Select Committee on Treasury Fifth Report

5  Dealing with failing banks

Why is it important that banks can fail?

167. We discussed earlier in this Report the notion of 'moral hazard'. Should it be thought that public authorities would intervene on a regular basis to prop up failing banks, this would encourage banks to partake in risky behaviour, safe in the knowledge that they would be bailed out of any difficulties.

Why banks are special

168. A failure of a manufacturing, retailing or other non-financial firm would see the start of an insolvency process, involving the appointment of an administrator, and the eventual payout of recovered monies to creditors and potentially shareholders, with such payouts prioritised in a predefined way. However, with regard to failing banks, the Governor of the Bank of England stated that "banks are not like other companies".[402] Why should banks require a special insolvency regime, different from that which exists for other types of company?

169. Banks are 'special', in one sense, because they have become an increasingly important part of modern life. Cash machines, direct debits and debit cards are all an essential part of everyday living for most people. We noted in our Report on Banking the unbanked: banking services, the Post Office Card Account and financial inclusion in November 2006 that "People who do not have access to banking services are limited in undertaking a wide range of everyday financial transactions, and those limitations are arguably increasing as such transactions become more sophisticated".[403] Therefore, the failure of a bank and the potential loss of access to banking services, even for a short time, could have a serious impact on the ability of people to live their lives, on top of the potential loss of their deposits held with that bank. This means that for consumers, their banking services are likely to be viewed as 'essential'. There are precedents for special insolvency regimes in certain other industries in order to protect essential services for consumers. As the Tripartite authorities note in Banking Reform—protecting depositors: a discussion paper:

    The UK has special administration regimes for the energy, water and railway industries. These ensure that essential services to consumers remain secure and uninterrupted in the event of a company providing those services becoming insolvent.[404]

Because of this need to protect consumers' access to banking services, it is necessary to ensure that, when banks fail, they do so in a manner which preserves that access.

170. In his account of why a decision was taken to intervene in the case of Northern Rock, the Chancellor of the Exchequer stated that he had made the decision that Northern Rock posed a "wider systemic risk to the financial system" and that intervention was needed as there was a "serious risk of contagion".[405] The contagion problem affects banks to a much greater extent than other industries. Should a retailer 'fail', this failure would normally be of benefit to other retailers, because it would afford them an opportunity to increase their market share. If a bank 'fails', however, customers may begin to worry about the safety of their deposits within other banks, which could lead to widespread bank runs, and thus a risk to the stability of the overall financial system (systemic risk). Reliable functioning of the banking sector is critical to confidence in the economy as a whole. Therefore, the risk of contagion must be accounted for when considering how banks are allowed to "fail".

171. A final reason sometimes cited as to why banks are not allowed to fail is that they may be classed as "too big to fail". This concept essentially merges the two arguments above. The institution in question may have many counterparties in the financial system, or be an integral part of the payments system, increasing the risk of contagion from its failure. As well as this, it may have hundreds of thousands of depositors, meaning that its failure could lead to widespread hardship for those customers. But this scale may not in itself pose a new problem for the regulator or the government, different from the two outlined above. The Governor of the Bank of England disagreed that large institutions required a different approach. He stated that:

    It is a practical matter. It is much harder to resolve problems with big banks than with smaller ones, but that is a question of effort and scale, not a question of principle.[406]

172. The larger deposit-taking institutions, such as banks and building societies, are 'special' organisations in modern life, similar in some ways to utility providers. Banks should be allowed to 'fail' so as to preserve market discipline on financial institutions. However, it is important that such 'failure' should be handled in an ordered manner, managed in such a way as to prevent further damage to the economy, the financial system and the interests of small depositors.

The potential role of public authorities

173. Public authorities can have two roles in the bank failure process. They can either ensure that, when banks fail, they do so in an orderly manner, or they can provide direct assistance to overcome the problems at the bank. The successful execution of the first role may require reform of the depositor protection system and the bank insolvency regime. The second role may include the injection of capital (by the taxpayer) into the failing firm or the provision of emergency support from the central bank. The remainder of this chapter examines the UK's existing framework for handling failing banks and suggests principles to which future changes to this framework must adhere.

