Banking Reform Bill Bulks Up

H.M. Treasury yesterday published 86 proposed amendments to the Banking Reform Bill. The bill is due to enter its committee stage in the House of Lords on the 8th October 2013. The proposed amendments were widely-flagged and broadly mirror the 11th March 2013 recommendations of the Parliamentary Commission on Banking Standards.  Highlights are as follows:

  • Payments: the introduction of a wholly new and distinct payment systems regulator, the intention being to stimulate competition by facilitating access to payment systems for new market participants, as well as decreasing the costs of account portability. A special administration regime to deal with cases where a key element in a payment fails or is likely to.
  • Misconduct: an extension of the FSMA approved persons regime. If passed, the amendments will allow the regulators to: make the approval subject to conditions or time-limits, extend time limits for sanctions against individuals, impose “banking standards rules” on all employees , and to hold senior managers responsible for regulatory breaches in areas which they control. PCBS chairman Andrew Tyrie, (perhaps confusing Ford Open Prison with Guantanamo), had previously advocated putting “guilty bankers in bright orange jump suits”; as widely expected, the proposals introduce criminal sanctions for reckless misconduct in the management of a bank.
  • Electrified ring-fence:  proposed new powers to formalise and streamline the “electrification” power introduced at the Commons report stage. The electricity in the ring-fence is the regulator’s power to compel separation of a banking group which breaches the boundary between retail and investment banking. The effect of the new powers is to make the ring-fence into a “variable-voltage” device. Under the proposal, the regulator will:
  1. issue a preliminary notice, the affected party will have a minimum of  14 days to reply and 3 months to make necessary changes to its behaviour/structure
  2.  failing this and with the consent of the Treasury, a warning notice will then be issued, itself triggering a minimum of 14 days for representations by the affected party
  3. a decision notice is then issued, which may be appealed before a Tribunal
  4.   a final notice is issued which set s a dead line by which a bank must separate its activities

The whole process will take approximately 14 months and the various notices will be issued in accordance with general FSMA principles.

Bail-in:  the introduction of a bail-tool as initially mandated by the European BRRD and recommended by the domestic ICB and PCBS. The Banking Act of 2009 will be amended to include a “stabilisation option” (bail-in), covering banks and investment firms and to be applied by the bank of England as lead resolution authority.  The conditions for its use are identical to those of the Special Resolution Regime:

  1. the regulator must determine that the bank is failing or is likely to fail
  2. it is not likely that any other action can avoid the failure
  3. The BoE determines that application of the bail-in power is in the public interest

The bail-in option includes the right to modify existing contracts for the purpose of mitigating the liabilities of a bank under resolution. There are a number of liabilities which will be excluded from the provision: client money, FSCS protected deposits, employee pension schemes, payment system liabilities, debts to a creditor who is critical to the bank’s daily functioning etc.

In short- the electric ring-fence is reconnected to the mains and bail-in is set to become a reality. These and other less fundamental proposed amendments represent a significant extension of regulatory powers. It remains to be seen if they will be rigorously and consistently applied to their full extent.

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Update on Banking Reform Bill

On 9 May 2013, the Financial Services (Banking Reform) Bill was reintroduced to Parliament, having been carried over to the 2013-14 session.  The text of the bill is the same as that originally published on 4 February 2013 (see this blog post for more detail).  The bill completed its committee stage on 18 April 2013 and will now proceed to the report stage, although the date upon which this is scheduled to take place is not yet known.

Banking Reform Bill: HM Treasury publishes Amended Statutory Instrument

On 18 March 2013, HM Treasury published an amended version of draft Financial Services and Markets Act 2000 (Ring-fenced Bodies and Core Activities) Order (the “Ring-Fenced Bodies Order”).  The Ring-Fenced Bodies Order is one of the pieces of secondary legislation to be made under the Banking Reform Bill.

The main change from the original version of the Ring-Fenced Bodies Order, published on 8 March 2013, seems to relate to high net worth individuals (“HNWI”) and small and medium sized enterprises (“SME”).  As detailed in our previous blog post, deposits are exempt from the requirement to be held within a ring-fenced body if they are held on behalf of:

  • HNWI (i.e. individuals who have, on average over the previous year, held free and investible assets worth GBP 250,000 or more); and
  • SME which are also financial institutions.

