House of Commons - Implementing the recommendations of the Parliamentary Commission on Banking Standards

Implementing the recommendations of the Parliamentary Commission on Banking Standards - Treasury Contents

4 'Ring-fencing' and proprietary trading

Background: recommendations of the Independent Commission on Banking, the draft Bill and pre-legislative scrutiny by the PCBS

18. In September 2011, the Independent Commission on Banking (ICB), set up by the present Government and led by Sir John Vickers, published its Final Report. The ICB recommended that, where continuous provision of service was vital to the economy and to a bank's customers, retail banking activities should be 'ring-fenced' from other activities, making it easier to resolve banks that get into difficulty without the need for taxpayer support.[16]

19. In response to the ICB's recommendations, the Government published a draft Financial Services (Banking Reform) Bill, the scrutiny of which was entrusted to the PCBS.[17] The draft Bill introduced a basis for partial structural separation of the banking system by ring-fencing the core activities of a bank (which the ICB referred to as "mandated activities") in order to protect them from the more risky activities connected with wholesale and investment banking. "Core activities" amounted simply to deposit-taking, but the draft Bill left open the option for the Treasury to add to the list of core activities in the future in response to changing economic circumstances.[18]

20. In its scrutiny of the draft Bill, the PCBS welcomed the Government's approach but considered that a new statutory regime should go further.[19] It believed that regulators should be provided with reserve powers to implement full separation of banks in the event that ring-fencing proved to be ineffective. The PCBS therefore recommended that the legislation contain a "first reserve power" to enable the regulator to require of an individual banking group full separation of the ring-fenced entity from the rest of the banking group. A "second reserve power" would make possible full structural separation across the sector as a whole. The PCBS recommended that this latter, wider, power be contingent on the recommendations of an independent review of the ring-fencing regime and would require further, secondary, legislation for its implementation.[20]

21. The First Report of the PCBS made clear that this 'electrification' of the ring-fence was intended as a deterrent against gaming of the ring-fence by banking groups.[21] The PCBS considered that electrification was necessary in the context of an industry notorious for innovative methods of circumventing regulation.[22] The Second Report of the PCBS stated that:

The PCBS recommendations

FIRST RESERVE POWER: SEPARATING INDIVIDUAL BANKING GROUPS

22. The PCBS recommendation for the first reserve power called for:

23. Its second report asked for a further power, recommending that the "Government make explicit provision in the Bill to enable the regulator to require a bank to divest itself of a specified division or set of activities which would fall short of the full divestment required under the first reserve power".[25] This power could be exercised:

²¹

24. The PCBS recommended in its first report that, given the significance of the first reserve power, a number of safeguards and restrictions should be put in place. The power was to not be exercisable by the regulator until after the completion of an independent review of the effectiveness of the ring fence (see further below). This was to be completed within four years of the ring-fencing rules coming into force.[26] The PCBS set out further safeguards, which included:

· a requirement to give a banking group early notice of the intended use of the reserve power;

· opportunities for the banking group to make representations and appeals;

· a requirement to have an external reviewer, approved by the Treasury, to consider the standards and conduct of the bank, its relationship with the regulator and any potential for discriminatory conduct by the regulator;

· a requirement for Treasury approval for any proposal by the regulator to separate a banking group; and

· A requirement for publication of the notices and decisions of the regulator and Treasury.[27]

SECOND RESERVE POWER: SECTOR-WIDE SEPARATION

25. In its First Report, the PCBS recommended a second reserve power to "implement full separation" of "the sector as a whole."[28] This power could only be exercised as a result of a recommendation of the independent review of the effectiveness of the ring-fencing regime (see further below). Referring to its First Report, the PCBS stated in its Second Report:

REVIEWS OF RING-FENCING

26. The PCBS recommended two different sets of reviews of the ring-fencing regime. First, it recommended that the PRA report annually on the operation of the ring-fence in order to shed light on any issues arising between banks and the regulator and to provide an opportunity to expose attempts by banks to circumvent the system. The recommendation specified that the PRA should:

27. Second, the PCBS recommended a statutory requirement for periodic, independent reviews of the effectiveness of a new ring-fencing regime, the first to be carried out after four years and each subsequent review to be carried out at five-year intervals. Statutory provision should be made:

· for the review's terms of reference, which should be based on the statutory objectives for the ring-fence and which should require the review body to express a view on whether ring-fencing was achieving those objectives and to assess the case for a move to full separation across the banking sector as a whole; and