Who bears the risk of bank failure?

174. We have concluded that banks must be allowed to fail, and that such failures must be managed in an orderly manner. For the sake of clarity and transparency, it is important that all stakeholders in banks should be aware how the risk of bank failure is distributed. In general, in non-financial companies, shareholders and creditors take on the risk of company failure, but the situation with regard to banks is more complex. If, as happened with Northern Rock, the Government steps in to prevent the collapse of a bank, it takes on a significant risk on behalf of taxpayers. Depositors are treated as unsecured creditors under the existing arrangements, so clearly bear the risk that they could lose the rights to their deposits.

175. In a valuable written submission, Dr Paul Hamalainen of Loughborough University argued that the risks and costs of bank failure should be clearly placed on large depositors, junior bondholders, and shareholders, rather than small depositors or the Government. He criticised the UK's existing arrangements for failing to achieve this in the case of Northern Rock:

176. The taxpayer has clearly taken on a significant liability in the case of Northern Rock. If the Treasury had not guaranteed deposits, and Northern Rock had entered into administration, that bank's depositors would have become embroiled in a drawn-out process that could have seen them unable to access their funds for several months, a matter we discuss in more detail later. At least in the case of Northern Rock, the firm had positive net assets, so that, if administration had been entered into and assuming no deterioration of assets, depositors should eventually have received the full value of their deposits. If another bank were to fail, however, its liabilities might exceed its assets, in which case depositors might not receive the full value of their deposits. This is where a deposit protection scheme can offer assurance to depositors that their money will be safe in the event of their bank failing.

177. In the UK, the Financial Services Compensation Scheme (FSCS) is the compensation scheme of last resort for consumers of financial services. Since its inception in 2001, it has completed 87,000 investment or deposit claims and dealt with the failure of 27 deposit-taking institutions. These failed institutions were all credit unions. Because no UK bank or building society has been in default since 2001, the FSCS has not been required to assist the depositors of any such institution.

178. During the course of inquiry we took evidence from a number of witnesses who argued that, if there had been a failure of a large financial institution, then the FSCS would have been unable to cope. The BBA recognised that, due to "the highly concentrated nature of the UK deposit base", failure of one of the largest deposit-taking institutions would not be fully covered by the scheme.[408] Indeed, the BBA admitted that the FSCS

    will not be able to cope with the failure of a systemically significant bank. Such a bank would need to be rescued [by the Government] to effectively protect depositors and limit systemic risk.[409]

179. The BSA Director-General, Adrian Coles, explained that the FSCS was designed to deal with losses of up to £4 billion, as a result of the funding reforms due to take effect in April 2008, and that the FSCS would not be able to help with any losses exceeding that figure.[410] Therefore, if a bank or building society were to fail, and the potential losses to depositors exceeded £4 billion, the Government would need to fund the shortfall to prevent depositors from losing their deposits. Indeed, there was a clear recognition from the BBA that the risk of a large, systemically-important bank failing was underwritten by the taxpayer:

    it is self evident that in this current environment it is difficult to envisage the authorities allowing the failure of a retail deposit taker.[411]

180. The FSA accepted that, even with the revised funding arrangements that will increase the insurance cover to £4 billion annually, the FSCS was still incapable of providing total cover in all instances, and expected that a large-scale failure would trigger the crisis management arrangements set out in the Memorandum of Understanding.[412] Sir Callum McCarthy said that, if there were a very large failure, "that essentially would have to be met in the last resort by Government".[413] The FSCS confirmed that, when forecasting their funding requirement for the year ahead, they did not consider the cost of any major institutions failing, because they only levied for firms that they believed were likely to give rise to pay-outs.[414]

181. The Governor of the Bank of England was clear that the UK ought to avoid a two-tier insurance scheme, with one for large banks and another for smaller deposit-taking institutions.

    I think any such reform to bank deposit insurance ought to cover all banks. That would be the sensible thing. It is a practical matter. It is much harder to resolve problems with big banks than with smaller ones, but that is a question of effort and scale, not a question of principle.[415]

182. The taxpayer should not bear the risk of banks failing. Nor do we believe that small depositors should bear such risk. Rather, the risk of failure should be borne by a bank's shareholders and creditors but exclude small depositors. The Government must ensure that the framework for handling failing banks insulates taxpayers and that small depositors should also be protected from the risk of banks failing.

