Financial Services (Banking Reform) Bill

Memorandum submitted by Neil Jeffares (FS 02)


· The depositor priority provisions set up by clause 9 of the Financial Services (Banking Reform) Bill 2012–13 represent a fundamental threat to the safety of banking in the UK, and combine unfairness with structural instability.

· The provisions raise serious questions of mis-selling unless understood by the public.

· But if understood, they will make it impossible for deposit-taking and transactional business to be conducted effectively. This will be counterproductive to the UK financial services industry and to the growth prospects of the UK economy.

· The retrospective effect on existing fixed term deposits may be unconstitutional.

About the author

1. I am a retired investment banker. This submission is made in a personal capacity.

Bailing in and bank failure

2. Everyone now understands that the providers of bank capital must be at risk in the next collapse if the "too big to fail" phenomenon is to be effectively challenged. As Lord Turner put it in evidence given by to the Banking Standards Commission (27 February 2013), there is "a [new] philosophy that we are going to accept in future that the actual failure of a bank – provided that it happens in a smooth fashion…with rapid payout of insured deposits – is not a regulatory failure."

3. Clause 9 will make it quite impossible to meet Lord Turner’s proviso if the ordinary users of banking services – businesses and individuals whose balance exceeds the Financial Services Compensation Scheme ("FSCS") limit of £85,000 on any day – are lumped in with shareholders, management and bondholders.

Bailing in and subordination of deposits

4. Under clause 9, which amends insolvency law on preferential debts, uninsured depositors are not merely to be bailed in, but they are to be subordinated to the claims of the rest of the banking industry whose rights to recover their FSCS contributions are to become preferential debts and thus given priority. The effect is that on liquidation, an uninsured depositor is likely to receive nothing, even where a bank’s asset quality might conceivably have been quite good and where the payout to senior creditors with pari passu treatment would have been high.

5. Here is a simple example. Suppose a bank has £100 of assets (all unpledged for simplicity), funded by £3 of equity, £90 of insured deposits and £7 of uninsured deposits. Its assets then shrink by say 10% (a level exceeded by HBOS’s 2008 loan book) to £90, and it is wound up. Under current rules the uninsured depositors will get back (7/97)x90 or 93p in the £ (the same rate as the FSCS, who have had to pay out the smaller depositors in full), while under the new rules the FSCS lays first claim on the £90 assets having paid out that amount to the smaller depositors, and nothing is left over for the uninsured depositors.

6. The arithmetic is a little more complicated when secured interbank funding is involved, but the same principle applies – the recovery rate for uninsured deposits will be significantly adversely affected, the beneficiaries of this being other banks. In essence anyone placing an uninsured deposit with a UK bank will have a risk analogous to a subordinated bond for which the banks would normally have to pay a coupon of say 7–10%, while the deposit pays no more than an FSCS guaranteed level of 1–2%.

Effects on depositors and banks

7. If this bill is enacted in its present form, it is only a matter of time before banks will find it impossible to raise deposits over £85,000 in the traditional manner. Large corporates will move their funds overseas and the damage to the UK economy and growth prospects will be incalculable.

8. You cannot run a modern economy where banks cannot be trusted to handle transactions as small as this limit. You cannot expect small businesses, charities or retired people with modest savings to "be responsible for monitoring and managing the risk associated with their investments" (as Greg Clark has suggested in a letter to my MP) by, presumably, performing credit analysis of the banks before placing deposits: even knowledgeable customers cannot do this (the regulators themselves failed), not least since Government policies have compounded the obscurity of bank financial information by continuing to allow banks to borrow from one another secured, while retail depositors cannot negotiate such protection. In practice depositors, unlike shareholders, have no votes, and cannot influence behaviour by changing management. Nor is the threat of moving their deposit realistic in an industry that offers inadequate competition.

Retrospective impact and mis-selling

9. Another deeply unsatisfactory aspect of this proposal is its retrospective effect. Many will have placed substantial, unbreakable fixed term deposits with UK banks before the legislation was mooted. They will have done so in the legitimate expectation, following Northern Rock, that whatever the legal position, Realpolitik would require support for retail depositors. There is ample evidence that this belief was rational. For example, in 2010 a High Court judge (Henderson J in Alliance & Leicester) said "It will be recalled that, when Northern Rock was on the point of collapse in September 2007, the government stepped in to guarantee deposits of any size with that institution, and I find it difficult to envisage circumstances where similar steps would not be taken in the future." And while the Chancellor signalled the new philosophy in evidence to the Banking Standards Commission in November 2012, Sir Mervyn King’s comments to the same committee indicated that he thought that the depositors of a large bank could not in practice be bailed in.

10. Despite the explosive political implications of the Government introducing a measure that favours banks over customers, astonishingly the press has not so far picked up on this. That will of course change the moment any UK bank gets into difficulties, and we will see endless newspaper articles drawing parallels with Cyprus etc. From that point the effects I describe in paragraphs 7 and 8 above will inexorably unfold. But until press coverage changes and the public fully understand that they are taking a 7–10% risk for a 1–2% return, deposits may continue to be placed on what I considered to be a fraudulent basis.

11. It may be that, consistent with the attitudes set out in paragraph 9 above (and see paragraph 16 below), Parliament considers that clause 9 will not in practice be applied in the resolution of a major UK bank. No doubt the Chancellor feels there is some advantage in retaining the discretion as to whether or not to bail out depositors in such banks, fearing perhaps that any clear statement of policy would be "gamed" by the industry, but it is profoundly unsatisfactory for the fortunes of millions of people to remain at the whim of an individual in a crisis rather than determined by clear rules established by Parliament without a gun to its head and consistently applied whatever the situation.

12. What is clear is that if clause 9 is enacted in its present form, but no steps are taken to warn business and retail customers that uninsured deposits are effectively "junk", the Government itself will be guilty of the most major mis-selling scandal ever, dwarfing PPI. (It is irrelevant that the losses incurred by depositors have not yet materialised. Risk has a price and, as with PPI, mis-selling has occurred if you sell risk for the wrong price even if the catastrophe does not eventuate.) If such warnings were issued, the breakdown of the deposit-taking business would inevitably follow.

13. That is the central flaw in this proposal: it can only be contemplated in a miasma of confusion about executive intentions and policies for bank resolution. Once that policy is made clear, the disastrous consequences of these depositor priority provisions will be apparent to all.

Parliamentary debate and commission recommendations

14. In the 26 March debate, Greg Clark responded to Chris Leslie’s question about the position of uninsured depositors by pointing out the need to place the burden of default on one or other class of creditors, but he also stated that "it is absolutely our intention to ensure that other subscribers bear the responsibility for bailing in banks, should they fail in future, rather than depositors." But unless there are provisions for much more radical change to the leverage and capitalisation of banks, the priority of deposits will remain a crucial factor in the recovery rate for uninsured deposits in the resolutions which are now seen as inevitable.

15. Since Government rejected the Vickers Commission’s leverage proposals, it is difficult for them to claim that clause 9 follows Vickers’s recommendations since Mr Clark argues that the provisions go together. The Parliamentary Commission on Banking Standards wisely recommended further investigation of this point.

16. Mr Clark’s 26 March statement quoted in paragraph 14 above does however reinforce the point that the Government continue to try to reassure depositors that it is "business as usual", with the implication that they have little to fear. For the reasons stated above I regard this ambiguity as profoundly unsatisfactory.

April 2013

Prepared 16th April 2013