to understand that they will be held to account for how they carry them out.
- Regulators will provide clear guidelines as to how responsibilities are to be identified and assigned, and have powers to take action when they are not followed.
A Licensing Regime
- This regime would sit alongside the Senior Persons Regime and apply to a broader range of bank staff (including those who are not currently required to be approved) whose actions or behaviour could seriously harm the bank, its reputation or its customers.
- It would centre on a revised set of Banking Standard Rules drafted by regulators in consultation with banks, staff and unions, which should incorporate concepts such as treating customers fairly and managing conflicts of interest.
- The Banking Standard Rules would replace the existing Statements of Principle for Approved Persons and the associated Code of Practice, which the Commission considers to be incomplete and unclear in their application.
- The new rules would apply to Senior Persons and Licensed bank staff and a breach would constitute grounds for enforcement action by the regulators.
Reform of the Register
- The register underpinning the Approved Persons Regime will be reformed to support the first two pillars and ensure that relevant information on individuals can be captured and used more effectively.
- For individuals only covered by the Licensing Regime, the register should only include their details where there has been an enforcement action against them.
The Commission considers that many of the problems deriving from remuneration in the banking sector, including incentives for misconduct and excessive risk-taking, have persisted, despite reforms in this area since the 2008/09 financial crisis. The post-crisis regulatory reforms have aimed to improve financial stability and remove the Government guarantee, but have not remedied other underlying causes of poor standards and culture in the banking industry.
Accordingly the Commission recommends the replacement of the current FCA/authorised person Remuneration Code and imminent EU bonus cap that will be imposed under CRD IV with a new Remuneration Code, which is intended to ensure that incentives and disincentives more closely reflect the long-term balance between business risks and rewards. The new Remuneration Code proposes a radical re-shaping of remuneration for Senior Persons and licensed bank staff.
The new Remuneration Code would contain the following key features:
- the deferral of more remuneration for periods up to 10 years;
- the deferred remuneration to be in forms that favour the long-term performance and soundness of the bank, such as bail-in bonds;
- the power to enable deferred remuneration for Senior Persons, Licensed individuals and unvested pension rights and entitlements to be cancelled if a bank requires direct taxpayer funding;
- an increased focus on long-term measures of bank profitability in calculating remuneration, with a particular scepticism for assessing return on equity;
- individual claims on outstanding deferred remuneration should be subject to cancellation due to misconduct or a downturn in the performance of the bank or a business area; and
- a prohibition on variable, performance-related remuneration for non-executive directors.
The Commission would like bank remuneration committees to disclose, in annual reports, the range of measures used to determine remuneration and the expected levels of remuneration by division, including an explanation of how risk has been taken into account. The regulators would then be responsible for carrying out a cost benefit analysis to ensure that risks in the long-term are properly aligned with remuneration, intervening where necessary.
3. Sanctions and enforcement
The Commission considers that the existing enforcement regime has failed and that a more effective regime is essential for the restoration of trust in banking. In particular, the Commission notes that too few enforcement actions have been brought against senior Approved Persons who have been unduly protected by a culture of collective responsibility despite multiple banking failures. In addition, the limited scope of the Approved Persons Regime has enabled many key decision makers to avoid effective enforcement, including many involved in the recent LIBOR scandals.
Therefore the Commission recommends the implementation of a new sanctions and enforcement regime, which attributes individual responsibility to key decision makers and ensures that they will be subject to a full range of civil enforcement powers.
The Commission makes the following recommendations:
- Reversal of the burden of proof: relevant Senior Persons will be required to demonstrate that they took all reasonable steps to prevent or mitigate the effects of a specified failing, if there is a failure leading to successful enforcement action against a firm. Any Senior Person unable to do so would face possible individual enforcement action.
- Individual responsibilities: all key responsibilities in a bank must be assigned to a specific, Senior Person, who will retain that responsibility even where responsibilities are delegated, or subject to collective decision making. In addition, the new Licensing Regime will ensure that all those who can do serious harm are subject to the full range of civil enforcement powers. This will encapsulate a greater number of key individuals then those currently covered by the Approved Persons Regime.