Under the original order, HNWIs and SMEs could effectively self-certify their status as such.  Under the amended order it seems that the institution in question is now responsible for determining whether HNWI or SME status is indeed appropriate.

PCBS Itching to Ban Proprietary Trading

On 15 March 2013, the Parliamentary Commission on Banking Standards (PCBS) published its Third Report on proprietary trading within banks.

The PCBS considers that there is no commonly-accepted definition of proprietary trading and recognises that most activity undertaken by banks results in some form of proprietary position.   However, it is primarily concerned with trading in which a bank uses its own funds to speculate on markets, without any connection to customer activity.  It accepts that proprietary trading results in risks which are not necessarily any different from those associated with other banking activities, many of which actually made a greater contribution to the financial crisis.  Nonetheless, it considers that the argument that proprietary trading can have harmful cultural effects within a bank has been “convincingly made”, creating a conflict of interest between a bank’s attempts to serve its customers and the trading of its own positions and, as such, being “incompatible with maintaining the required integrity of customer-facing banking”.

Despite its in-principle opposition to proprietary trading, even outside of a ring-fenced bank, the PCBS recognises the practical difficulty in establishing a definition of “proprietary trading” which is capable of being effectively enforced, given its similarity to other activities such as market-making.  Even alternative metric-based approaches, such as those being considered in the US, which track patterns of trading activity remain unproven, relatively complex and resource-intensive.  Consequently, the PCBS believes that it would not be appropriate to attempt immediate prohibition of proprietary trading through the Banking Reform Bill (BRB).  However, it does recommend that the current legislation require the regulators to carry out, within three years of the BRB being enacted, a report to include, inter alia, a full assessment of the case for and against a ban on proprietary trading.  This report would be presented to the Treasury and to Parliament and serve as the basis of a full and independent review of the case for action in relation to proprietary trading by banks.  In the meantime, the PCBS recommends that the Prudential Regulation Authority (PRA) monitor the main UK-headquartered banks’ assertion that they no longer engage in proprietary trading, and should use its existing tools such as capital add-ons or variations of permission to “bear down on such activity and incentivise the firm to exercise tighter control”.

PCBC Publishes Second Report on UK Banking Reform

On 11 March 2013, the Parliamentary Commission on Banking Standards (PCBS) published its second report on banking reform in the UK.

The second report addresses the UK government’s response to the first report of the PCBS and specifically the suggestions made therein in relation to banking reform.  It makes a number of recommendations and observations, including:

  • Independent Review: the PCBS encourages the government to implement a fully independent review of the workings of the ring-fencing mechanism, and not just a regulator review as currently proposed.  This, the PCBS claims is “wholly inadequate” and amounts to no more than the “regulator marking its own examination paper”;
  • Full industry–wide structural separation: despite the government’s rejection, the PCBS continues to believe that the Banking Reform Bill should include legislation which would enable full structural separation of the banking industry if the independent review of the workings of the ring-fencing mechanism proposed above concluded that this were necessary;
  • Ownership structures: the PCBS is ‘disappointed’ that the government has chosen not to restrict the ability of an investment bank to own a ring-fenced bank; and
  • Leverage Ratio – the PCBS regards the case for maintain the acceptable leverage ratio of a bank at 3% (i.e. 33 times leveraged) as “extremely weak” and continues to press for a 4% (i.e. 25 times leveraged) limit.

The PCBS intends to publish its final report by mid-May 2013.

The Banking Reform Bill: Secondary Legislation Hints at the Data Challenge Facing Banks

Introduction

On 8 March 2013, three draft statutory instruments to be made under the Financial Services (Banking Reform) Bill 2012-13 (the “Banking Reform Bill”) were published by HM Treasury:

These statutory instruments are starting to put flesh on the bones of the Banking Reform Bill, a piece of framework legislation which was published last month.  For more detail on the Banking Reform Bill in general, please see our previous blog post.

