Following on from its Interim Report published in April this year, the Independent Commission on Banking (Commission) published its Final Report yesterday, setting out its recommendations on reforms to promote stability and competition in UK banking. The recommendations on financial stability call for both structural reform and enhanced loss-absorbency within UK banks. Structural change in UK banking markets is recommended in order to promote competition in the sector.

The Commission’s recommendations aim to:  

  • reduce the probability and impact of systemic financial crises in the future;
  • maintain the efficient flow of credit to the economy and the ability of households and businesses to manage their risks and financial needs over time; and
  • preserve the functioning of the payment systems and guaranteed capital certainty and liquidity for small savers including small and medium-sized enterprises (SMEs).

Key Recommendations

The Commission’s key recommendations include:  

  • The Commission has rejected the idea of total separation between retail banking and wholesale and investment banking. The Commission recommends the retail ring-fencing of UK banks, such that UK retail activities will be carried out in separate subsidiaries which are legally, economically and operationally separate from the rest of the banking group to which they belonged.
  • Domestic retail banking services should be inside the ring-fence, global wholesale/investment banking should be outside, and the provision of straightforward banking services to large domestic non-financial companies can be in or out. The Commission estimates that between one sixth and one third of the £6 trillion on the balance sheets of UK banks would be within the retail ring-fence.
  • On loss-absorbency, the Commission recommends that large UK retail banks should have equity capital of at least 10% of risk-weighted assets, exceeding the Basel III minimum. Retail and other activities of large UK banking groups should have primary loss-absorbing capacity of at least 17-20%. There are also recommendations relating to depositor preference, resolution buffers and leverage ratios.
  • The Commission believes that the prospects for competition in UK retail banking would be improved by the creation of a new challenger by way of the Lloyds divestiture and recommends that the Government seek agreement with Lloyds to ensure that the divestiture leads to the emergence of a strong challenger bank.
  • To improve switching of accounts, a free redirection service should be set up for personal and SME current accounts.
  • Transparency of accounts should be improved by requirements on banks to disclose more information about prices and by making current accounts more easily comparable.
  • The Commission has decided not to recommend the referral of any banking markets to the Competition Commission at present, but recommends that such a reference be considered if certain requirements are not met by 2015.

Timing

The Commission would like the Government to establish its policies in light of the Commission’s recommendations by the end of 2011 and for legislation to be passed within the current Parliament.

In terms of implementation by banks, the Commission encourages banks to implement operational changes as soon as possible after legislation is passed, and suggests that:  

  • foregone interest should appear on bank statements no later than January 2013;
  • the proposed redirection service to facilitate the switching of accounts should be fully operational by September 2013;
  • given the additional capital the proposed reforms will require, full implementation of the structural and loss absorbency elements should not be required until the start of 2019 in line with the Basel III reforms.

A summary of the recommendations is set out below.

Recommendations from the Final Report of the Independent Commission on Banking

A. Retail ring-fence

The Commission recommends the implementation of a retail ring-fence based on the principles below:

Mandated services

The UK regulator should only give permission to provide certain vital "mandated" services to ring-fenced banks (which includes building societies). The banking services that are "mandated" should be those where:  

  • even a temporary (up to seven days) interruption to the provision of service resulting from the failure of a bank has significant economic costs; and
  • customers are not well equipped to plan for such an interruption.

The Commission currently recommends that mandated services should comprise the taking of deposits from, and the provision of overdrafts to, individuals and small and medium-sized organisations.

Prohibited services

Ring-fenced banks must not provide certain "prohibited" services, in order to improve financial stability through separation. The banking services that should be "prohibited" are those which meet any of the following criteria:  

  • make it significantly harder and/or more costly to resolve the ring-fenced bank;
  • directly increase the exposure of the ring-fenced bank to global financial markets;
  • involve the ring-fenced bank taking risk and are not integral to the provision of payments services to customers, or the direct intermediation of funds between savers and borrowers within the non-financial sector; or
  • in any other way threaten the objectives of the ring-fence.