- A new criminal offence: individuals in the Senior Persons regime would be subject to a new criminal offence for reckless misconduct in the management of a bank. A conviction for this offence may result in a prison sentence and must be brought within 12 months of successful enforcement against banks. Remuneration received by an individual during the period of reckless behaviour would be recoverable through the civil recovery regime under the Proceeds of Crime Act 2002.
In addition, the Commission proposes that a new autonomous body be created to assume the decision-making role of the FCA's Regulatory Decisions Committee for the specific enforcement needs of the banking sector. The Commission would like this body to:
- consist of a lay majority, but also contain several members with extensive senior banking experience and be chaired by someone with senior judicial experience;
- have statutory autonomy and be appointed by the joint agreement of the PRA and FCA boards; and
- publish an annual report on its activities and the Chairman should be prepared to appear before Parliament to discuss their findings.
4. Bank governance, standards and culture
The Commission concludes that there have been serious failings in corporate governance in banks and in financial institutions generally and that reform is necessary to reinforce individual responsibility. The Commission recommends the following:
Bank boards and governance
- the heads of the risk, compliance and internal audit functions in banks should have individual and direct lines of access and accountability to the board and much greater levels of protection for their independence, in particular sanctions or dismissal should require the agreement of non-executive directors;
- the Government should consult on amending section 172 of the Companies Act 2006 to remove shareholder primacy in respect of banks, requiring bank directors to ensure the financial safety and soundness of the company ahead of shareholder interests. In response to the Commission's Final Report, the FRC were unconvinced that disenfranchising shareholders was the right solution and expressed concern that removing shareholder primacy may affect the ability of banks to attract future capital;
- the UK Corporate Governance Code (Code) and PRA Principles for Businesses be amended to include a requirement that banks and their directors must operate in accordance with the safety and soundness of the firm and that director's responsibilities to shareholders, customers and taxpayers should be interpreted in light of this requirement;
- the FRC should amend the Code to improve the process for nominating board members to address the perception that "natural challengers" are being unfairly sifted out. In response, the FRC has confirmed that they will continue to review and report on the implementation of the Code annually and that if changes to the Code are required, they would be subject to public consultation and would take effect from October 2014;
- the regulators should consider whether each non-executive vacancy on the board of a bank above the ring-fence level should be publically advertised;
- the Chairman should have direct personal responsibility under the Senior Persons Regime to ensure the effective operation of the board, including effective challenge by non-executives. The Senior Independent Director should ensure that the Chairman fulfils this role and meet the PRA and FCA to demonstrate how the Chairman has held the CEO to account, encouraged challenge from other independent directors and maintained independence in leading the board; and
- the role of Chairman should be a full-time and preclude holding other commercial non-executive or executive positions for large banks.
Risk and compliance
- each bank should have a separate risk committee chaired by a non-executive director with bank industry experience and the character necessary to effectively challenge the executive. This committee should be supported by a strong risk function led by the Chief Risk Officer, who should be covered by the Senior Persons Regime and maintain independence from the executive; and
- firms internal control frameworks should be strengthened and increased responsibility should be given to particular non-executive directors to protect those responsible for key internal controls.
Standards and culture
- a named non-executive director, usually the Chairman, should oversee fair and effective whistle-blowing procedures, and should be held accountable when an individual suffers detriment in consequence of blowing the whistle;
- the regulator should periodically examine a firms whistleblowing records and banks should inform it of any employment tribunal cases brought by employees relying on the Public Interest Disclosure Act where found in the employees favour, based on which the regulator can determine whether to take enforcement action;
- the regulators should consider what information banks should include on whistleblowing in their annual reports;
- the FCA should undertake research into the impact of financial incentives in the US in encouraging whistleblowing; and
- the main UK-based banks should publish the gender breakdown of their trading operations within six months and thereafter in annual reports, and where there is a significant imbalance, they should state what steps they will take to address the issue.
5. Better functioning markets
The Commission makes a series of recommendations intended to improve the functioning of the banking markets and, in particular, the competitiveness of those markets. A level playing field between mainstream banks, investment firms and alternative providers is required in order to bring about higher standards and improve innovation and customer choice.