The draft statutory instruments deal with four main issues:

  • The class of institutions which are exempt from the definition of “ring-fenced body” (“Exempt Institutions”);
  • The types of deposit that do not need to be held within a ring-fenced body (“Exempt Deposits”);
  • The types of activities that will not be regarded as “excluded” and therefore can be conducted by a ring-fenced body (“Exempt Activities”); and
  • The amount of exposure a ring-fenced entity is permitted to incur to a “financial institution” (“Permitted Exposure”).

A more detailed summary of the draft statutory instruments is provided in the Schedule below.  As more information becomes known we will provide additional updates.  However, even at this stage of the legislative process, what becomes immediately apparent is the huge data challenge firms will face in monitoring the height and location of the ring-fence, particularly with respect to the process surrounding Exempt Deposits and when incurring exposure to financial institutions.

Schedule

The Ring-fenced Bodies Order

In general, the Ring-fenced Bodies Order defines:

  • The class of Exempt Institutions; and
  • The class of Exempt Deposits.

Exempt Institutions

The following institutions do not qualify as ring-fenced bodies and are therefore not subject to the ring-fencing rules:

  • broadly, any deposit taking institution which has held, on average, GBP 25 billion or less in deposits (calculated by reference to all UK deposit taking institutions in the group);
  • insurance companies; and
  • credit unions or industrial and provident societies.

Exempt Deposits

Deposits are Exempt Deposits if they are held on behalf of:

  • high net worth individuals (“HNWI”) (i.e. individuals who have, on average over the previous year, held free and investible assets worth GBP 250,000 or more); and
  • small and medium sized enterprises (“SME”) which are also financial institutions and have been certified as such within the preceding 18 months.

An SME is:

  • an enterprise which
    • employs fewer than 50 staff; and
    • has a turnover of GBP 6.5 million or less, or an annual balance sheet total of GBP 3.26 million or less; or
  • a charity which has gross income (calculated on a group-wide basis) of GBP 6.5 million or less.

Note, however, that the following do not qualify as “financial institutions” and so deposits held for these institutions cannot qualify as Exempt Deposits irrespective of whether the institutions would qualify as SMEs:

  • ring-fenced bodies;
  • building societies;
  • credit unions; or
  • investment firms authorised to deal in investments as principal or agent.

In addition, if a statement regarding HNW or SME status is not refreshed every 12 months, or if a firm is notified that an account holder no longer benefits from HNW or SME status, and the deposit is held by a firm which is not already:

  • a ring-fenced body;
  • an Exempt Institution; or
  • a building society

then the firm in question must notify the account holder that the deposit will become a “core deposit” (and therefore subject to the ring-fencing requirements) if the HNW or SME status is not refreshed within 18 months of its original date.  The notification must also request that the account holder respond to the firm within six months:

  • providing an updated HNW or SME certificate;
  • nominating a ring-fenced body to which the deposit can be transferred if it becomes a “core deposit”; or
  • acknowledging that the account holder will accept repayment of the deposit, together with details necessary to effect such repayment.

The account holder must also be warned that a failure to respond will result in the transfer of the deposit to an identified ring-fenced body.  If the firm has a group member which is also a ring-fenced body, then the transfer of the deposit should be made to that group member.

The Excluded Activities Order

Exempt Activities

Under the Banking Reform Bill, ring-fenced bodies are not allowed to partake in “excluded activities” (i.e. dealing in investments as principal).  However, under the Excluded Activities Order, a ring-fenced body will not be regarded as carrying on an excluded activity by:

  • entering into a transaction if the sole or main reason for doing so is to hedge interest rate, currency, default or liquidity risk;
  • buying, selling or acquiring investments for the purposes of maintaining liquid resources as required by BIPRU 12 (provided that this does not result in a breach of the “Financial Institutions Exposure Limits” detailed below); or
  • entering into derivatives transactions with its accounts holders, provided that such transactions comply with the “Derivative Transactions” requirements detailed below.

