3 Specific issues on ring-fence implementation |
Ring-fenced banks acting as principal
in the sale of derivatives
36. In chapter 10 of our First Report we considered
some specific issues on the implementation of the ring-fence,
including some where proposed Government policy was at odds with
the proposals of the ICB. Of these issues, the most vexed and
complex related to the sale of derivatives. The ICB recommended
that ring-fenced banks should not themselves take on exposures
arising from the sale of derivatives, and concluded that the best
way to secure this was by requiring ring-fenced banks to act as
agents for products sold by others, rather than acting as principal.
The Government took a different view, arguing that ring-fenced
banks should be able to sell simple derivatives, but soliciting
this Commission's views on the matter.
37. We identified a number of prudential and
conduct risks associated with the sale of derivatives, such that
the sale of derivatives within the ring-fence posed a risk to
its success. We accepted that there might be a case in principle
for permitting the sale of derivatives within the ring-fence,
subject to three conditions:
i) There were adequate safeguards to prevent
ii) 'Simple' derivatives could be defined in
a way that was limited and durable;
iii) There were limits on the proportion of the
bank's balance sheet that could be taken up by derivative products.
We recommended early consultation on a proposed definition
of 'simple' derivatives and a cap on the gross volume of derivative
sales by ring-fenced banks.
38. Giving evidence in January, Martin Taylor
was more forthright on the potential problems of the sale of derivatives
within the ring-fence than he had been previously. He argued that,
if ring-fenced banks held exposures resulting from derivatives
on their balance sheet, resolution would become "more difficult
It would also result in some trading business within banks benefiting
from the cheaper funding likely to be available to ring-fenced
banks. A prohibition would be an easy rule to write; anything
short of that would open the door to problems, being "the
kind of unforced error that we will really regret".
Summing the matter as he saw it up, he said:
I can't see the point of having a fence round the
chicken coop, electrifying it to keep the foxes out and then inviting
a family of tame foxes to live inside it [...] My views on this
have hardened, and I think that, if you allow derivatives inside
the fence, you weaken it, and even with the electrification proposals,
you end up somewhere worse off than Vickers mark 1.
39. Sir John Vickers told us that he remained
sceptical as to whether a practical definition of 'simple' derivatives
could be arrived at, while accepting that, if it could, the concerns
which underlay the ICB's recommendations might be allayed in part.
However, he reminded us that the sale of derivatives had been
part of the expansion of UK banks into riskier fields in the decade
before the crisis.
He thus remained concerned that the sale of derivatives by ring-fenced
banks could act as the thin end of a wedge leading to the problems
of less resolvable banks and greater counter-party risk among
the banks that ring-fencing was designed to reduce.
40. Bill Winters, another member of the ICB,
noted that our support for the inclusion of derivatives within
the ring-fence had been very conditional.
He went on to identify the potential problems from a burgeoning
derivatives trade within the ring-fence:
Derivatives, particularly as they become more complicated,
provide all sorts of avenues for banksor corporations for
that matterto effectively move around value and cash from
one place to another in ways that cannot easily be tracked.
As to whether 'simple' derivatives could be effectively
defined, he replied:
There will be simple derivatives, of one form or
another, inside the ring fence in any case, because there have
to be for the treasury operations of the bank, otherwise we would
be forcing them to take imprudent risk, which no one is suggesting.
The question is: can regulators properly police this concept of
"simple" or the underlying motives? I say that it will
be difficult, but not impossible. The alternative is to say, "You
simply cannot manage your risk, either for yourself or for your
customers inside the ring fence", which would be the wrong
conclusion in my opinion.
He supported the concept of a gross cap if it could
serve as a trigger point for heightened supervision and provided
that the level of the cap were not set in stone.
41. The Financial Secretary to the Treasury has
acknowledged the provisional nature of the conclusions in our
First Report on derivatives:
The Commission expressed the interim view that it
was reasonable [...] for simple derivatives to be provided from
within a ring-fenced bank. However, it wants to reflect further
on whether any of its inquiries into the culture of banking may
have implications for that. We will await its conclusions.
In its response to our Report, the Government has
agreed that ring-fenced banks might be permitted to sell certain
simple derivatives subject to strict safeguards. The Government
has undertaken to ensure that our recommendations on safeguards
are reflected in the secondary legislation that would be made
available by the Commons Committee stage of the Bill.
We assume that this includes our specific proposal for a gross
cap. The Commission
will consider the draft secondary legislation relating to the
definition of simple derivatives when it is published. We will
wish to satisfy ourselves as to whether the Government has come
forward with proposals for a concise and enduring definition of
simple derivatives which respond adequately to our other recommendations
for safeguards, including a gross cap, before deciding whether
to support the sale of derivatives within the ring-fence in our
42. Our First Report identified the need, in
the event that simple derivatives were to be sold within the ring-fence,
for continuing transparency and accountability on the matter.
We recommended that the regulator be required to report annually
on the extent and nature of the sale of derivatives within the
ring-fence, including the effects of any changes to secondary
legislation proposed by a future Government.
The Government has not responded to this specific recommendation,
and the reporting requirements on the new regulator in relation
to the ring-fence are couched in more general terms.
to both Houses the provisions of Amendment O in the Appendix,
which would facilitate more transparent regulatory oversight of
any sale of derivatives within the ring-fence.
