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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The Tyrie Report: Now it’s Personal

On 21 June 2013 the Parliamentary Commission on Banking Standards (PCBS) published its Final Report “Changing Banking for Good”, widely referred to as the “Tyrie Report” after its chairman Andrew Tyrie MP.  The PBBS was established in July 2012, with the broad brief to conduct an enquiry into the standards and culture of UK banking and to make recommendations.  Whilst highly critical of just about everyone – the government, regulators, banks, and individuals – its final 571 page report contains surprisingly little in the way of strategic regulatory proposals.

Instead, its recommendations are strongly focused upon the senior individual, effectively imposing financial penalties and/or criminal culpability for (potentially) less pay. The substantive recommendations may be broadly grouped under two headings: people and pay.

People

  • The FSA’s “Approved Persons” regime to be replaced by “Senior Persons”.  The new regime would only apply to senior management; however they would have to accept responsibility for specific areas; and
  • Junior employees would be subject to an enhanced licensing regime.

Pay

  • A new remuneration code more closely aligning risk and reward, with emphasis upon more extensive deferment of pay.  A recommendation that bonuses may be deferred for up to 10 years;
  • Regulatory powers to cancel deferred pay/unvested pensions and/or dismiss senior management in the event of their bank requiring taxpayer support; and
  • A new criminal offence of “reckless misconduct in the management of a bank”.

The only macro-prudential elements of the report are the suggestion that the UK consumer is ill-served by lack of competition in retail banking, that this may be ameliorated by the break-up of RBS, and a characterisation of the government’s management of Lloyds and RBS as “interference”.

During Prime Minister’s Questions on the 19 June 2013, David Cameron affirmed his intention to append at least the bonus clawback and new criminal offence proposals to the Banking Reform Bill, which is currently making its way through Parliament.

PCBS asks PRA to “bear down” on proprietary trading

On 3 April 2013, the Parliamentary Commission on Banking Standards (PCBS) published a letter sent to Andrew Bailey, Chief Executive Officer of the Prudential Regulation Authority (PRA), regarding proprietary trading by banks.

In the third report of the PCBS, a summary of which can be found here, it was concluded that, whilst it was not a suitable activity for UK-headquartered banks, it would not be appropriate to attempt immediately to prohibit proprietary trading.  Instead, the PCBS recommended that the PRA should monitor indicators of whether banks appear to be engaging in proprietary trading and, if necessary, use existing supervisory tools to “bear down” on such activity.  Accordingly, the PRA is asked to confirm how it intends to respond to this recommendation, in particular:

  • how it will conduct heightened monitoring of trading activities and judge whether these are ultimately conducted to serve customers;
  • what processes it would expect to follow and what measures it would take if its monitoring activities raised concerns;
  • how it will report, and require banks to report, on the outcomes of monitoring and any actions taken; and
  • whether legislative change is needed to give it the authority and tools to carry out these actions.

In an accompanying press release, the PCBS Chairman, Andrew Tyrie MP noted that a Volcker-style bank may ultimately be required, but that the UK would be in a better position to determine whether this was actually the case in a “few years”.

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.

Bank Ring-fencing in the UK: The Financial Services (Banking Reform) Bill 2013

Introduction

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.

Ring-fencing

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

Simple Derivatives

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

“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[1] 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.

Conclusion

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.


Electrify the Vickers Ringfence Says Commission

On 21 December 2012, the Parliamentary Commission on Banking Standards published its first report, in which it gives consideration to the draft Financial Services (Banking Reform) Bill and associated proposals which give effect to the conclusions detailed in the Vickers’ report.

Whilst the Commission supports the introduction of ring-fencing, its Chairman Andrew Tyrie MP, stated that the proposals “fall well short of what is required”.  The Commission recommends “electrification” of the ring-fence by given regulators the power to forcibly separate any bank found guilty of trying to circumvent the rules.  In addition, the Commission proposes that the Financial Services and Markets Act 2000 should include a legal duty on boards of directors to preserve the integrity of the ring-fence.

Better news is found in the Commission’s conclusion that there is a case in principle for permitting the sale of simple derivatives to small businesses from within the ring-fence.  However, such permission would need to be subject to conditions and agreement on a satisfactory definition of “simple derivatives”.  Less welcome will be the news that the Commission will investigate further as to whether a ban on proprietary trading – akin to a Volcker Rule – is appropriate.