Memorandum submitted by the Bank of England (BAN 02)

 

 

Introduction

 

1 The Bank of England strongly supports the main provisions of the Banking Bill. This short paper sets out what the Bank regards as the key features of the Bill and comments on the powers provided under the Bill.

 

The Special Resolution Regime

 

2 The Special Resolution Regime (SRR) for failing banks is at the heart of the Bill (Parts 1-3). The UK lacks a coherent regime for dealing with banking failure. It is alone in the G7 in not having a separate regime for handling problems in banks. The Bill will rectify that.

 

3 The SRR can be triggered only if two conditions are satisfied (clause 7): first, a bank must stop or be about to stop meeting its threshold conditions for authorisation, which include adequate capital and liquidity; and second, all possible actions to restore the position, whether by regulators, by the bank itself or by others, have been exhausted. The SRR is thus a last resort. Its very existence should act as an incentive for bank management to take necessary action to restore a failing bank to financial health. With more focused and forward-looking risk-based bank supervision, and more incentives for bank management to take necessary remedial action, an indicator of the success of the SRR will be that it is exercised only rarely.

 

4 But if a bank does fail, it is essential for the authorities, as an alternative to immediate committal to slow and uncertain corporate insolvency procedures, to be able to resolve its affairs quickly and effectively. The Bank, as the Special Resolution Authority, will act to safeguard the public interest, defined broadly (in clause 4) to include the maintenance of financial stability, the preservation of banking continuity and the protection of depositors, all at the lowest possible risk to the taxpayer, and will be required to balance the public interest with the interests of the failing bank's shareholders and counterparties, whose property rights are protected by the Human Rights Act 1998.

 

5 Depending on the systemic risk posed by the failure of the bank, an orderly resolution could take the form of a sale of part or all of the bank or its business to a private sector purchaser, either directly or by using a bridge bank initially (clauses 10-11), if necessary facilitated by the authorities. Alternatively, it could entail closure of the bank and rapid payoff of insured depositors (ie exercise of the new "bank insolvency procedure", as set out in Part 2 of the Bill). It is vital to have a range of options, as no two banking failures are alike. Although temporary public ownership will remain an option under the SRR (clause 12), a full alternative toolkit will ensure that it becomes a last rather than a first resort, thereby providing better protection to the taxpayer.

 

Partial property transfers

 

6 A bridge bank is likely to be used by the Bank where it believes that the failure of the bank will have wider adverse systemic consequences and that a buyer of part or all of the bank's business can be found within a short period (of up to a year). For this to work partial transfer powers are necessary. The aim is to preserve the viable parts of the business and to wind down the rest in an orderly way. A buyer may require some time to carry out due diligence on the failed bank's books, especially if it contains an extensive range of complex products. During that period a conservatively-run bridge bank, controlled by the Bank, will be needed to maintain whatever franchise value the failed bank retains. The bridge bank will take over as much of the failed bank's staff and systems as possible, ensuring that households and businesses have continuing access to their current and deposit accounts and overdraft and loan facilities. It will also have new senior management brought in by the Bank, and a new business plan.

 

7 Experience in the US, where bridge banks have been used successfully by the FDIC on many occasions, including to resolve some large bank failures, shows it is vital for the bridge bank to be perceived as a strong entity. This means that the authorities must have scope to move assets between the bridge bank and the rump of the failed bank to optimise the strength of the bridge bank's balance sheet and maximise its saleability to the private sector. The supplemental and onward transfer powers in the Bill (covered in particular in clauses 25-28, 39-40 and 138), and the new "bank administration procedure" (Part 3 of the Bill) which comes into effect in a partial transfer, provide some scope for such asset transfers. Maximum flexibility is needed, because the larger the premium achieved in the sale of the bridge bank, the better the outcome for creditors and counterparties whose claims are left in the rump of the failed bank.

 

8 Concerns have been expressed about the powers available under the SRR, notably those relating to partial property transfers. Two points must, however, be borne in mind here. First, as noted above, these powers will be exercised only if all other action, including voluntary action by shareholders and creditors of the failing bank, has failed, so that the only alternative is insolvency. And second, the exercise of the partial transfer powers will be subject to safeguards set out both on the face of the bill (in particular in clauses 42-43 and 55) and in secondary legislation (drafts of which will be available to the Committee during its hearings). One safeguard relates to netting and set-off arrangements, and will protect all master netting agreements and financial contracts under such agreements (clause 43). Another will ensure that, in a partial transfer, creditors whose claims are not transferred to a private sector purchaser or to a bridge bank will still at a minimum be compensated so that they are no worse off than they would have been (according to an independent evaluation) in an immediate liquidation of the whole bank (clause 55). Other safeguards will protect secured claims and the existing priorities of creditors, subordinated debt holders and shareholders in insolvency. And if necessary on financial stability grounds, it will still be possible to make whole non-transferred creditors.

 

9 It has been suggested that partial transfers should be restricted to retail deposit book transfers alone. We do not support that, for the major reason that systemic risk in a large bank failure, and the risk of contagion to other banks, is as likely to affect wholesale depositors and non-deposit creditors as retail depositors. And a potential buyer may be prepared to pay a greater premium for such business than for the retail deposits alone. Restricting partial transfer powers would once again make nationalisation more likely, as any whole bank solution is likely to require the full support of the state, increasing the risk to the taxpayer.

