Banking reform: towards the right structure - Parliamentary Commission on Banking Standards

Banking reform: towards the right structure - Parliamentary Commission on Banking Standards Contents

2 Reinforcing the ring-fence

Introduction

5. In our First Report, we found convincing evidence on the benefits of structural reform, not only on grounds of financial stability but also for its potential to change the culture of banks for the better—an area not examined by the ICB.[8] We identified a number of challenges that a new structural framework for banks would face.[9] In the light of these challenges, we concluded that the proposals for the ring-fence as they stood at the time the draft Bill was published in October 2012 might well not be sufficient to achieve the Government's policy objectives.[10] We reflected upon the advice from the Chancellor of the Exchequer, and Sir Mervyn King, Governor of the Bank of England, not to miss the opportunity created by a measure of agreement on implementing a ring-fence.[11] Accordingly, we set out a series of measures to reinforce the ring-fence in order to increase the prospect of it proving durable in the long-term.[12] The Commission's approach was welcomed by Sir John Vickers, who supported the approach of increasing the durability and permanence of the ring-fence.[13]

6. In its response the Government has agreed with our view that "it is essential to ensure that the framework is robust, and not susceptible to erosion over time".[14] The Government has also agreed "that further steps should be taken to ensure that the ring-fencing framework stands the test of time".[15] The Commission welcomes the Government's acceptance of the principle that its proposed framework for ring-fencing requires reinforcement. In this chapter, we consider progress in relation to our main suggestions with this aim in mind.

Electrifying the ring-fence

THE RATIONALE FOR ELECTRIFICATION

7. The analysis which we undertook of the approach of banks towards their regulation, and the likely response of regulators and of politicians, led us to conclude that there was a significant risk that the effectiveness of the ring-fence would be eroded over time. In reaching this view we were influenced by the evidence of Paul Volcker, former Chairman of the US Federal Reserve, about the US experience with bank structural reforms in the past and the possible permeability of the ring-fence.[16] The US has twice endeavoured to establish a far greater degree of organisational separation than is envisaged under the ring-fence, as early as the National Bank Act of 1866,[17] and again—in the aftermath of the Wall Street Crash—in the Glass-Steagall Act of 1933. Both of these attempts were eventually frustrated, by banks establishing investment affiliates to get around the prohibition,[18] and by bank lobbying which led to the repeal of key provisions of the Glass-Steagall Act in 1999.[19] Drawing on evidence from the Governor of the Bank of England, we identified a risk that banks would view the new framework and the rules that flowed from it as basis for negotiation rather than a line in the sand.[20] The Financial Secretary to the Treasury has observed that "the history of financial regulation shows that banks have been able to discover ways of circumventing the rules".[21] Drawing on a phrase in our Report,[22] the Secretary of State for Business, Innovations and Skills has said:

the Commission rightly raised concerns about the banks' future behaviour. There is a risk that, when the banks regain, as they surely will, their reputation for alchemy—for turning base metal into gold—they may be tempted to "game" the ring-fence, perhaps by constructing complex instruments. These instruments might technically be classed as retail banking products and - in practice - fail to respect the spirit of ring-fencing.[23]

8. Our intention in our specific proposals for 'electrification' of the ring-fence was to create a significant new disincentive for banks seeking over time to test the ring-fence with a view to undermining its effectiveness. This disincentive was in the form of powers to enforce full institutional separation at the level of individual banks or the sector as a whole. We concluded:

Additional powers are essential to provide adequate incentives for the banks to comply not just with the rules of the ring-fence, but also with their spirit. In the absence of the Commission's legislative proposals to electrify the ring-fence, the risk that the ring-fence will eventually fail will be much higher.[24]

9. Sir John Vickers did not see it as inevitable that banks would seek to test the ring-fence, but acknowledged that "they might well do so" and that it was thus "a risk that one would want to guard against very seriously and effectively".[25] He considered that the proposals for electrification would "further reinforce the chance of ring-fencing working".[26] He also thought that it would increase the chance of it working "for longer. It is a question of durability and permanence."[27] He emphasised that the powers could be a "credible threat" to influence bank behaviour without needing to be used.[28] The Chancellor has now accepted the rationale for electrifying the ring-fence:

We're not going to repeat the mistakes of the past. In America and elsewhere, banks found ways to undermine and get around the rules. Greed overcame good governance. We could see that again— so we are going to arm ourselves in advance. In the jargon, we will 'electrify the ring-fence'.[29]

THE FIRST RESERVE POWER

10. Our First Report recommended two distinct reserve powers, the first of which would enable the regulator to take steps that could lead to a specific banking group affected by the ring-fence being required to divest itself fully of either its ring-fenced or its non-ring-fenced bank.[30] This power could thus be exercised in respect of an individual bank (or more than one if necessary) while retaining the benefits across the sector as a whole of diversification, with different banking models continuing to operate alongside each other, thus taking account of the case for such diversification made to us by Sir John Vickers in October.[31]

11. The possible impact of this reserve power, and the issues raised about the circumstances in which it might be exercised, were raised by both Anthony Browne, Chief Executive of the BBA[32], and Martin Taylor.[33] Sir John Vickers also stressed the need for checks on the exercise of the power.[34] In our First Report we outlined proposals on how the first reserve power might work, and also several safeguards, which were:

a) A stipulation that the regulator could only commence the process if it felt there was a significant risk to the objectives of the ring-fence;

b) A provision that the power would not be exercisable before the first independent review of the effectiveness of the ring-fence (an independent review which we discuss in the next section of this Report);

c) A requirement for the regulator to give a banking group early notice of any intention to use the reserve power;

d) The appointment of an external reviewer to consider the relationship between the banking group concerned and the regulator;

e) A right of appeal in relation to the exercise of the power; and

f) A Treasury power to override implementation.[35]

12. In its response, the Government has agreed with us that "a reserve power to require an individual banking group to move to full separation of retail and wholesale activities could be a powerful additional tool for the regulator to ensure the independence of a ring-fenced bank".[36] The Chancellor of the Exchequer told us in February that he viewed this reserve power as probably "the most powerful tool" the regulator would have.[37] The Government has agreed to amend the Bill to include provisions giving the regulator the power to enforce full separation between retail and wholesale banking in a specified group. It also stated that it would establish "strict statutory conditions [...] setting out the circumstances in which this power can be used, tests that must be met and factors the regulator must take into account before deciding to require a group to separate".[38] The Government has also indicated that Treasury approval would be required for such a requirement. The Government has announced that it would bring forward an amendment to the Bill to include the necessary provisions.[39] The Government has not referred specifically to our proposal relating to the involvement of an external reviewer to examine the relationship between the regulator and the bank concerned before the power is exercised, but the Financial Secretary to the Treasury confirmed that the amendment would reflect the Commission's recommendations.[40]

13. When our First Report was published in December, the Chief Executive of the BBA, Anthony Browne, was reported as saying that "the threat of banks being broken up was causing uncertainty, and making it harder for them to raise money which could then be loaned to small firms".[41] In evidence in January Anthony Browne said that he had been seeking to make a wider point about regulatory uncertainty, but reiterated that regulatory uncertainty made it harder for banks to raise capital.[42] When the Government's response was published in early February, Anthony Browne was again reported as expressing almost identical views as in December: "This will create uncertainty for investors, making it more difficult for banks to raise capital, which will ultimately mean that banks will have less money to lend to businesses"[43]

14. In view of the significance of the potential concern about the impact of the measure on bank capital raising, we explored it further with witnesses in the New Year. Both Sir John Vickers and Martin Taylor were unpersuaded by the argument that electrification increased uncertainty, given that its intention was to ensure that the ring-fence operated properly.[44] Sir John said:

The only way I can see it increasing uncertainty is if banks intend to play around the boundary, flirting with it.[45]