183. Although the Financial Services Compensation Scheme is portrayed as offering protection to the depositors of all financial institutions, examination of its funding indicates that it would not be able to cope with the failure of a medium-sized, let alone a major, financial institution. If such an event were to occur under present arrangements, only the Government, using taxpayers funds, would be in a position to protect depositors, as it did with Northern Rock. We are concerned that banks and building societies appear to be viewing the Government's support to Northern Rock as an acknowledgement that no bank would be allowed to fail. The Government must take steps to ensure that its framework for maintaining financial stability does not provide free insurance to banks. We do not believe that a deposit protection scheme should apply solely to the very smallest institutions. All banks and building societies should be covered by a deposit insurance scheme, such that, in cases such as Northern Rock, or an even larger bank, the Government would not be required to step in to protect depositors.

Prompt corrective action

184. The UK's Financial Services Compensation Scheme (FSCS) is a reactive agency—it only becomes involved in a failing financial institution once that institution is "in default". The Scheme's funding is also reactive, in the sense that defaults that had not been forecast require the FSCS to levy financial institutions for additional payments. Dr Hamalainen criticised the reactive ethos of the FSCS, both in the way the FSCS was funded and in the slow manner in which depositors were paid following bank failure. He contrasted this with the Federal Deposit Insurance Corporation (FDIC) in the United States, which is pre-funded by banks and aims to reimburse depositors within days of their bank defaulting.[416]

185. The reason for the relatively late recognition that a bank was failing in the UK was, according to Dr Hamalainen, because the "fear of law suits from [in this case] Northern Rock stakeholders such as the junior bondholders and shareholders would be too heavy a burden for any one [regulator] to bear". A solution to this forbearance problem, argued Dr Hamalainen, was a prompt corrective action [PCA] approach such as is taken by the FDIC in the US.[417] Instead of relying solely on the judgment of regulatory authorities, a PCA approach formalises specific tripwires which, when breached, serve as the basis for mandatory action by the authorities. The FDIC's tripwires focus on solvency and increasingly harsh restrictions apply as an institution's solvency deteriorates. These restrictions include increased monitoring, requiring the raising of additional capital, requiring acceptance of an offer to be acquired, and closure of the institution. Dr Hamalainen argued that the UK should consider adopting a similar PCA approach, but use not only solvency tripwires, but also liquidity ones. These tripwires would induce increasingly aggressive regulatory action, so that the relevant authorities had a comprehensive structural and legal mechanism enabling them to act early in preventing a bank problem becoming a full-blown crisis. Two additional benefits to the PCA approach, added Dr Hamalainen, were that tripwires placed banks under increased solvency and liquidity scrutiny, and the likelihood that fewer claims would be made on the deposit insurance scheme as a result of earlier intervention by the authorities.[418]

186. The BBA accepted that it was important to focus on developing preventive and corrective measures which reduced the likelihood of a distressed bank moving towards insolvency and triggering a call on the deposit scheme. In their view, a more proactive intervention framework would include a range of regulatory indicators, a toolkit of options for supervisory action linked to clearly defined and transparent event triggers, and increased dialogue between the Bank of England and individual banks and the FSA to enhance intelligence-gathering and inform more proactive monitoring and intervention.[419] The BBA indicated that suitable tripwires might include a deteriorating financial position with respect to liquidity, capital, earnings and asset quality; suspected or actual fraud; and a significant growth in business or shift in strategic business planning.[420]