· to require the review body to make recommendations to the regulator and the Treasury about the design and application of secondary legislation and ring-fencing rules.[31]

28. The PCBS envisaged that the independent review would draw on the work and reports of the PRA in coming to its conclusions. The PCBS stated that:

Government response to the First Report of the PCBS

29. The Government, as part of its response to the first PCBS report, supported the creation of a reserve power for regulators to separate individual banking groups (the first reserve power) and for the PRA to conduct annual reviews into the operation of the ring-fence. It said in its response to the PCBS:

30. The Government did not, however, accept the need for the second reserve power or for periodic, independent reviews of the ring-fence's effectiveness:

The Second Report of the PCBS

31. Following the Government's response to its First Report, the PCBS published a Second Report which reiterated the case for the two reserve powers and set out its own proposed amendments to give effect to 'electrification' of the ring-fence. The amendments covered the first and second reserve powers and the independent review of the ring-fence.[35]

Passage of the Bill through the House of Commons

32. Although the Government had agreed in principle with many of the PCBS's recommendations on ring-fencing, the original amendments tabled by the Government at Report stage in the Commons fell well short of the PCBS's proposals, as the former Chairman of the PCBS, Andrew Tyrie MP, told the House on 8 July 2013:

[…] the Government's amendments would render the specific power of electrification virtually useless.

[…]

[...] the Government accepted the case for ring-fencing, arguing that banks that test the ring fence should be strongly deterred and, if necessary, prevented from doing so. However, I am afraid that that will not be the effect of the Government's amendments. On the contrary, the Government amendments almost guarantee that banks will not get a shock, and will not be discouraged from testing or gaming the ring-fence. The regulator needs a useable and credible deterrent. This proposal creates too many obstacles and delays to the sanction of full separation.

Frankly, it is inadequate for three main reasons. First, it requires the regulator to issue—we have already heard a little about this—no fewer than three preliminary notices and a warning notice before it can act. Secondly, it then requires the regulator to obtain permission from the Treasury no fewer than three times while the process is in train. Putting that requirement on the statute book would transfer most of the effective regulatory decision-making power away from the PRA and the Bank of England to the Treasury. It cannot be appropriate for the Treasury to be the regulator. The Commission argued for a Treasury override at the end of the process, not at the beginning or in the middle, but the Government's amendment requires the regulator to secure the consent of the Treasury on three occasions prior to that point. Even so-called preliminary notices—in effect, expressions of concern by the regulator—will require Treasury consent. That is absurd and compromises the regulator's independence.

33. Opposition spokesman Chris Leslie MP also objected to the Government's amendments. His principal concerns were the numerous stages and notices involved in the separation procedure and the length of time that it would take for separation to take effect. He referred with approval to the PCBS's draft amendments on electrification.[37]

34. Greg Clark MP, then Financial Secretary to the Treasury, responded to Mr Tyrie that:

Amendments to the Bill introduced in the House of Lords

35. In response to the concerns raised by Commissioners in the House of Commons, Lord Deighton, Commercial Secretary to the Treasury, said during the Second Reading of the Bill in the House of Lords on 24 July 2013:

COMMITTEE STAGE

36. At Committee stage of the Bill in the House of Lords, the Government tabled a revised amendment in relation to the first reserve power to separate individual banking groups. It made the following changes:

· only one Preliminary Notice from the regulator would be required;

· Treasury consent would be required only once (in relation to the Warning Notice);

· the warning notice period was reduced from 6 months to a minimum of 3 months and maximum of 6 months;

· overall, the minimum period from preliminary notice to final notice was reduced to 4 months, roughly in line with the PCBS's own amendments, which stipulated a minimum period of 5 months from the first notice to the last; and

· the requirement to have a minimum of five years to complete a forced divestment or full separation ordered by the regulator was removed entirely and was replaced by regulatory discretion in relation to the deadline for completion.[40]

37. These amendments substantially addressed the recommendations of the PCBS. However, the Government continued to differ from the PCBS on the following points:

· There was no provision in relation to the first reserve power for an external reviewer to examine the relationship between the regulator and the banking group as a safeguard on the regulator's exercise of its power. The PCBS had recommended that such a review take place after the issuing of the preliminary notice. The Government, however, argued that the availability of a right of appeal to the Tribunal was the appropriate mechanism to safeguard against any abuse of power by the regulator.