15. In view of the fact that the BBA purports to represent banks and to lobby on their behalf and that its principal source of funding is from the banks directly affected by the ring-fence proposals, we were keen to seek the views of individual banks. We asked Antonio Horta-Osório, Group Chief Executive, Lloyds Banking Group, whether he agreed with the BBA's opposition to electrification. He replied:

We were not notified about those comments, which I think were made by the CEO of the BBA in his name. I support electrification, like I supported ring-fencing. As you know, we were the only bank publicly to support ring-fencing. The reason why I support your proposal is that, if we think that for society as a whole it is better to have ring-fencing, both from a financial stability point of view and from a cultural point of view, I absolutely agree that you should have strong enforcement and strong incentives in order for that to happen.[46]

Both Sir David Walker, Chairman of Barclays and Douglas Flint, Executive Chairman of HSBC, also indicated that they supported the proposal for the first reserve power, the latter saying:

In the event that it is judged that participants are circumventing or frustrating the purpose of the ring-fence, it seems to me quite reasonable for there to be a sanction.[47]

In evidence to the Treasury Committee, the next Governor of the Bank of England, Dr Mark Carney, also indicated his support for the first reserve power.[48]

16. The Commission finds it surprising that the Chief Executive of the British Bankers' Association should adopt a policy position which has no public support from the major banks most directly affected by the ring-fence.

17. The Commission sees no merit in the proposition that the first reserve power will create uncertainty for banks or put at risk their attempts to raise funds for lending. That power will be a source of uncertainty only for those minded to take actions that conflict with the objectives of the ring-fence. For all other banks, for regulators, for Parliament and the public, it will be a source of greater certainty about the effectiveness of the ring-fence. The Commission welcomes the Government's commitment to amend the Bill to provide for a reserve power to break-up a bank that seeks to flout the ring-fence.

18. We consider it important that the regulator's powers to break-up a bank should be exercisable only after consideration of the regulator's relationship with the bank by an independent reviewer. It is also important that the reviewer should be independent of Government. We welcome the Financial Secretary to the Treasury's commitment to give careful consideration to our specific proposals on the conditions on the exercise of this power. Amendments J and K in the Appendix are intended to provide an early opportunity for the House of Commons to consider further this reserve power and the appropriate limits upon its exercise. We would also envisage a specific timetable relating to the exercise of the powers, to be determined at the outset.

19. We have also considered whether it would be appropriate in certain circumstances for the reserve power to create a complete split between a ring-fenced bank and an investment bank to be supplemented by a specific regulatory power to require banks to cease certain, specified activities. We note that, under the prospective EU Recovery and Resolution Directive, the regulators are expected by the Government to be given "substantial powers to require reorganisations", but this power is only to be exercisable in the context of achieving resolvability.[49] We envisage a power that would be exercised to secure protection for the cultural position of ring-fenced activities by removing specified activities from within a particular bank that posed a cultural threat rather than a threat to resolvability. We recommend 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. We envisage that this power would be subject to limits on its exercise similar to those of the first reserve power.

THE INDEPENDENT REVIEW MECHANISM

20. Although the Government has accepted the principle of the first reserve power, it has not yet been convinced of the case we set out for a statutory independent review mechanism. In our First Report we concluded that the review of the ring-fence envisaged in the draft Bill was too narrow. We recommended both an annual review of the operation of the ring-fence by the Prudential Regulation Authority (PRA) and a regular independently-led review—the first after four years, and every five years thereafter—of the ring-fence's effectiveness.[50]

21. The periodic independent reviews represent a crucial part of the architecture for implementation of the reserve powers that we recommended. The first reserve power, to which we referred in the previous section, would not be available to the regulator until after the completion of the first such review.[51] The second reserve power for full separation across the banking sector as a whole, which we consider in the next section, would only be exercisable following recommendations of such a review.[52]

22. The Government has accepted that the PRA should be required to conduct annual reviews of the operation of the ring-fence,[53] and has made provision for this in the Bill.[54] The Government has said that it will review the ring-fence and its effectiveness on a continuing basis,[55] and the Bill provides for the PRA itself to carry out reviews of the ring-fence every five years.[56] In its response to our Report, the Government did not address the case for an independent and external review of the kind we recommended, but in oral evidence in February the Chancellor of the Exchequer told us that he would be "very happy" to consider an independent review of the overall effectiveness of the ring-fence.[57] He said that his concerns had been about a review being tasked specifically with considering the case for full separation.[58]