To ensure that these objectives can be achieved, the Commission recommends that:
Competition in retail banking
- the Competition and Markets Authority should immediately commence a full market study of competition in the retail and SME banking sectors, with a full public consultation on the extent of competition and its impact on consumers, to be completed on a timetable consistent with a market investigation reference by the end of 2015. The OFT have subsequently launched a market study of SME banking and the Chancellor of the Exchequer has specifically asked this study to consider what can be done to ensure that mandatory branch sales by RBS and Lloyds helped to boost competition;
- the Government closely monitors the practical application of the FSA's (now FCA's) prudential reforms aimed at reducing barriers to entry for the authorisation and approval of new entrants, with the regulator to provide a progress report in two years;
- the Government examines the merits of requiring large banks to relinquish ownership of the payments system and reports to Parliament on its conclusions before the end of 2013;
- the Department for Communities and Local Government reviews it guidance on the importance of high credit ratings as a measure of financial strength for local government investments, including the scope for new banks to demonstrate credit worthiness;
the regulators' should ensure the diversity of provision in the retail banking market, in particular:
- the PRA should avoid prudential requirements which deter alternative business models emerging; and
- the FCA should review whether alternative providers are put at a disadvantage and report to Parliament within 4 years.
- the FCA consult on a requirement to publish a range of statistical measures to enable consumers to judge the quality of service and price transparency delivered by different banks and periodically examine whether banks' systems for carrying out their own assessments are adequate;
- the Treasury should examine the tax treatment of peer-to-peer lending and crowdfunding firms to ensure a level playing field with mainstream banks and investment firms;
- the Treasury should establish an independent panel of experts to assess the technical feasibility, costs and benefits of greater personal bank account portability, which should report within 6 months on switching and 12 months on portability and central storage of consumer data; and
- the PRA should have competition as a statutory objective, subject to its overriding responsibility for financial stability.
Provision of basic bank accounts
- major banks should reach voluntary agreement on minimum standards for the provision of basic bank accounts, including access to the payments system and money management services, and free use of the ATM network, within 12 months or be subject to a new statutory duty;
- increased disclosure of lending decisions by the banks is necessary to enable policymakers to identify markets and geographical areas currently poorly served by the mainstream banking sector; and • the British Banking Association and the banks should be held to their commitment to refer declined loans to Community Development Finance Institutions.
- the Government should immediately announce a process for considering alternative strategies for the future of RBS, including splitting the bank and putting its bad assets in a separate legal entity, to report to Parliament by September 2013. In addition, the Government should also examine and report to Parliament on the scope for disposing of an RBS "good bank" as multiple entities to support the emergence of a more diverse and competitive retail banking market; and
- the UKFI should be wound-up, due to its lack of independence from the Government, and its resources and responsibilities for RBS and Lloyds Banking Group should be absorbed back to the Treasury.
Complaints and redress
- banks should dramatically improve their complaints handling records;
- the FCA should consider whether banks should be required to write to all identified customers in the PPI mis-selling scandal (except those who were previously contacted or brought a complaint) and subsequently report to Parliament;
- the FCA should consult on options for widening access to the Financial Ombudsman Service, in particular for small businesses; and
- the FCA should consider readjusting the FOS case handling fee to incentivise banks to manage a customers complaint fairly in the first instance.
6. Regulatory and supervisory approach
The Commission determined that while the primary responsibility for banking standards failures lies with those who ran the banks, the "scale and breadth of regulatory failure was also shocking". Although the Commission accepts that the PRA and the FCA are new organisations with new supervisory approaches, it considers that more effective oversight and empowerment tools are necessary to ensure that regulators' exercise greater judgment. To ensure that this can be achieved the Commission recommends that:
- supervisors should be close enough, and have a detailed enough understanding, of businesses to take swift decisions based on up-to-date information;
- senior regulatory staff should ensure that they employ a judgment-based approach when assessing risk and should expect to be held accountable to Parliament;
- regulators should not create an atmosphere of fear that stifles normal operations through regulatory actions; and
- the FCA's strategic objective of "ensuring that the relevant market functions well" should be dropped.