· The Government did not accept the need for an independent review of the operation of the ring-fencing regime more generally. The PCBS considered such a review to be essential, on the grounds that such a radical re-design of the banking system ought to be independently reviewed. However, the review was also linked to other PCBS recommendations: a first review was to be carried out after four years and the regulator would not be able to use its first reserve power before this date; and recommendations contained in this or any subsequent reviews (at five year intervals) were to be the trigger for bringing into force the second reserve power.

· The Government continued to reject the need for a second reserve power to separate the banking sector as a whole. The Government argued that complete separation was a different policy from that embodied in the Bill, that is, that ring-fencing was the appropriate mechanism for safeguarding against future failures in the banking system; that such a radical change to the banking system as a whole should properly be effected by primary legislation, affording opportunity for appropriate debate; and that any provision for full separation in the Bill would provide only for a binary option—full separation or not—and leave no opportunity to give effect to any third way recommended by an independent review.

38. Mr Tyrie issued the following press notice on the 1 October 2013, welcoming what was contained in the revised amendment:

At the request of the Banking Commission the Government withdrew its original amendment on electrification of the ring fence for individual banks—'the specific powers'. It has now come forward with a major revision which largely reflects the Banking Commission's intentions. This is very welcome, the product of a number of helpful discussions with ministers.

REPORT STAGE AND THIRD READING

39. Following further pressure from former Commissioners, the Government accepted that an independent review should be set up to consider the operation of the ring-fence and that this review should be able to make recommendations, including a recommendation for full separation of retail from wholesale operations within the banking system. Lord Deighton stated that:

40. Under the new provisions, the review panel will be independent of the Treasury and of the regulators and the Treasury must consult the Chairman of the Treasury Committee of the House of Commons before appointing its members. As a result of a further Government amendment tabled at Third Reading, the review is to be held two years after the ring-fence comes into force. This means that the review will be in 2021, as ring fencing is to be introduced in 2019.[43]

41. By the time the Bill completed its passage through Parliament, therefore, almost all of the major recommendations of the PCBS in relation to ring-fencing had been implemented. The only substantial matter outstanding was the second reserve power itself. However, the independent review of the ring-fence two years into its operation will be able, if it sees fit, to recommend changes that would give effect to full separation.

Other PCBS recommendations on ring-fencing, and developments since the passage of the Act

42. Following the passage of the Act, it fell to the Government to set out more details of the ring-fencing regime in secondary legislation, and to the regulator to implement it in practice.

43. The Government published its proposals for secondary legislation in June 2014. This clarified the definition of a "ring-fenced body" in the Act, as well as the scope of activities that ring-fenced bodies will be allowed to perform.[44] Among other things, the proposed secondary legislation:

· exempts from the definition of a ring-fenced body any banking groups which hold less than £25 billion in core deposits (to allow them to compete and grow without incurring disproportionate costs). The PCBS concluded in its first report that a 'de minimis' exception was "a sensible compromise between maintaining financial stability and encouraging new entrants to the banking industry".[45]

· allows organisations with a turnover of more than £6.5 million, more than 50 employees or a balance sheet total greater than £3.26 million, and high net-worth individuals with more than £250,000 of financial assets, to choose to bank outside the ring fence. The PCBS concluded in its first report that an exemption for large deposits "makes sense", and that it "is right that holders of large deposits should be required to make an informed decision to hold their deposits in a non-retail bank".[46]

· prohibits ring-fenced bodies from having exposures to other financial institutions outside their own corporate group, with a number of exceptions: they may have exposures for the purpose of managing their own risks; they may have exposures for the purpose of providing trade finance services; and they may have exposures arising from the provision of payments services to other financial institutions, subject to any requirements imposed by the regulator.

· prohibits ring-fenced bodies from establishing branches of subsidiaries outside the European Economic Area. In its first report, the PCBS said that it was "broadly content" with the Government's approach to geographic limits on the business of ring-fenced banks, but that consideration needed to be given to the effects on UK banks' ability to support trade. The PCBS therefore recommended that, when the relevant secondary legislation came into force, the Treasury monitor and report to Parliament on its assessment of the trade-off between these two factors.[47]

· prevents ring-fenced bodies from dealing in commodities, in order to insulate them from swings in global commodity prices. This is in addition to the provision in the Act preventing them from dealing in investments as principal.

