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.