In order to ensure that the regulators have met their new objectives, the Commission recommends that the Treasury Committee undertakes an inquiry in three years' time into the supervisory and regulatory approach of the regulators. The inquiry should specifically consider:
- whether the FCA's approach to data requests and analysis has been appropriate;
- the FCA's use of their new product prevention tools; and
- the risk that the PRA and FCA appear to act as shadow directors in their new judgment-based approach to regulation.
In addition, a successful regulatory framework will depend on regular and frank discussions between senior regulators and bank executives. The PRA and FCA should keep summary records of all meetings with senior bank executives, which should be available for Parliamentary inspection.
Special Measures – a pre-enforcement tool
- The Commission recommends providing the PRA and FCA with a new regulatory "special measures" tool that can be deployed to deal with systemic weaknesses of leadership, risk management and control.
- This tool could be adopted as a pre-cursor to formal enforcement action by the regulator if a bank fails to address the regulator's concerns satisfactorily.
- Before the deployment of special measures, the regulators will commission an independent skilled person's report assessing the initial concern and enter into dialogue with a bank, providing them with a reasonable period of time to address the concerns.
- Special measures will take the form of a formal commitment by a bank to address the concerns raised by the regulators.
- Once in special measures, a bank would be subject to more intensive and frequent monitoring by the regulators and an individual within the bank would be charged with ensuring that the remedial action was implemented. If necessary the regulators could require an independent person to oversee this process.
The Commission considers that international regulatory approach implemented through Basel II was flawed and that Basel III and the associated EU legislation failed to address the problems. As such, the Commission recommends that:
- the Bank of England should report to Parliament on the extent to which Basel III has addressed the shortcomings of Basel II;
- the regulators should prepare a report for Parliament on their progress in reducing the dependence on credit rating agencies ratings for the purpose of assessing capital adequacy and further plans for action by June 2014;
- the capital "leverage ratio" should be substantially higher than the 3% minimum proposed under Basel III;
- the FPC should be given the duty of setting the "leverage ratio" from Spring 2013; and
- the FPC should consider and publicise a report on whether the "leverage ratio" should act as a regulatory front-stop as opposed to a back-stop given the recognised inadequacies, by the end of 2013.
Bank of England Accountability
The Commission considers that it is "essential" to strengthen the Bank of England's accountability following the creation of the FPC, PRA and the FCA. This requires the transformation of the structure and role of the Bank of England's Court of Directors – the body responsible for managing the central bank's affairs, except for the formulation of monetary policy. The proposed transformation would be similar to that previously recommended by the Treasury Committee in 2011, who suggested that the "anachronistic" court be "transformed into a board effective enough to exercise meaningful governance".
In addition, the Commission considers that the senior independent Bank of England Board member should chair the PRA rather than the Governor, to ensure that the accountability and authority of the PRA's chief executive is not undermined.
The Commission also reiterated the call for the Bank of England to be "given a duty" to respond to reasonable requests for information from Parliament.
Changing the tax regime
The Commission considers that the current tax regime is misaligned with regulatory objectives in that it incentivise banks to obtain funding through debt rather than equity, which creates greater risk for banks issuers. Accordingly, the Commission recommends the Government to consult on whether to introduce a limited form of an Allowance for Corporate Equity for the regulated banking sector. The Commission also suggests that an uplift in the bank levy may be appropriate.
Accounting for regulatory needs
The Commission consider that reform of accounting standards should better reflect the needs of bank regulators and investors. As such, the Commission recommends that:
- there should be mandatory dialogue between supervisors and external auditors, with the Bank of England responsible for providing a periodic report on the quality of the dialogue;
- a separate set of accounts based on specified prudential principles for regulatory purposes should be produced and externally audited, with the option for publication where there is a public interest. The auditors' report should include specific commentary on the key subjective matters of valuation, risk and remuneration, which are key to an investors understanding of a bank's business model; and
- the HMRC, PRA and FCA should jointly publish a paper setting out how they intend to bring about appropriate useful sharing of information and expertise within the existing rules. In addition, the National Audit Office should undertake a periodic review of how effectively the PRA uses its powers to promote information sharing.
The Commission also noted that it was presented with a wide range of evidence on the deficiencies of IFRS accounting for banks, but that further consideration of this evidence was outside its remit.