There are some exceptions to this last provision:

· Ring-fenced bodies will be allowed to sell a narrow range of simple derivatives to their customers, such as interest rate swaps and simple foreign exchange options. In its first report, the PCBS concluded that there was a case in principle for permitting the sale of simple derivatives within the ring-fence, but that this would need to be subject to conditions and safeguards.[48] Under the Government's proposals, ring-fenced banks' derivative folios will have caps on their size and riskiness, and the derivatives sold will be required to be traded in liquid markets and capable of valuation on the basis of observable market inputs.

· Ring-fenced bodies will be able to deal in investments as principal for the purpose of reducing their exposure to specified risks, including interest rate, currency and liquidity risk. This implements an ICB recommendation.

· Ring-fenced bodies will be allowed to trade with central banks.

44. On 6 October 2014, the PRA published proposals on the implementation of ring-fencing.[49] As part of these proposals, the PRA confirmed that it expected groups containing ring-fenced banks to adopt a 'sibling structure', in which ring-fenced and non-ring fenced banks must be subsidiaries of a UK holding company. This followed comments from Lord Deighton during Lords Committee stage of the Bill, that:

In turn, this followed the PCBS's recommendation in its first report:

The PRA did not propose to make rules to this effect, but said it would "consider using its existing powers, as necessary […] to implement this policy".[52]

45. The Act requires the PRA to set out rules on the governance of ring-fenced bodies, designed to safeguard the core services they provide and their independence from other group entities. This provision followed a recommendation in the PCBS's first report that secondary legislation "should give the regulator a duty of ensuring operational independence for the ring-fenced bank in respect of governance, risk management, treasury management, human resourcing, capital and liquidity".[53] In its October 2014 consultation, the PRA accordingly proposed rules governing:

· The independence of ring-fenced bodies from other group entities generally, including the management of any conflicts of interest;

· The risk management and internal audit functions of ring-fenced bodies;

· The remuneration policies of ring-fenced bodies; and

· The HR policies of ring-fenced bodies.

· The composition of the boards of ring-fenced bodies.

46. The PRA also proposed rules on the continuity of services and facilities that ring-fenced bodies must have in place to perform their core functions. It will consult on further ring-fencing proposals—implementing, for example, the requirement to make rules restricting payments between ring-fenced bodies and other group members—in due course.[54]

Proprietary trading

47. The third report of the PCBS considered the prudential and cultural risks arising from 'proprietary trading'—in broad terms, trading where the bank is using its own funds, raised from shareholders, depositors and creditors, to speculate on markets without any connection to customer activity.

THE PCBS'S RECOMMENDATIONS

48. The PCBS concluded:

The PCBS was also concerned that proprietary trading could pose risks to the culture of a bank:

49. Many of the leading UK banks told the PCBS in evidence that they were not currently engaged in proprietary trading, and a number of them agreed that proprietary trading was not a suitable activity in which customer-oriented banks should engage. However, the PCBS concluded that such reassurances alone could not provide a guarantee against the re-emergence of proprietary trading over time, "as public attention on banks' activities fades, economic circumstances change and another generation of bank leaders less scarred by recent events emerges".[57]

50. The PCBS therefore recommended that the PRA undertake immediate supervisory action, to hold banks to their assertion that they were not engaged in proprietary trading, and to bear down on it where necessary using existing tools such as capital add-ons. The PCBS further recommended:

51. In addition to this immediate regulatory action, the PCBS recommended that the regulators carry out a report on proprietary trading within three years of the Act being passed. The report should include:

· analysis of the monitoring and corrective actions conducted in accordance with the recommendation for the PRA to monitor and bear down on proprietary trading;

· an assessment of any impediments encountered to such actions;

· the impact, by then, of the moves towards ring-fencing on banks' trading activities;

· lessons about the feasibility of defining and prohibiting proprietary trading within banks, based on the experience of other countries, in particular the USA, attempting to do this; and

· a full assessment of the case for and against a ban on proprietary trading.

The PCBS recommended that this report be presented to the Treasury and to Parliament upon completion, and that it serve as the basis of a further full and independent review of the case for action in relation to proprietary trading by banks. Legislation should be introduced to provide for such a review and to provide assurances about its independence, including a role for the House of Commons Treasury Committee in the appointment of the persons to carry out the review.[59]

GOVERNMENT'S INITIAL RESPONSE

52. The Government responded to the PCBS's Report on proprietary trading on 8 July 2013. It agreed with the PCBS that the risks from proprietary trading could be considerable and should be properly controlled. However, the Government initially rejected the PCBS's recommendation of a regulatory report into proprietary trading:

It did not respond to the PCBS's proposal for an independent review.

