On 25 February 2013, the EU Parliament’s Committee on Legal Affairs published its final opinion proposing certain amendments to ‘proposal for a Directive of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and investment firms’ (the “RRD”). This is a follow up to the draft opinion published on 5 February 2013. The amendments proposed in the final opinion exactly mirror those detailed in the draft opinion, as summarised in our previous blogpost.
In a sign that the political tide may be turning, the FT is reporting that the Federal Reserve and the Federal Deposit Insurance Corporation have raised the prospect of taking severe action against banks that submit deficient living wills, including increased capital requirements or even forced break-ups.
Whereas previously, it was accepted that RRP was an iterative process that may take a number of years to get fully up to speed, it seems that truly credible plans will now be required when the next round of RRP are submitted in July 2013. This is due, at least in part, to the regulators’ disappointment at the lack of detail and clear proposals for resolution in the 2012 submissions.
On 27 February 2013, the European Commission published an updated summary of the legislative and non-legislative proposals it expects to adopt between 21 February and 31 December 2013.
Among the legislative acts expected to be adopted are a:
- Directive/Regulation on the reform of the structure of EU banks (i.e. Liikanen), expected in Q3 2013;
- Framework for crisis management and resolution for financial institutions other than banks, expected in Q4 2013; and
- Regulation on a single resolution authority and a single resolution fund within a Single Resolution Mechanism (SRM), expected in Q4 2013.
As previously reported on this blog, on 20 February 2013 the FSA published an update to its Recovery and Resolution Planning guidance. It was announced that, in the future, firms will not have to update their resolution information pack (RRP Modules 3-6) on an annual basis as a matter of process. Instead, they will only be required to respond to requests for resolution planning information from their supervisors.
It seems difficult to reconcile the FSA’s new position with other RRP guidance. The FSB’s “Key Attributes” document states clearly that “supervisory and resolution authorities should ensure that RRPs are updated…at least annually or when there are material changes to a firm’s business or structure”, a requirement which is echoed in the draft Recovery and Resolution Directive (RRD). More generally, given the enormous amount of data processing effort that goes into updating a resolution plan in practice, it is difficult to see how any firm which does not follow processes designed to facilitate the periodic updating of a resolution plan could ever be taken to be in compliance with the “Key Attributes” requirements that it must be able to demonstrate an ability to produce the essential information needed to implement a resolution plan within 24 hours or be capable of delivering sufficiently detailed, accurate and timely information to support an effective resolution.
Firms would also be forgiven for being confused as to how best to react to this guidance in light of other regulatory developments which offer incentives for those who are prepared to constantly seek to optimise their resolvability, including:
- the additional loss-absorbency requirements of Basel III for Global Systemically Important Banks;
- the Liikanen proposal that structural separation above and beyond that relating to ‘significant’ trading activities should be dependent on the robustness of RRPs; and
- the Vicker’s recommendation that an additional levy of up to 3% of equity capital be required of a UK banking group that is judged “insufficiently resolvable to remove all risk to the public finances”.
Enhancing resolvability demands a proactive, rather than a reactive, approach to RRP legislation. By its nature, the assimilation of resolution information is not a process that can be easily mothballed and simply dusted-down as and when required, particularly for firms operating in multiple jurisdictions. Rather, if it is to mean anything, optimising resolvability requires huge commitment and continued cooperation on the part of both firms and authorities. In light of the drafting of the “Key Attributes” document and particularly the RRD, it is at least questionable whether the new FSA guidance will survive the test of time. The message to firms must surely be to note the FSA’s new guidance with interest but to continue on a ‘business as normal’ footing with their RRP preparations.
On 25 February 2013, the FSA published Policy Development Update Number 156 detailing forthcoming publications from the FSA on a wide range of issues, including:
- RRP: Policy Statement to CP11/16 and PS12/5 on recovery and resolution planning. This is expected to be published in Q2 2013; and
- CASS RP: Policy Statement to CP 12/20, “Review of the client money rules for insurance intermediaries”. This will include finalised rules regarding CASS Resolution Packs for firms subject to CASS 5 and is expected to be published in Q3/Q4 2013.
The FSA has published an update to its Recovery and Resolution Planning (RRP) guidance dated 20 February 2013.