23. The case for a statutory, periodic and independent review was made in evidence rehearsed in our First Report, notably that from the Governor of the Bank of England.[59] In subsequent evidence, Sir John Vickers supported the proposal for a "serious periodic review", suggesting that it should also consider the allied measures on capital and loss absorbency.[60] Sir David Walker also emphasised the importance of any review of the ring-fence before any changes were made being "independent": "if it is an independent review after a period of time, I don't see how we could object to that".[61] Douglas Flint also supported the proposition:

I think it would be remarkable if everybody who has been involved in this process is able to anticipate everything that might arise from the operationalising of the ring-fence over the next three to five years. I actually think that the first independent review might be earlier than five years, because problems, if they arise on either side of this application, will probably arise quickly in its operation, rather than later. So I think maybe three years afterwards would be a good first time.[62]

24. The Government's proposal for the periodic review to be conducted by the regulator is wholly inadequate. Such a review conducted by the regulator would be little different in character from the regulator's annual report and could amount to no more than a case of the regulator marking its own examination paper. The creation of a periodic independent review arrangement is crucial to the balance that we sought to strike between giving regulators the tools they need to do their job effectively and giving Parliament, the public and the banks affected confidence that there will be independent constraints upon the exercise of those regulatory powers. One of the strengths of the banking industry (as well as one of its weaknesses) is its capacity for innovation. The new framework must be subject to regular periodic, independent review to ensure that that framework keeps pace with innovation in the banking sector as well as the experience of the operation of the ring-fence. We welcome the Chancellor of the Exchequer's indication that he is happy to consider the case for an independent review. We urge the two Houses of Parliament to support our proposal for an independent review; Amendment N in the Appendix enables the two Houses to debate and reach a decision in principle on this proposition.

THE SECOND RESERVE POWER

25. Alongside our proposal for a group-specific regulatory power to enforce full structural separation, we recommended that the independent review should be required to assess the case for a move to full separation across the banking sector as a whole.[63] To strengthen the hand of the review in considering this issue, we recommended that legislation to give effect to any such recommendation should be included in the Bill now before Parliament.[64]

26. The Government has rejected the case for a reserve power at this stage for full structural separation. The Government advances several grounds for that rejection. First, it contends that passing such legislation would entail the Government pursuing a "different policy" from that contained in the Bill, a policy which in the Government's view would be based on the assumption that the ring-fence might fail, when the Government does not itself believe that the ring-fence will fail.[65] Second, the Government argues that "it is not necessary to legislate now for a reserve power to abandon ring-fencing at some point in the future", because this is a decision best made by Government and Parliament at the time.[66] Third, it contends that it would be wrong for the final decision on whether to bring in such a radical change to be in the hands of the regulator rather than for Government and Parliament.[67]

27. The Government has been at pains to make the case against the provision for full separation being implemented on the say so of the regulator. The Government has erected a straw man which it has then successfully demolished, because we made no such recommendation in our First Report. Instead, we envisaged that the legislative provisions would be brought into force only in the light of the recommendations of the independent review.

28. The Commission continues to believe that statutory provision for full separation should be included in the Bill now before Parliament. Amendments L and M in the Appendix facilitate debate and decision in principle on this proposition. The power would not be available to be implemented until after the case for full separation across the sector had been considered by an independent periodic review of the effectiveness of the ring-fencing framework which had come to a recommendation to that effect. The view of the regulator would be of great importance in such consideration, but we would expect the decision to implement full separation across the sector to be a matter for Government and Parliament. We have therefore made provision for the amendments which give effect to full separation across the sector as a whole to come into force only after an affirmative resolution in both Houses.