LEGISLATIVE CHANGE

53. During Lords Report Stage, Lord Lawson of Blaby tabled an amendment to PCBS's recommendations, requiring the regulators to conduct a review of proprietary trading, and requiring the Treasury to arrange for an independent review on receipt of this.

54. Lord Deighton, speaking for the Government, accepted the spirit of the amendment, saying:

[W]hile the regulators are currently equipped to deal with risks if and when they arise, it seems only reasonable that these arrangements should be reviewed over time and that we should take a strategic look at what any future risks from proprietary trading might mean for the UK banking sector as a whole, including whether the regulators' powers are appropriate.

I believe that the approach recommended by the PCBS on this is the right one. First, it should be for the PRA and FCA to review the situation, assess their powers and recommend further action to the Government. However, it also seems right that we review this matter once ring-fencing is in place and its effects have been analysed. It would therefore make sense for any such review to incorporate the thinking from the wider review into the ring-fence.

Therefore, I propose to noble Lords that the Government commit to a review of proprietary trading if the PRA deems it necessary, having evaluated its powers and practices in this area. The Treasury will therefore ask the PRA whether it feels equipped to deal with any risks from proprietary trading that may have arisen by that time. If the PRA does not think that it has the right tools, the Treasury will conduct a review of proprietary trading and its impacts, including on ring-fenced banks. That review of course will consider further safeguards against potential future risks from proprietary trading, including a ban, should it conclude that such safeguards are necessary.

Any review that does its job will also consider the experience that other countries have had with structural reforms. The Volcker rule in the US would of course be an obvious candidate, as my noble friend Lord Lawson said. […]

Lord Deighton undertook to return at Third Reading with a proposal to this effect. Lord Lawson therefore withdrew the amendment, noting:

55. At Third Reading, the Government tabled an amendment to the Bill that required the PRA to conduct a review of proprietary trading, to begin within twelve months of ring-fencing coming into effect. This review would consider:

· the extent to which banks engaged in proprietary trading;

· whether proprietary trading engaged in by banks gave rise to any risks to their safety and soundness;

· whether any kinds of proprietary trading were particularly likely to give rise to such risks;

· anything done by the PRA to minimise risks to the safety and soundness of banks arising from proprietary trading engaged in by them; and

· any difficulties encountered by the PRA in seeking to minimise such risks.

The review would also include an assessment by the PRA of:

· whether the PRA's powers under FSMA 2000 are, and might be expected to continue to be, sufficient to enable it to advance its objectives in relation to banks who engage in proprietary trading; and

· the effectiveness of restrictions imposed in countries or territories outside the United Kingdom on proprietary trading by banks.

56. The Government also tabled an amendment at Third Reading requiring an independent review of proprietary trading based on the PRA's report. This would commence within two years of ring-fencing coming into force, and report within "a reasonable time". The final report would:

· state whether the panel agrees with the conclusions reached by the PRA in its report;

· state whether the panel recommends any further restrictions on any kind of proprietary trading in relation to banks; and

· make such other recommendations as the panel thinks fit.

16 Independent Commission on Banking, Final Report, September 2011 Back

17 HM Treasury, Sound banking: delivering reform, Cm 8453, October 2012 Back

18 HM Treasury, Sound banking: delivering reform, Cm 8453, October 2012, para 2.22 Back

19 Parliamentary Commission on Banking Standards, First Report of Session 2012-13, First Report, HL Paper 98/HC 848, paras 93 and 94 Back

20 Parliamentary Commission on Banking Standards, First Report of Session 2012-13, First Report, HL Paper 98/HC 848, paras 164-171 Back

21 Parliamentary Commission on Banking Standards, First Report of Session 2012-13, First Report, HL Paper 98/HC 848, para 163 Back

22 Parliamentary Commission on Banking Standards, First Report of Session 2012-13, First Report, HL Paper 98/HC 848, paras 7-9; Q948 Back

23 Parliamentary Commission on Banking Standards, Second Report of Session 2012-13, Banking reform: towards the right structure, HL Paper 126/HC 1012, para 8 Back

24 Parliamentary Commission on Banking Standards, First Report of Session 2012-13, First Report, HL Paper 98/HC 848, para 165 Back