It expects to publish formal RRP rules “soon” after the FSA hands responsibility over to the Prudential Regulation Authority on 1 April 2013. An updated RRP information pack for firms can be expected soon thereafter with subsequent updates aimed at aligning UK domestic requirements with Financial Stability Board guidance and the EU Recovery and Resolution Directive also expected.
In light of the experience of RRP submissions to date and international policy development, the FSA update also details the following two policy changes:
- firms will be required to update recovery plans annually as part of their normal risk management procedures and submit it to supervisors for review when requested; and
- firms will not have to update their resolution information pack (RRP Modules 3-6) on an annual basis as a matter of process. Instead, they should respond to requests for resolution planning information from their supervisors.
On 12 February 2013, Julian Adams, FSA Director of Insurance, gave a speech at the Economist Insurance Summit in London on the lessons for insurance supervisors from the financial crisis.
Mr Adams explained that the overall objective of the FSA is to create an environment in which no insurer is too big, too complex or too interconnected to fail, and where participants are able to exit the market in an orderly fashion which ensures continuity of access to critical services.
He noted that the UK currently does not have a resolution regime for insurers, instead relying on ‘run-off’, Schemes of Arrangement and formal insolvency. However, each of these options carries attendant risks meaning that it is necessary to at least consider whether a resolution regime for insurers in necessary. Any such regime would be consistent with the Financial Stability Board’s ‘Key Attributes’ document and would also take a lead from the International Association of Insurance Supervisors, which is due to publish its initial list of Globally Systemic Important Insurers in the summer of 2013. The key challenge is to recognise the specificities of insurance compared to other financial sectors – particularly the factors that make an insurer ‘systemically important’. On this topic, Mr Adams highlighted three issues:
Use of Leverage – such as:
- engaging in stock lending in order to invest proceeds in higher yielding (and therefore higher risk) paper; or
- facilitating borrowing by non-insurance group members on the strength of an insurance business;
Asset Transformation – such as the sale of long-term investment products by life insurance companies; or
Assumption of Credit Risk – such as:
- the securitisation of corporate paper; or
- the funding of annuity liabilities through exposure to subordinated corporate debt.
If the answer to any one of these questions, alone or in combination, is positive then the FSA would “consider carefully” whether the firm in question was systemically significant.
On 16 February 2013, the finance ministers and central bank governors of the G20 published a communique following the closure of their meeting in Moscow on 15 and 16 February 2013. Amongst other things, the G20 confirmed that operational resolution plans for all global systemically important banks (G-SIBs) should be developed by the end of June 2013 and resolved to address all impediments to effective home-host cooperation of resolution authorities for internationally active banks.
On 4 February 2013, the Financial Services (Banking Reform) Bill 2013 (the “BRB”) was published on the UK Parliament website. The BRB had its first reading in the House of Commons on 4 February, and its second reading on 5 February. Its purpose is to implement the recommendations of the Independent Commission on Banking (ICB) and deals with the following issues:
- ring-fencing requirements for the banking sector;
- depositor preference; and
- Financial Services Compensation Scheme.
This article focuses on ring-fencing requirements, an initiative which the UK government estimates will cost the banking industry between GBP 1.5 and 2.5 billion to implement and between GBP 1.7 and 4.4 billion per annum thereafter in terms of increased capital, funding and operational costs.
The BRB will implement ring-fencing in the UK via amendments to the Financial Services and Markets Act 2000 (“FSMA”). As currently drafted, the Prudential Regulation Authority (“PRA”) will be charged with ensuring that the business of “ring-fenced bodies” is carried on in a way that avoids any adverse effect on the continuity of the provision in the UK of “core services”.
A “ring-fenced body” is a UK institution which carries out one or more “core activities”. Currently, the only “core activity” is the accepting of deposits. It is widely assumed that a de minimis exemption will apply for UK institutions with less than GBP 25 billion in deposits from individuals and small and medium sized entities (“SMEs”). In addition, building societies are not regarded as “ring-fenced bodies” or otherwise subject to the BRB, although the Treasury is empowered to pass similar rules for these institutions.
“Core Services” include the provision of:
- facilities for the accepting of deposits or other payments into an account which is provided in the course of accepting deposits;
- facilities for withdrawing money or making payments from such an account; and
- overdraft facilities in connection with such an account.