 

10 The Bank also does not accept arguments that the use of partial transfers or other powers in the SRR will increase the cost of capital to UK banks or undermine London's position as an international financial centre. As noted at the start of this paper, all other G7 countries have such regimes available as a last resort to failing banks. There is little to suggest that the introduction of such regimes had any adverse effect on bank funding costs or competitiveness. And the safeguards proposed for the UK regime go considerably further than those available in other countries, especially the US. In many respects, the proposed UK SRR is more creditor-friendly than the US regime, in which there is not full protection for netting and set-off rights and depositors are preferred to wholesale non-deposit creditors. With the "no creditor worse off" safeguard in place, depositor preference will not be a feature of the UK regime.

 

Other aspects of the bill

 

(i) Deposit insurance and role of the FSCS

11 The Bank fully supports the Bill's reforms in Part 4 relating to deposit insurance, and related measures, notably the 7-day target for payout to insured depositors and the earlier raising of the compensation limit to 50,000. Further work needs to be done urgently to find a practical solution that would protect balances that are temporarily inflated above the compensation limit, for example as a result of house sale or receipt of a bequest.

 

12 In addition, the Bank believes that the recent resolutions of Bradford and Bingley and the UK entities of Icelandic banks provide strong evidence of two further desirable features of a new deposit insurance regime. One is that the Financial Services Compensation Scheme (FSCS) should have the ability to make an up-front contribution to a partial or whole transfer of a failed bank's business to a healthy private sector purchaser or bridge bank, provided that this contribution is no greater than it would have been had the bank been liquidated and the insured depositors paid out (clause 157). The second is that such an approach would be facilitated if the FSCS were able to call upon a pre-funded scheme.

 

13 In the absence of pre-funding, the FSCS has to borrow the funds from the Bank or Government (as happened in the recent resolutions) and subsequently levy the banking industry. That is one model, and it is important to realise that the levy-payers will then pay no more, and most probably less, than they would have done in a whole-bank liquidation. But a more attractive alternative would be for the FSCS to call first upon a pre-fund; recourse to Government borrowing would then be a last rather than first resort. So the Bank supports the power in the Bill (in clause 156) to introduce a pre-funded scheme when conditions in the banking sector improve. This is a feature of many other countries' regimes, including countries with similar degrees of concentration in the banking sector as the UK (eg Canada).

 

14 The Bank also believes that the insurance premiums which banks should pay to build up such a fund should be related to objective measures of the riskiness of those banks. This is necessary to avoid any implicit subsidy of riskier banks: given that they benefit more from deposit insurance than less risky banks, it seems reasonable that they should pay a higher price for the privilege. This will help to reduce moral hazard and excessive risk-taking among banks. The bill contains a provision in clause 156 to introduce such risk-based deposit insurance premiums. And as noted above it seems better to levy such premiums before rather than after banking failures, not least because in the latter case the failed bank itself will pay no premium, while other banks, which may also have been adversely affected by the bank's failure or the circumstances that gave rise to it, will be less able to bear a levy.

 

(ii) Oversight of payment systems

 

15 The Bank will be given statutory oversight of UK payment systems. Internationally, central banks are generally responsible for payment systems oversight, and the existing memorandum of understanding describes payment system oversight as a function of the Bank: but the UK has been very unusual in not granting statutory authority to its central bank in this area. Although the Bank has sought to enhance its non-statutory oversight of payment systems through the development of a more quantitative oversight risk framework, the publication of regular oversight reports and the use of general moral suasion, the granting of statutory authority to the Bank in this area will clearly reinforce and strengthen its ability to exercise effective oversight.

 

(iii) Issuance of Scottish and Northern Irish banknotes

 

16 Part 6 of the Bill modernises the existing framework, almost unchanged since 1845, by which those commercial banks which were issuing Scottish or Irish banknotes at that time have been able to continue doing so. Back in 2005, the protection for holders of these notes was deemed to be inadequate in two respects. First, although the notes were required to be backed by Bank of England notes and coin, the letter of the law only required that to happen on Saturdays. Second, even when these backing assets were being held, they could not be earmarked in any way for the benefit of the note holders. Ranking behind protected depositors, as unsecured creditors of the issuing bank, the note holders would therefore have been at risk of losing the entire face value of their notes in the event that the issuing bank became insolvent.

 

17 Following extensive discussions with all seven commercial issuing banks and other interested groups, agreement has been reached on the way in which the Bank will in future regulate commercial note issuance in Scotland and Northern Ireland. This will protect holders of the notes fully while taking account of costs incurred by the issuing banks, so allowing this tradition to continue. As in 1845, no new issuers will be allowed to enter the market, but that will not inhibit continuing and uninterrupted note issuance in the event of bank mergers or changes of ownership.

 

(iv) The Bank of England's Court and financial stability objective

 

18 The 1998 Bank of England Act provided for a monetary policy objective, but the Bank's financial stability role was confined to the Memorandum of Understanding that sets out the responsibilities of the Tripartite authorities. The Bill gives the Bank the responsibilities described above, and a new overall objective: to "contribute to protecting and enhancing the stability of the financial systems of the United Kingdom". A Committee of Court (the Bank's Board), chaired by the Governor but with a majority of non-executives, is to oversee the discharge of this objective; some of the areas on which it will advise are set out in the Bill and the Court can delegate more functions to it. The Committee's performance will be reviewed by the Court, which will have fewer members and a non-executive chair appointed by the Chancellor.

 

October 2008