Accordingly, the Commission' considers that prohibited services should include (but need not be confined to):  

  • any service which is not provided to customers within the European Economic Area;
  • any service which results in an exposure to a non-ring-fenced bank or a non-bank financial organisation, except those associated with the provision of payments services where the regulator has deemed this appropriate;
  • any service which would result in a trading book asset;
  • any service which would result in a requirement to hold regulatory capital against market risk;
  • the purchase or origination of derivatives or other contracts which would result in a requirement to hold regulatory capital against counterparty credit risk; and
  • services relating to secondary markets activity including the purchase of loans or securities.

Ancillary activities

Ring-fenced banks should only be permitted to engage in the following activities:  

  • the provision of services which are not prohibited; and
  • those ancillary activities which are necessary for the efficient provision of such services (these could not be standalone lines of business).

Examples of such necessary activities include employing staff and owning or procuring the necessary operational infrastructure. Certain (otherwise prohibited) financial activities – for risk management, liquidity management, or in order to raise funding for the provision of non-prohibited services – could be undertaken, but only to the extent that they are strictly required for the purposes of a ring-fenced bank's treasury function.

A ring-fenced bank may transact with and become exposed to non-ring-fenced banks and non-bank financial organisations when conducting ancillary activities. The Commission recommends backstop limits on the proportion of a ring-fenced bank’s funding which is permitted to be wholesale funding, and on its total exposures (secured and unsecured) to non-ring-fenced banks and other non-bank financial companies.

Legal and operational links

The authorities must be able to isolate a ring-fenced bank from the rest of any wider corporate group of which it may form part within days, and to continue the provision of its services without providing solvency support. To ensure this can be achieved, the Commission recommends that:  

  • Ring-fenced banks should be separate legal entities Any UK regulated legal entity which offers mandated services should only also provide services which are not prohibited and conduct ancillary activities;
  • Limits on activities of financial organisation owned or partly owned by ring-fenced banks Any financial organisation owned or partly owned by a ring-fenced bank should conduct only activities permitted within a ring-fenced bank. This organisation’s balance sheet should contain only assets and liabilities arising from these services and activities;
  • Arrangements within the wider group The wider corporate group should be required to put in place arrangements to ensure that the ring-fenced bank has continuous access to all of the operations, staff, data and services required to continue its activities, irrespective of the financial health of the rest of the group; and
  • Payment systems The ring-fenced bank should either be a direct member of all the payments systems that it uses or should use another ring-fenced bank as an agent.

Economic links

A ring-fenced bank that is part of a wider corporate group must conduct its relationships with entities in that group on a third party basis. The ring-fenced bank's solvency and liquidity should not depend on the continued financial health of the rest of the corporate group. This is to be achieved through a combination of regulation and sufficiently independent governance.  

Where a ring-fenced bank is part of a wider corporate group, the Commission recommends that:  