Additions to the lists of “core activities” and “core services” are possible but, broadly, require the Treasury to form the view that an interruption of the provision of the activity or service in question could adversely affect the stability of all or a part of the UK financial system.
The Location and Height of the Ring-Fence
The location and height of a ring-fence at any time should be considered within the context of the general powers of prohibition granted to the Treasury. These powers allow it, inter alia, to prohibit a ring-fenced body from entering into transactions of a specified kind or with persons falling within a specified class if it considers that it would be more likely that the failure of a ring-fenced body would have an adverse effect on the continuity of the provision in the UK of core services. With that in mind, some clarity has been provided as to the type of services that can, and cannot, reside inside a ring-fence.
Outside of the Ring-fence
Ring-fenced bodies are not permitted to carry out “excluded activities”. Presently, only the regulated activity of dealing in investments as principal constitutes an “excluded activity”. However, the Treasury has powers to define other “excluded activities” if it considers that the carrying on of that activity by a ring-fenced body would make it more likely that its failure would have an adverse effect on the continuity of the provision in the UK of core services. In addition, the Treasury has power to allow a ring-fenced body to deal in investments as a principal if this would not be likely to result in any significant adverse effect on the continuity of the provision in the UK of core services.
Inside the Ring-Fence
Secondary legislation will define the conditions under which ring-fenced banks may enter into derivatives contracts. The government has confirmed that this will reflect the recommendations of the Parliamentary Commission on Banking Standards (“PCBS”), which require:
- the implementation of adequate safeguards to prevent mis-selling;
- agreement on a “limited and durable” definition of “simple” derivatives; and
- the imposition of limits on the proportion of a bank’s balance sheet which can be allocated to derivatives.
“Non-Core Deposits” are deposits made by high-net-worth private banking customers and larger organisations. They may be taken by a bank which is either inside or outside of a ring-fence. However, outside of a ring-fence, safeguards will be enacted via secondary legislation to ensure that depositors are able to make an informed choice prior to placement of the deposit. These safeguards are likely to include monetary thresholds and a requirement that eligible individuals and organisations must actively seek the exemption if they wish to use it.
Retail and SME Lending
Banking groups will not be required to carry out retail and SME lending exclusively from within the ring-fence.
Electrifying the Ring-fence
In order to ensure its robustness and effectiveness over time, the PRA will be required to report annually on the operation of the ring-fence. Specifically, it will be required to address:
- the extent to which ring-fenced bodies have complied with ring-fencing provisions,
- steps taken by ring-fenced bodies to comply;
- enforcement measures taken by the PRA; and
- the extent to which ring-fenced bodies have acted in accordance with guidance regarding the operation of the ring-fence.
In addition, the government has confirmed that it will amend the BRB in order to give the PRA the power, if required, to enforce full separation between retail and wholesale banking with respect to an individual banking group. However, it has chosen not to act on the recommendation of the PCBS to grant the PRA the power to enforce industry-wide separation, considering that decisions over the fundamental structure of banking in the UK should be left to Parliament rather than to a regulator.
Independence of the Ring-Fenced Body
Ring-fenced bodies will be required to ensure that, as far as reasonably practicable:
- the carrying on of core activities is not adversely affected by the acts or omissions of other members of its group;
- it is able to take decisions independently of other members of its group;
- it does not depend on resources from group members which would cease to be available in the event of the insolvency of the group member; and
- it would be able to continue to carry on core activities in the event of the insolvency of one or more other group members.
In order to give teeth to these provisions, ring-fenced bodies will be required to:
- enter into contracts with group members on arm’s length terms;
- restrict the payments (e.g. dividends) that it makes to other group members;
- disclose to its regulator information relating to transactions between it and other group members;
- include on its board of directors members who are independent both of the ring-fenced body and the wider group as well as non-executive members;
- act in accordance with a remuneration policy and a human resources policy meeting specified requirements;
- make arrangements for the identification, monitoring and management of risk in accordance with specified requirements; and
- implement such other provisions as its regulator considers necessary or expedient.
In addition, the government has confirmed that:
- directors of ring-fenced banks should be personally responsible for ensuring that their banks comply with ring-fencing provisions; and
- a director of a ring-fenced body must be an approved person so that the full range of PRA disciplinary powers may be applied to any director who is knowingly concerned in a contravention of any ring-fencing obligation.