Derivative Transactions

A ring-fenced body may enter into derivatives transactions with its account holders provided that those transactions:

  • have a linear pay-off (i.e. no options); and
  • the sole or main purpose of the transaction is to hedge:
    • interest rate risk;
    • currency risk; or
    • commodity price risk; and
  • there is evidence available to assess the “fair value” of the investment; and
  • the “position risk requirement” (i.e. the capital requirement applied to market risk positions under BIPRU 7) attributable to all such transactions remains less than TBD% of the ring-fenced body’s own funds; and
  • the sum of the position risk requirements attributable to each individual transaction is less than TBD% of the “credit risk capital requirement” of the ring-fenced body calculated in accordance with GENPRU 2.1.51.

Financial Institution Exposure Limits

Ring-fenced bodies are prohibited from entering into any transaction under which it will incur exposure to a financial institution unless:

  • the sole or main reason for entering into the transaction is to hedge:
    • interest rate risk;
    • currency risk; or
    • default risk; and
  • where the transaction is concluded with a member of the ring-fenced body’s group, it is done so on arms’ length terms; and
  • where the financial institution in question is a “small credit institution” (judged by reference to the size of its balance sheet), the transaction does not increase the ring-fenced body’s exposure:
    • in aggregate to small credit institutions above TBD% of the ring-fenced body’s own funds; or
    • to its counterparty (i.e. to the small credit institution) above TBD% of the ring-fenced body’s own funds; and
  • the transaction does not:
    • increase the aggregate payment exposure of the ring-fenced body to an amount equal to or greater than:
      • TBD% of the ring-fenced body’s own funds in relation to overnight payment exposure[1], or
      • TBD% of the ring-fenced body’s own funds in relation to intra-day payment exposure; and
      • increase the ring-fenced body’s exposure to the financial institution to an amount which is TBD% or more of the ring-fenced body’s own funds; and
  • the transaction does not:
    • increase the aggregate settlement exposure of the ring-fenced body to an amount equal to or greater than:
      • TBD% of the ring-fenced body’s own funds in relation to settlement exposure with a maximum tenor of t+2, or
      • TBD% of the ring-fenced body’s own funds in relation to settlement exposure with a maximum tenor of t+5[2]; and
      • increase the ring-fenced body’s exposure to the financial institution to an amount which is TBD% or more of the ring-fenced body’s own funds; and
  • in relation to letters of credit issued to a financial institution on behalf of a customer of the ring-fenced body:
    • the customer is not a financial institution; and
    • the letter of credit:
      • is issued in connection with the supply of goods or services; and
      • specifies the transactions to which it relates; and
      • specifies the total credit available under it; and
      • is subject to the uniform customs and practices for documentary credits 2007 version[3]; and
      • the total exposure of the ring-fenced body in relation to letters of credit is less than TBD% of the ring-fenced body’s own funds.

Ring-fenced bodies will be required to disclose payments exposure, settlements exposure and exposure to letters of credit.

Other Developments

Inter-bank Clearing and Settlement Services

Ring-fenced bodies will be required to access inter-bank clearing and settlement systems either directly, or indirectly via another ring-fenced body.

Non-EEA Branches and Subsidiaries

Without the approval of the Prudential Regulation Authority (“PRA”), a ring-fenced body may not:

  • maintain or establish a branch in any country or territory which is not an EEA member state; or
  • have a participating interest in any undertaking which is incorporated in or formed under the law of country which is not an EEA member state.

Moreover, although a ring-fenced body will be deemed to have provisional approval for its application, ultimately the PRA will only be able to approve an application if, at a minimum:

  • information sharing arrangements exist which will enable the PRA to obtain any required information;
  • any stabilisation powers exercised by the Bank of England or the Treasury would be recognised in the jurisdiction in question; and
  • approval of the application would not increase the risk that the failure of the ring-fenced body would have an adverse effect on the continuity of the provision within the UK of “core services”

The Fees Order

These regulations enable HM Treasury to charge certain expenses associated with the UK’s participation in the Financial Stability Board, to a defined class of market participants.


[1] The implication appears to be that incurring payment exposure which is greater than overnight is not permitted.

[2] The implication appears to be that incurring settlement exposure in excess of t+5 is not permitted

[3] As published by the International Chamber of Commerce