187. Once a PCA tripwire had been breached, the relevant authorities would need to possess an appropriate toolkit of measures to either rectify the problem, or, alternatively, facilitate an orderly failure. The BBA considered how, initially, low-level triggers might lead to a challenge by the relevant authority to the risk assessment of an institution, then by working more proactively with Tripartite partners to head off, or better manage, a problem which might arise and, lastly, the consideration of a move towards administration. This might enable, for example, the authorities to intervene in a scenario where a bank remained solvent, but a material risk had gone uncorrected or had increased.[421] This latter point is important. In the US, tripwires alert the authorities not only when a bank is entering a period of distress, but also when a bank radically changes its business model, or pursues an existing business model to an extreme extent. In this way, the relevant authority becomes aware of outliers in the banking industry, even if, at the time, the conduct of those outliers appears to be resulting in high profits and strong growth. The authority would then be in a position to check that the risks being taken had been fully considered, and, if not, secure a suitable response. Such measures might well have been helpful in the supervision of Northern Rock, where triggers based on financial ratios might not have given much warning. An alert triggered by Northern Rock's rapid growth and the business model's reliance on the wholesale market for funding could perhaps have been prompter and more effective. The intent of a PCA approach is not to stifle innovation by preventing firms from conducting their business as they wish, but instead to ensure that the relevant authority knows how each firm is developing and is confident that appropriate risk assessment (bearing in mind the public interest at stake) has been conducted.

188. The Chancellor of the Exchequer signalled his approval of the concept of a prompt corrective action approach:

    I do think that one of the gaps in the supervisory regime at the moment is that it is not clear that the FSA has all the powers that I think it needs in order to get information from institutions and, crucially, when it looks like an institution is getting into difficulty, I think it needs more powers along the lines of the systems in America and Canada which intervene earlier to help a bank that might be in trouble and perhaps at a later stage even help with restructuring if a bank is getting into real difficulties or a reorganisation, even a merger or acquisition.[422]

189. The Chancellor also stressed how the sharing of information between the Tripartite authorities, where appropriate, was an important part of a "PCA" approach:

    I think what we need to do is to have better visibility of what institutions are doing re arrangements for looking after the depositors, the systems they may have if they need to pay money out and also to get information and, having got information, to be able to talk to the Bank of England about it because, as you know, there can be difficulties if I get information from you for a perfectly good reason and I cannot then pass it on to somebody else, another supervisor in this case because you are talking about the Bank of England, so it is to clarify the law in some cases where the FSA say there are gaps there, but also to make sure that we have got the information we need when the appropriate circumstances arise so that we can take prompt action.[423]

190. The Chancellor then stated that a PCA approach required a strong legal framework:

    I think there would have to be clear rules because the law can only operate on the basis of certain things happening. As I said earlier on, I am not in favour of legislation which would give the state the arbitrary power to intervene in a bank when there is no possible justification for doing so. Inevitably, you have to have some degree of discretion because you cannot legislate for every conceivable possibility. You can think of 101 reasons why a bank might get into difficulties and pose a systemic risk. I think it is important that we provide as much certainty as possible, precisely … we want people to be able to invest in this country with certainty, where they know what the rules are, just as if they invest in America or Canada or wherever they know what the rules are there, and they understand that and they are quite happy with that. We do need a degree of certainty. We cannot just give people blanket sweeping powers but, on the other hand, you do not want to get into a situation where you find the one thing that you had not got down in the Act happens and you are back to square one again.[424]

Alongside clear rules, the Chancellor said that this approach also required an element of judgement:

    What you need is a legal framework. If you take everything that we have been discussing this morning, whether it is in relation to the lending to Northern Rock or supervision, inevitably there has to be a degree of judgment, especially in relation to supervision. For example if you take Northern Rock as it was, there has to be a degree of judgment as to at what point do you intervene. The FSA accepts that perhaps looking at it now they should have said to Northern Rock, 'You cannot carry on in a situation where you have got no plan B'.[425]

191. In an interview with the Financial Times on 4 January 2007, the Chancellor of the Exchequer suggested that one trigger for prompt corrective action could be the request—such as the one made by Northern Rock—for an emergency support facility:

    When certain trigger points are reached or you have offered lender of last resort facilities, you could say that as a condition of that it may be necessary to reorganise or take a particular course of action.[426]

The Chancellor stressed in that interview that not every bank applying for Bank of England assistance would be subject to intervention, but said that he wanted "no political discretion and very clear ground rules". The suggestion that an application to the support facility might be a suitable trigger contrasts with the kinds of triggers used in the US by the FDIC. When members of the Committee visited the US, it was made clear to them that the FDIC's triggers were designed to notify authorities of potential problems well before an institution felt the need to apply for assistance to a central bank as lender of last resort, which, as its name implies, is a "last resort".