  • Non-ring-fenced entities within the same group For regulatory purposes its relationships with other group entities that are not ring-fenced banks should be treated no more favourably than third party relationships;
  • Other parts of the group All transactions (including secured lending and asset sales) with other parts of the group should be conducted on a commercial and arm’s length basis, in accordance with sound and appropriate risk management practices;
  • Possibility of further rules to ensure arm’s length relationships Additional rules should be considered where the application of existing regulation will not ensure third party arm’s length relationships.
  • Sale and acquisition of assets The ring-fenced bank should only buy assets from, and sell assets to, other group entities at market value, and should not acquire assets from other group entities unless those assets could have resulted from the provision of non-prohibited services;
  • Solo accounting The ring-fenced bank's regulatory requirements, including those for capital, large exposures, liquidity and funding, should be met on a solo basis;
  • Dividends, capital transfers and other payments The board of the ring-fenced bank must be satisfied that the ring-fenced bank has sufficient financial resources before any dividend payments and other capital transfers can be made. Unless explicit regulatory approval has been given, payments which would cause the ring-fenced bank to breach any kind of capital requirement, including requirements to hold buffers above minimum requirements, should not be allowed;
  • Independent board The board of the ring-fenced bank should be independent. The level of independence appropriate would depend on the proportion of the banking group’s assets outside the ring-fenced bank: unless the vast majority of the group’s assets were within the ring-fenced bank, the majority of directors should be independent non-executives of whom:
  1. one should be the Chair; and
  1. no more than one sits on the board of the parent or another part of the group;
  • Disclosure requirements on a solo basis A ring-fenced bank must make all disclosures which are required by the regulator of the wider corporate group and/or its other relevant substantial subsidiaries, and those which would be required if the ring-fenced bank were independently listed on the London Stock Exchange, on a solo basis.
  • Duty to maintain ring-fence The boards of the ring-fenced bank and of its parent company should be subject to a duty to maintain the integrity of the ring-fence, and to ensure the ring-fence principles are followed at all times.

B. Loss-absorbency

Equity

  • Ring-fenced banks with a ratio of risk-weighted assets (RWAs) to UK GDP of 3% or more should be required to have an equity-to-RWAs ratio of at least 10%.
  • Ring-fenced banks with a ratio of RWAs to UK GDP in between 1% and 3% should be required to have a minimum equity-to-RWAs ratio set by a sliding scale from 7% to 10%.

Leverage ratio

  • All UK-headquartered banks and all ring-fenced banks should maintain a Tier 1 leverage ratio of at least 3%.
  • All ring-fenced banks with a RWAs-to-UK GDP ratio of 1% or more should have their minimum leverage ratio increased on a sliding scale (to a maximum of 4.06% at a RWAs-to-UK GDP ratio of 3%).

Bail-in

  • Primary bail-in power The resolution authorities should have the power to impose losses on long-term unsecured debt (bail-in bonds) in resolution before imposing losses on other non-capital, non-subordinated liabilities.
  • Secondary bail-in power The resolution authorities should have the power to impose losses on all other unsecured liabilities in resolution.

Depositor preference

  • All insured depositors should rank ahead of other creditors in insolvency (and therefore also in resolution), to the extent that those other creditors are either unsecured or only secured with a floating charge.

Primary loss-absorbing capacity

  • UK-headquartered global systemically important banks (G-SIBs) with a 2.5% G-SIB surcharge, and ring-fenced banks with a ratio of RWAs to UK GDP of 3% or more, should be required to have capital and bail-in bonds (together, primary loss-absorbing capacity) equal to at least 17% of RWAs.
  • UK G-SIBs with a G-SIB surcharge below 2.5%, and ring-fenced banks with a ratio of RWAs to UK GDP of in between 1% and 3%, should be required to have primary loss-absorbing capacity set by a sliding scale from 10.5% to 17% of RWAs.

Resolution buffer

  • The supervisor of any G-SIB headquartered in the UK, or ring-fenced bank, with a ratio of RWAs to UK GDP of 1% or more, should be able to require the bank to have additional primary loss-absorbing capacity of up to 3% of RWAs if, inter alia, the supervisor has concerns about its ability to be resolved at minimum risk to the public purse.
  • The supervisor should determine:
  • how much additional primary loss-absorbing capacity, if any, is required;
  • the form it should take;
  • the entities within a group to which the requirement should apply; and
  • whether the requirement should be applied on a sub-consolidated or solo basis.

C. Competition

Market structure

The Commission recommends that the Government should reach agreement with Lloyds Banking Group (LBG) to ensure that the entity which results from its state aid divestiture:  

  • has a funding position at least as strong as its peers, including as evidenced by its loan-to-deposit ratio (LDR) relative to its peers’ LDRs at the time of the disposal; and
  • has a share of the personal current account (PCA) market of at least 6%.