Objectives in primary legislation

29. The draft Bill set out a proposed 'continuity objective' for the regulator—in almost all cases the new PRA—in discharging its functions in relation to the ring-fence. This objective was defined as "protecting the continuity of the provision of core services", a term itself defined by reference to the management of retail deposits and associated payments and overdraft facilities. Drawing on evidence from regulators and others, we concluded that the proposed objective did not adequately reflect the stated objectives of the underlying policy, relating to absorbing losses, reducing the costs and difficulties of resolution and curbing incentives for excessive risk-taking. We recommended that these underlying objectives be reflected in the relevant statutory provisions and that the relationship between the continuity objective and other regulatory objectives should be clarified.[68]

30. The Government has now agreed that "the objectives of ring-fencing should be fully reflected on the face of the Bill and that the relationship between the PRA's continuity objective and the regulator's other objective should be clarified".[69] To achieve the latter end, the Government has amended the Bill to make the continuity objective part of the PRA's general objective—promoting the safety and soundness of the institutions that it regulates—so that it is one means by which the PRA advances that general objective.[70] According to the Government, "as a result of this change, it should be clear that ensuring continuity of (ring-fenced) core services is a central pillar of the PRA's general objective, and not an additional obligation".[71] The Government has revised its formulation of the continuity objective in an endeavour to reflect the ICB's three objectives for ring-fencing and set out its reasons for its approach.[72] The Commission welcomes the Government's clarification of the relationship between the continuity objective and the PRA's general objective, and the steps it has taken with regard to the formulation of the continuity objective. We invite the two Houses of Parliament to examine the Government's changes alongside Amendments A to D in the Appendix, which we consider adhere more fully to the ICB's objectives for ring-fencing.

Delegated powers and scrutiny of secondary legislation

THE APPROACH OF THE DRAFT BILL AND THE ASSOCIATED RISKS

31. The draft Bill was primarily an enabling Bill, seeking the powers that would enable the Treasury to implement its proposed policy through secondary legislation.[73] Although some of the key concepts to give effect to the ring-fence were included in the proposed primary legislation, these were to be subject to qualification and adaptation through the exercise of delegated powers. We pointed out that this enabled very different policy outcomes, some of which might be quite distinct from the Government's stated policy, to be delivered through the same statutory vehicle.[74] We concluded that the heavy reliance on secondary legislation left open too many questions of significant policy importance, creating uncertainty for the regulators charged with making the framework operational and for the banks required to operate within it. In consequence, the jury was still out on whether the Government would implement the letter and the spirit of the ring-fence as then proposed.[75] We recommended a number of specific steps to redress the imbalance that might flow from the Government's proposed approach, the main ones of which we consider in this section.

CONSIDERATION OF INITIAL PROPOSED SECONDARY LEGISLATION IN DRAFT

32. During the initial phase of our inquiry the Government committed itself to producing the principal draft secondary legislation before the House of Commons Committee stage and to publish all draft secondary legislation later in 2013.[76] We recommended that the principal draft secondary legislation should be published at the same time as the Bill, and that there should be a pause of three sitting months between the publication of the Bill and the commencement of Committee stage.[77] In its response to our First Report, the Government has restated its previous commitment in slightly more specific form:

To assist Parliamentary scrutiny of the Bill, the Government will by the Bill's Commons Committee stage publish drafts of the principal statutory instruments, including those establishing the scope of the ring-fence, the de minimis exemption from ring-fencing, the specific prohibitions on ring-fenced banks, and the precise conditions for exemptions.[78]

In answer to an urgent question the same day, the Financial Secretary to the Treasury went slightly further, stating that "Drafts of the principal statutory instruments to be made will be made available to the House before Second Reading".[79] The Commission notes with disappointment that even the 'principal' secondary legislation was not available at the time of publication of the Bill as we had recommended, but welcomes the commitment to publish it before Second Reading.