192. We see great merit in the "prompt corrective action" approach adopted in the US and other countries. When a bank or building society shows signs of being in distress, or there has been an unusual change to or extreme development of its business model, it is vital that the relevant authority should not only be in a position rapidly to identify that situation, but also be able to take steps to lessen the wider impact of that financial institution's difficulty. We do not propose that the relevant authority should have unfettered rights to interfere in the business of healthy institutions, but that, given the public interest in preventing banks from failing in a disorderly way, the relevant authority must have full access to the financial accounts of all FSA-authorised deposit-taking institutions, and the right to undertake additional visits and request additional information as needed.

193. We further recommend that the judgement of the relevant authority, supplemented by a set of quantitative triggers, be used to identify when a bank is either "failing", at risk of failing, or pursuing a business model that is an obvious outlier within the industry. Once a financial institution has been so deemed, the relevant authority should have a well-defined menu of options for taking action. The purpose of such prompt corrective action would not be to prevent banks failing as such, but to prevent them failing in a disorderly manner.

194. We do not view a bank's recourse to the Bank of England in its capacity as lender of last resort as an ideal trigger for prompt corrective action. This option is a last resort, and the relevant authorities must be able to identify a bank as failing prior to this stage.

A special resolution regime?

195. Earlier in this chapter, we noted the process through which a failing bank would be wound-up in the event of it entering administration. The UK's current resolution system ranks bank depositors alongside other unsecured creditors, which would mean that a failed bank's depositors would have to wait months, maybe even years, before receiving their insured deposits through the depositor protection scheme. Banks are treated in insolvency law just as any non-financial firm would be, yet the Governor of the Bank of England argued that "banks are not like other companies".[427]

196. Earlier in this chapter we also discussed reasons why banks might be considered 'special'—including the essential utility of banking services in modern life, and the need to maintain these services. Another reason why banks are 'special' is because of the harm to financial stability that a failing bank can inflict. If depositors lack confidence that they will be able to gain speedy access to their deposits in a failing bank (even if they were guaranteed to receive 100% of their deposits), they will have a strong incentive to join a bank run. One potential solution to this problem is the ring-fencing of insured deposits when a bank gets into distress, guaranteeing depositors that their money was safe, and, crucially, rapidly accessible.

197. The Governor of the Bank of England described the UK's system for dealing with bank insolvency (and deposit insurance) as "markedly inferior to other countries" and "inadequate".[428] He argued that

    We now require a serious reform of deposit insurance, of the administration of banks, of the clash between the wish for transparency of companies to their shareholders, the tension between that and how it applies to banks when in difficulty, and the length of time it takes to deal with transfer of ownership of banks.[429]

The Governor pointed out that the UK authorities were alone in the G7 in being unable to deal with a distressed bank under a special resolution regime, relying instead on normal corporate insolvency laws. He explained that, if a bank entered administration, depositors might have to wait a considerable time to gain access to their funds, so they would have a strong incentive to join a bank run. For that reason, the UK authorities could not allow a bank to fail unless it were clearly insolvent. In turn, the Governor explained, the expectation that the authorities would try to avoid insolvency put a floor under the bank's share price, and that prevented the authorities from intervening to implement a reorganisation of the bank. The Governor asserted that a "special resolution regime is the most important reform now and it will require legislation".[430] He went on:

    the difficulty of reaching and reorganisation of Northern Rock, which is absolutely, desperately needed, is made much more difficult by the fact that the shareholders can block what seems to be a sensible discussion of reorganisation by the people who are financing the vast bulk of the balance sheet, and it is precisely that problem to which the idea of early, prompt, corrective action and having an agency that can intervene in a failing bank before it reaches the stage of insolvency which is, in my view, so important. It is why all the other G7 countries have introduced a mechanism like that, and the FDIC is perhaps the best.[431]

