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.

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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”.

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

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.


“2013 is the year when we re-set our banking system…”

…said George Osborne in a speech to staff at JP Morgan in Bournemouth yesterday.  According to the Chancellor, the reset button comprises four main elements:

  • The transfer of responsibility for banking supervision from the FSA back to the Bank of England, which will have the “power to call time before the party gets out of control”;
  • The ringfencing of retail banking from investment banking;
  • Changing the culture and ethics of the banking industry; and
  • Giving customers more choice in their receipt of banking services.

Ringfencing

On the subject of ringfencing of retail banking, Mr Osborne confirmed that the Banking Reform Bill was published yesterday.  The bill is based on the recommendations of the Vickers Report and will require the creation of a ringfence around the retail arms of banks, enabling essential operations to continue in the event that the whole bank fails.  If a bank flouts the rules, the Bank of England and the Treasury will have the power to break it up altogether.  Mr Osborne expects the bill to be passed into law this time next year.  In addition, the Chancellor announced that:

  • A high street bank will be required to have different bosses from its investment bank;
  • A high street bank will manage its own risks, but not the risks of its investment bank; and
  • Investment banks will not be allowed to use retail savings in order to fund “risky investments”.

Increased Choice

On the subject of increased choice, the Chancellor announced that the Government would bring forward detailed proposals to open up payment systems, ensuring that new players in the market can access these systems in a “fair and transparent way”.  The implication is that responsibility for supervision of payment systems will be taken away from the Payments Council, a bank-led body.

Further Blow Dealt to Liikanen

The FT reports that the German finance ministry has proposed legislation dealing with banking reform that has been interpreted as a rejection of the concept of ringfencing as contemplated by the Liikanen report.  Instead, the draft bill would require banks to set up a separate unit for proprietary trading activities that accounted for either EUR 100 billion of assets or 20% of balance sheet.  If passed by the German parliament, the measures would likely come into force by mid-2015.

The draft bill largely mirrors French proposals, published in December 2012, to ringfence speculative trading activities.  However, it is in contrast to both the Vickers proposals in the UK (pursuant to which deposit taking activities would be ringfenced) and the Liikanen proposals (which require the ringfencing of all trading activities above a certain threshold).

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.