CONDITIONS ON THE EXERCISE OF CERTAIN DELEGATED POWERS

33. We expressed particular concern about the delegated powers to exempt a class of institutions from the requirements of the ring-fence and to change the definition of an 'excluded activity'—one that ring-fenced banks cannot conduct. The proposed condition was framed as a negative test—relating to the likelihood of a significant adverse effect on the provision of core services—whereas we recommended that exemptions be permitted only if they did not pose a risk to the continuity objective and provided a significant economic or financial stability benefit.[80] In response the Government has agreed that the tests should be "tough" and indicated that it "will consider further amendments to ensure that the tests deliver the policy intention".[81] The Commission welcomes in the Government's commitment in principle to consider toughening the tests for the exercise of delegated powers for exemptions from the ring-fence. We believe that the specific tougher tests we proposed in our First Report are the right ones. We commend Amendments E and F to assist in parliamentary consideration of that recommendation.

PARLIAMENTARY SCRUTINY

34. One way in which concerns about the extent of delegated powers can be allayed is by making provision for effective parliamentary scrutiny. In November, the Chancellor of the Exchequer accepted the need for proper scrutiny.[82] However, under the draft Bill, almost all of the powers to determine and then amend the location of the ring-fence were proposed to be subject to the weakest form of scrutiny—the negative resolution procedure. We supported the assessment of the Delegated Powers and Regulatory Reform Committee that the Government's justification for its proposed approach was unsatisfactory, and recommended that the key delegated powers should be subject to the affirmative resolution procedure.[83] In order to reduce the risk of the ring-fence being undermined over time, we devised a set of measures to ensure that subsequent proposals to amend the secondary legislation governing the ring-fence were subject to full consultation and parliamentary scrutiny by an ad hoc committee of the two Houses of Parliament before they took final form, except in urgent cases.[84]

35. In its response, the Government has again accepted the need for proper scrutiny of secondary legislation, and the Bill has been amended to provide for the affirmative resolution procedure in respect of the powers we identified.[85] In November, the Chancellor of the Exchequer told us that, "if this Commission recommends further ways of scrutinising that secondary legislation, of course I will be very willing to listen to it".[86] The Government has made clear its intention to "publish all secondary legislation for consultation where possible".[87] However, the recommendations we devised to ensure greater transparency for secondary legislation which could move the ring-fence have been rejected by the Government in a single sentence: "The Government does not consider that an additional Parliamentary scrutiny process is necessary".[88] The Commission remains firmly of the view that the considerable scope for moving the location of the ring-fence through the exercise of delegated powers necessitates enhanced parliamentary scrutiny. We invite the two Houses of Parliament to consider Amendment I in the Appendix which seeks to give effect to our proposals and which additionally provides that the Chair of the Treasury Committee should be the chair of the ad hoc joint committee.

8 First Report, para 45 Back

9 First Report, paras 63-78 Back

10 Ibid., para 94 Back

11 Ibid., paras 79, 91 Back

12 Ibid., para 126 Back

13 Qq 2562, 2571 Back

14 Banking reform, para 2.12 Back

15 Ibid. Back

16 First Report, para 84 Back

17 The 1864 National Bank Act, which created the OCC and the federal bank charter, from the beginning had limitations on banks' abilities to engage in non-banking activities, which in effect limited them and ring fenced them prior to US deposit insurance. Prior to that various States that had organized banking charters (such as New York) had similar provisions. Back

18 Most banks created affiliates. Two examples were National City Bank in 1911 and Chase National Bank in 1917 who both created affiliates able to transact securities business their 'parent' banks were precluded from.(National City was a New York state chartered bank and Chase was a National Bank (and accordingly subject to the National Bank Act): Stock Exchange Practices, Report of the Committee on Banking and Currency 1934, pp 156, 159. Back

19 The Gramm-Leach-Bliley Act, also known as the Financial Services Modernization Act of 1999, was enacted on 12 November 12 1999. It repealed part of the Glass-Steagall Act of 1933, removing barriers in the market among banking, securities and insurance companies that prohibited any one institution from acting as any combination of an investment bank, a commercial bank and an insurance company. With the passage of the Gramm-Leach-Bliley Act, commercial banks, investment banks, securities firms, and insurance companies were allowed to consolidate. Back