198. Professor Buiter argued that the current framework's inability to put banks into administration without the deposits being frozen was a "terrible situation" and that "the kind of open-ended breastfeeding of a private institution that goes on at the moment is the worst of all possible worlds".[432] He advocated the adoption of a US-style arrangement, where the FDIC can take a threatened bank promptly into public ownership, ring-fence its deposits for distribution to depositors, and re-open the bank immediately to manage its existing activities and commitments, while a longer-term plan is being worked out.[433] This arrangement, known as the Bridge Bank approach, leaves any non-secured creditors with the deposit institution that is in receivership. The FDIC's intention with a Bridge Bank is to sell it to a bidder within two years of its creation and the FDIC has a duty to resolve the problem of the failed bank at least cost to the taxpayer. According to Dr Hamalainen,

    The FDIC's experience with the Bridge bank approach is that it can be particularly useful in dealing with deposit institutions that have failed as a result of liquidity problems. This is because, compared to a situation in which asset quality problems have built up over time, a bridge bank gives the FDIC and potential bidders an opportunity to review the bridge bank in a more stable environment and arrange a permanent transaction. The FDIC has also found the bridge bank approach especially useful if the failing deposit institution is large or complex. This is partly because they did not have to negotiate with a failed institution's shareholders and bondholders. [434]

199. The BBA suggested a range of intervention tools that could be considered, including the suspension of dealing in the distressed bank's shares whilst the situation was stabilised, handing control to the senior management of an acquiring bank or special administrator, and maintaining critical banking functions through a bridge bank arrangement or by one bank assuming operational control of the distressed bank.[435] In order to maintain competitiveness, the BBA argued, consumers ought to be able to choose the new institution they wanted to bank with, rather than all accounts (or blocks of accounts) being transferred to a designated institution.[436]

200. Sir Callum McCarthy admitted that there were "certainly things we can learn from the US experience where they have the ability to deal with a failure rapidly and in a way which enables them to take powers to deal with a failing bank".[437] The Chancellor of the Exchequer indicated his support for the concept of a special resolution regime:

    we will have proposals in the future … which will allow us to separate out depositors' cash and then get it paid out as quickly as we can, should [a bank failure] happen in the future.[438]

201. Under the current system, where depositors' funds can be tied up for months upon the failure of a financial institution, depositors have a clear and strong incentive to join a bank run and withdraw their deposits. This incentive would remain, even if depositors were guaranteed eventually to receive 100% of all of their deposits, if the inconvenience of being unable to access savings for prolonged periods is not tackled. Because of the potential impact of bank runs on financial stability, we recommend that insured deposits at a failing bank be ring-fenced by the relevant authority, to reassure customers that their insured deposits are safe and accessible. This will require a special resolution regime for financial institutions. We note that the Tripartite authorities currently have no means of quickly resolving a failing bank. The new special resolution regime we propose would grant powers for the relevant authority to establish a "Bridge Bank" which would take over and continue to run the failing institution with the aim of quickly returning it to health, and returning it to the private sector, either as a standalone organisation, or as part of another bank. The relevant authority should also have the power to employ a third-party financial institution to manage a failing bank's deposits, if that would facilitate the smooth administration of the failing bank. In carrying out such an operation, the relevant authority should have an obligation to resolve the situation at least cost to the taxpayer.

202. The BBA raised concerns about the potential impact that a special resolution regime might have on the cost of funding for UK deposit-taking institutions. If depositors were to be prioritised over other creditors, investing in UK banks would consequently become relatively less attractive. Bank creditors would demand higher interest rates to compensate them for taking on a greater risk that they would not receive repayment of their loan. The BBA argued that "an increase in funding costs could seriously dampen the competitive position of UK banks".[439] The FSA also warned that, if the Government were to change insolvency law, it would have to be very careful because that would change the relative attractiveness of investing in banks. The FSA argued that, before making a particular change, it would be very important to consider the overall effect on the banking system.[440] We recognise that the ring-fencing of insured deposits, and transfer of them to a third party, would be to the detriment of other creditors of banks, and that this might serve to increase banks' funding costs. However, we believe that this is a cost that the banking industry must bear, because we view a special resolution regime "to be" an essential pillar of an effective system for ensuring financial stability.