Barriers to entry

The Prudential Regulatory Authority (PRA) should work with the Office of Fair Trading (OFT) to review the application of prudential standards to ensure that prudential requirements for capital and liquidity do not unnecessarily limit the ability of new entrants to enter the market. It should ensure that use of the standardised approach to calculating risk weights does not penalise banks that are unable to make the transition to an advanced approach because of the high fixed cost of doing so.

Switching

To smooth the process of switching current accounts for individuals and small businesses, a current account redirection service should be established to:  

  • catch all credits and debits going to the old account, including automated payments taken from debit cards as well as direct debits;
  • be seamless for the customer, ensuring that they retain full use of their banking services without being inconvenienced by debits or credits going to the wrong account;
  • ensure that annual payments are caught, by continuing for at least 13 months;
  • continue to send reminders and provide support to direct debit originators to ensure that they update their details for people who have switched accounts;
  • guarantee that customers will not suffer loss should there be mistakes during the switching process; and
  • be free to the customer.

The Government should ensure that the redirection service is fully operational by September 2013.

The redirection service should not impose disproportionate costs on new entrants and banks that access payments systems through agency arrangements. Small banks, building societies and small business direct debit originators should not be penalised by these changes.

A maximum timescale should also be introduced for the release of security after repayment of borrowing, and banks should improve the process for transferring security. The Commission believes this should ease switching for small businesses.

Transparency

The OFT, and the Financial Conduct Authority (FCA) once established, should work with the banks to improve transparency across all retail banking products, in particular for PCAs and business current accounts (BCAs). The Commission recommends the following:  

  • Data on cost of services Banks should provide data on the cost of their services (including before and after any introductory period) for a sample of representative customer profiles to demonstrate potential costs, and should provide price information in an accessible form in response to any reasonable request from a price comparison site.
  • Foregone interest on bank statements The Commission recommends that interest foregone relative to the Bank of England base rate should be incorporated into the annual statements which are being introduced following the OFT’s work on PCAs. The FCA should carry out customer research on how best to present foregone interest on bank statements, and should require banks to provide this information in the standardised way it prescribes. Foregone interest should appear on bank statements as soon as possible and, in any event, no later than January 2013.
  • Other options to improve transparency Following implementation of the OFT’s current transparency remedies, the FCA should consider other options for further improving transparency, including:
  • making account usage data available to customers in electronic form so that it can be used as an input by price comparison sites;
  • requiring that product ranges include an easily comparable standardised product;
  • improving price comparison tools for PCAs and creating a code of practice for comparison sites; and
  • developing comparison tools for non-price product characteristics.

Financial Conduct Authority

The Commission welcomes the Government’s proposal to give the FCA a new primary duty to promote competition but believes the duty should be clarified:  

  • In the FCA’s draft objectives, the efficiency and choice operational objective should be replaced with an objective to “promote effective competition” in markets for financial services.
  • The duty to discharge its functions in a way which promotes competition should be retained. It should be clear that the FCA should use competition as a means of achieving any of its operational objectives – not just the competition objective – wherever possible.
  • The Government should reframe the FCA’s strategic objective so that there is greater clarity on the fundamental issue of making markets work well – in terms of competition, choice, transparency and integrity.

Market investigation reference – PCA and BCA markets

The OFT intends to carry out a review of the PCA market in 2012. The Commission is not suggesting that there should be an immediate market investigation reference to the competition authorities in respect of the PCA and/or BCA markets. However, the Commission believes such a reference might be appropriate if, by 2015, one or more of the following has not been achieved  

  • the LBG divestiture has given rise to a strong and effective challenger;
  • ease of switching has been transformed by the early establishment of a robust and risk-free redirection service; and
  • a strongly pro-competitive FCA has been established and is demonstrating progress to improve transparency and reduce barriers to entry and expansion for rivals to incumbent banks.