The Treasury may also require banking groups to split pension schemes between ring-fenced and non ring-fenced entities as the former cannot become liable to meet, or contribute to the meeting of, liabilities in respect of pensions or other benefits payable to or in respect of persons employed by non ring-fenced bodies. However, this requirement will not enter into force until 1 January 2026 at the earliest.
The BRB inevitably leaves many question unanswered, including:
- the exact scope of the ring-fence i.e. the activities and assets which can (or cannot) be within the ring-fenced body: whilst some guidance has been provided at the edges the majority in the middle remains unknown;
- the exact nature of exemptions (including the de minimis exemption) from ring-fencing;
- specific prohibitions on the activities of ring-fenced banks; and
- the definition of a “simple” derivative: despite the recent mis-selling scandal it would appear that interest rate swaps used for the purposes of hedging can be sold from within the ring-fence. Presumably the same will be the case for vanilla currency swaps.
Much of the detail of the BRB remains to be fleshed out via statutory instrument. However, despite this, fundamental questions already exist about the enforceability of ring-fencing as current drafted. For example, the prohibition on non ring-fenced group companies benefiting from funding providing by a ring-fenced entity does not appear to be entirely consistent with Article 16(1) of the draft EU Recovery and Resolution Directive (“RRD”), which requires Member States to “ensure” that group companies can enter into an agreement to provide financial support to one another in the event of financial difficulties.
The UK government remains lukewarm at best to the idea of implementing further reform along the lines of the Volcker Rule, as advocated by the PCBS. Neither is it minded to increase the Basel III Leverage Ratio from its current 3% to 4%; another PCBS suggestion. Further afield, attempts to implement structural reform of banks at a national level within Germany and France may yet halt the momentum behind the Liikanen reforms. Ultimately, time will tell, but perhaps UK banks should be thankful for small mercies in that they may only face the prospect of having to split themselves in two, rather than three or even four, parts.
Whatever the final form of the BRB and other structural reform initiatives, one thing is certain: the process of separating a retail bank from a wholesale bank will be a monumental undertaking. It will require a detailed analysis of assets and liabilities for the purposes of allocation inside or outside of the ring-fence, fundamental legal and operational re-structuring, wholesale re-papering of contractual relationships and robust policies and procedures for the purposes of monitoring the location and height of the ring-fence on an ongoing basis. Despite the 2019 deadline and the many blanks in the legislation yet to be completed, any bank likely to be subject to the BRB should already be planning how it will implement organisational change on this scale.
 In the HM Treasury paper “Banking reform: a new structure for stability and growth”
On 5 February 2013, the EU Parliament’s Committee on Legal Affairs published a draft opinion proposing certain amendments to the ‘proposal for a directive of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and investment firms’ (the “RRD”). The draft opinion is very short and the proposed amendments most worthy of note are detailed below.
Recital 18 of the RRD currently refers to the ability of less systemically important firms to produce “simplified” resolution plans. The Legal Affairs Committee proposes to amend this reference so that resolution planning is “proportionate” to systemic relevance. However, to date, there appear to be no consequential changes to Article 4 which deals with “simplified” recovery and resolution obligations for less systemically important firms.
Article 5 of the RRD includes an ability for regulators to require institutions to update recovery plans more frequently than annually. In a welcome development, the proposed amendment would only allow this to happen if it were “necessary for the stability of the financial markets” so as to avoid needlessly burdening firms with red tape.
Article 78 of the RRD enables any person affected by a decision of a resolution authority to take a resolution action to apply for judicial review of that decision. However, as currently drafted, notwithstanding the right to apply for judicial review, the actual decision of the resolution authority is “immediately enforceable and shall not be subject to a suspension order issued by a court”. The Committee on Legal Affairs proposes to delete this caveat. The justification for this proposal is that it is not appropriate to restrict a court’s right to suspend resolution actions if breaches of rules are detected. Whilst understandable in principle, the reality is that, by the very nature of resolution itself, one or more parties are always likely to feel aggrieved following the initiation of resolution action. This amendment does not seek to restrict itself to ‘breaches of rules’ and the lack of certainty it would introduce into the resolution process risks creating problems of a higher order than those it seeks to cure.