203. Following the introduction of a special resolution regime, shareholders would see no change to their ranking position in the event of the winding-up of a bank, because they already occupy the lowest rank. Nevertheless, shareholders will still be affected by the proposals we suggest. Shareholders will, for example, lose the comfort blanket of believing that the State will step in to prevent their company from failing. As we noted earlier, the view of the Governor of the Bank of England was that the expectation that the authorities would try to avoid insolvency put a floor under Northern Rock's share price, and this prevented the authorities from intervening to implement a reorganisation of the bank.[441] The Governor went on to say that the reorganisation of Northern Rock had been made "much more difficult by the fact that the shareholders can block what seems to be a sensible discussion of reorganisation by the people who are financing the vast bulk of the balance sheet".[442]

204. As currently constituted, the putting of a bank into administration need not lead to a 'fire sale'. The Government's own guidance notes on the procedure state:

    The first objective of the administrator must be to consider rescuing the company. This means rescuing the company as a going concern with all or most of its businesses intact—it does not mean ending up with the legal shell of the company. This new emphasis on company rescue in administration will help to ensure that viable companies are preserved and jobs are safeguarded.[443]

Nevertheless, there are immediate disadvantages, particularly the freezing of retail deposits. We believe that this issue could have been addressed in urgent legislation and we believe that the issue could now be helpfully addressed to improve the framework for the future.

205. We recognise that shareholders will consider themselves to be disadvantaged by the new powers we propose for the relevant authority. At the moment, bank shareholders appear to be protected from the total collapse of their firm by the State's unwillingness to allow a bank to fail. Our proposals would remove this taxpayer-funded prop, equalising the status of bank shareholders with that of non-financial firms' shareholders, who receive no such assistance. Because of the unique nature of banking, bank shareholders cannot be expected to have the sole final say over the direction of their company, if that company has become reliant on State support to continue trading. The relevant authorities should be in a position to undertake a solution in the public interest that may be to the detriment of shareholders.

206. The Government should also consider whether it will be possible, in the event of a bank failure, to endow the relevant authority with the decision-making powers currently held by the shareholders, whilst protecting those shareholders' financial interest. Any new legislation must clearly set out any changes to the status of shareholders of banks and members of building societies.

Critical banking functions

207. Earlier we discussed the increasing importance of banking services in modern life. Many people's lives involve an intricate web of direct debits, standing orders, automatic transfers: they rely heavily on being able to withdraw cash from automatic teller machines (ATMs) on demand, and being able to purchase items with debit and credit cards. Any interruption to these essential services can cause acute disruption; a prolonged interruption could cause chronic problems to the functioning of daily life.

208. The BBA accepted that UK consumers had become increasingly reliant on banking services in their daily lives and that provision needed to be made to maintain transactional services in the event of bank failure, to facilitate, for both consumers and businesses, the critical functions of salary payments, cash withdrawals, debit card payments and direct debit payments. However, the BBA also noted that banks provide many other services and that it could be difficult to divide a bank and its personnel between critical and non-critical functions. The BBA argued that business customers, especially those too large to be covered by the deposit scheme, were likely to have more complex needs than private individuals and would be most likely to need more time to transfer to a new provider.[444] For the BBA, the main issue for private customers was likely to be the need for access to immediate funds, and the BBA argued that the Government ought to be willing to provide automatic emergency funding, via the Bank of England, of individual customers' balances up to around £5,000 per individual. This would reflect around two months' income for an average household, and should therefore allow sufficient time for replacement banking arrangements to be put in place and further payments under the scheme to be made.[445] The Japanese depositor protection scheme, for example, has provisions for payments of ¥600,000 (approximately £3,000) to cover immediate living costs if full repayment is expected to take a long time.[446]

209. Guy Sears from the Investment Management Association suggested how cash machine withdrawal facilities might be maintained throughout a bank failure:

    Given that most people take money through a cash point I presume it is not beyond the wit of man somehow to plug into the cash point system so people can still withdraw money while there is an insolvency up to the limits of the protection … I presume there must be a way of plugging the Bank of England into [the ATM network] at moments of crisis up to some limit.[447]

210. The UK is increasingly reliant on transactional banking services and any disruption to salary payments, direct debits, standing orders, ATM availability and other banking services would cause profound problems for the banking system as a whole. If a bank were to fail, a smooth transition to a Bridge Bank or third-party bank would be essential. We recommend that, in bringing forward its proposals on improvements to the system of handling failing banks, the Government address the issue of how essential banking services would be maintained.

Lender of last resort

211. A lender of last resort is an institution willing to extend credit when no one else will. In the UK, this role is taken on by the Bank of England, which lends to deposit-taking institutions in emergency circumstances.

212. The measures that we have outlined in this chapter are designed to minimise the need for banks to call on the Bank of England's resources in this capacity. We view such a development as important for two reasons. First, use of such a facility puts at risk taxpayers' money, whereas the risk of bank failure ought to be borne by a bank's shareholders and large creditors.

213. Second, the run on Northern Rock was largely triggered by the announcement of the Bank of England's support operation. The fact that an operation designed to assist Northern Rock should cause yet more damage indicates that the level of stigmatisation now attached to such a facility is such that its effectiveness must now be in doubt. Such operations have been stigmatised for a period to come by the experience of Northern Rock.

214. If a support operation could be conducted covertly, the problem of stigmatisation might be avoided. In Chapter 4, we concluded that, in the case of Northern Rock, the barriers to a covert support operation were real and probably insuperable. These barriers were both practical and legal. Practically speaking, the chances of any large covert support operation going unnoticed by the market for any period of time at all are extremely slim, and it would not take long for the market to establish the identity of the recipient of such emergency lending.

215. In terms of legal barriers, we noted in Chapter 4 that the Governor of the Bank of England received legal advice to the effect that the Market Abuse Directive, as it stands, is a substantial barrier to a covert operation, even if information pertaining to the operation could be kept confidential. However, the Committee learnt on its visit to Brussels that preventing covert operations by a central bank was certainly not the intention behind the Directive. We recommend that the Government seek to work with the European Commission, European Central Bank and national central banks within the European Union to establish whether the Market Abuse Directive ought be amended, so as to ensure that covert support operations by a central bank are permitted in specified circumstances.

216. We further recommend that the Government review the interaction between the terms of the Market Abuse Directive and other aspects of the regulatory regime including the FSA guidelines, to ensure that they do not unnecessarily restrict areas of the discretion otherwise allowed under the Directive.

402   Q 1630 Back

403   Treasury Committee, Thirteenth Report of Session 2005-06, "Banking the unbanked": banking services, the Post Office Card Account and financial inclusion, HC 1717. para 2, p5 Back

404   Tripartite authorities, Banking reform - protecting depositors: a discussion paper, October 2007, Box 3.3, page 13 Back

405   Q 1782 Back

406   Q 1741 Back

407   Ev 254-5 Back

408   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,
page 4 

409   Ev 299 Back

410   Q1552 Coles Back

411   Ev 299 Back

412   Ev 233 Back

413   Q1435 McCarthy Back

414   Q1443  Back

415   Q1741  Back

416   Ev 255 Back

417   Ev 254 Back

418   Ev 253-4 Back

419   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,
page p6 

420   Ibid Back

421   Ibid Back

422   Q 1753 Back

423   Q 1795 Back

424   Q 1868  Back

425   Q 1869 Back

426   'Last resort' loans could be trigger for FSA input, Financial Times, 4 January 2008 Back

427   Q1630  Back

428   Qq 19, 48 Back

429   Q14  Back

430   Q1608  Back

431   Q1654  Back

432   Q864  Back

433   Ev 328 Back

434   Ev 255 Back

435   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,
page 6 

436   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,

437   Q1451  Back

438   Q1801 Back

439   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,

440   Q1448  Back

441   Q1608  Back

442   Q1654 Back

443   Government Insolvency Service, Administration Guidance Notes Back

444   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,

445   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,

446   Deposit Insurance Corporation of Japan, A Guide to the Deposit Insurance System, page 9 Back

447   Q1416  Back

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