The de minimis requirement
43. The Government also departed from the ICB
recommendations in proposing a 'de minimis' exception to the ring-fence
for institutions with retail and SME deposits below a certain
value. We concluded in our First Report that this exemption for
smaller deposit-taking institutions represented a sensible compromise
between maintaining financial stability and encouraging new entrants
to the banking industry. We recommended that the factors to be
taken into account in setting or revising a de minimis requirement
should appear on the face of the Bill, and that these factors
should include effects on competition and on new entrants to the
market in particular. We also proposed that the regulator should
report annually on developments affecting the appropriateness
of the level of the threshold.
44. The Government has arguably accepted that
the criteria for judging the de minimis exemption should be clearly
specified, but maintained that the Bill "already achieves
this clarity" as a result of the requirement that any exemption
should not be likely to have an adverse effect on the continuity
of core services. The Government has nevertheless agreed to amend
the Bill to include an additional requirement to have regard to
the impact of the de minimis exemption on competition.
The Government has not referred to our recommendation of a regulatory
report on the level of the exemption. We
welcome the Government's commitment to refer specifically to competition
as a factor in determining the level of the de minimis threshold.
We commend Amendment P in the Appendix which gives effect to this
in a way which refers specifically to new entrants and Amendment
Q which provides for annual reporting by the regulator on the
developments affecting the appropriateness of the level of the
Independence and governance of
the ring-fenced bank
45. While the main decisions on the precise position
of the ring-fence were to be determined by delegated legislation
made by the Treasury, the draft Bill proposed that the rules for
the extent of separation between the ring-fenced entity and the
rest of the banking group and of the former's independencethe
'height' of the ring-fenceshould be set by the regulator.
This approach caused concern to the prospective regulators, who
told the Commission that this laid them open to challenge to a
far greater degree than if they operated under a mandate set with
Parliamentary authority. Having concluded that the proposals represented
a delegation too far, we recommended that the parameters for the
rules on the height of the ring-fence should be set by the Government
in the relevant provisions of the Bill or in secondary legislation
subject to parliamentary approval.
46. The Government has responded positively to
both these recommendations. It has agreed that "regulators
should be given greater guidance on the face of the statute to
assist them in making rules to implement ring-fencing and in particular
in setting the height of the ring-fence" and has amended
the Bill accordingly.
The Government has also indicated its intention to create a power
to clarify the parameters further through secondary legislation.
The Commission welcomes the
steps the Government has taken to enable a clearer parliamentary
mandate for the height of the ring-fence to be provided for the
regulator in setting rules. To facilitate early parliamentary
consideration of the principle of parameters for the rules being
set by parliamentary means, Amendments G and H in the Appendix
make provision for the additional delegated power to which the
Government has agreed in principle.
47. In addition to the principle of the mandate
with parliamentary authority, we considered carefully ways in
which the ring-fenced bank could be able to operate effectively
as an independent entity within a wider banking group. Andy Haldane
identified several ingredients for the requisite independence:
i) Separate governance;
ii) Separate risk management;
iii) Separate balance sheet (treasury) management;
iv) Separate remuneration structure and human
Sir John Vickers added independence of capital and
liquidity to this list. The Chancellor of the Exchequer subsequently
endorsed what he dubbed the "Haldane principles" with
Sir John's addition.
We recommended that these elements of separateness be required
in the initial secondary legislation to set parameters for the
48. The Government has arguably gone further
than we recommended, seeking to reflect the 'Haldane principles'
on the face of the Bill. The relevant proposed new section of
FSMA has been expanded to specify the areas in which operational
and economic independence must be established.
According to the Chancellor of the Exchequer, the effect of these
changes is to provide that:
- "Your high street bank
will have different bosses from its investment bank";
- "Your high street bank will manage its own
risks, but not the risks of the investment bank"; and
- "The investment bank won't be able to use
your savings to fund their inherently risky investments".
We strongly support the Government's
decision to place on the face of the Bill some of the key parameters
for ensuring the operational and economic independence of ring-fenced
49. Even if the directors of a ring-fenced bank
are different from those of an investment bank, we noted in our
First Report that a tension would continue to exist between the
duties that directors of the ring-fenced banks would owe to that
entity and their duties to the parent company and through them
to shareholders. We recommended that the Government insert within
the Financial Services and Markets Act 2000 (FSMA) a legal duty
on boards of directors to preserve the integrity of the ring-fence.
This recommendation was welcomed by Sir John Vickers.
We also recommended that the Government "set out, in its
response to this Report, a full account of how directors would
be expected to manage the relationship between such a duty and
their duties to the shareholders".
50. In response, the Government has agreed that
independent governance was "an essential part of ensuring
the legal, economic and operational independence of ring-fenced
banks from their wider corporate groups". The
Government has agreed to amend FSMA to ensure that a director
of a ring-fenced bank will always be an approved person under
that Act, so that any such director "who is knowingly concerned
in a contravention by a ring-fenced bank of any of the ring-fencing
obligations [...] or ring-fencing rules [...] will be subject
to the full range of the regulators' disciplinary powers (which
may in serious cases include lifelong suspension and/or [...]
very large fines".
The Government has also provided an account of its assessment
of the legal position of directors, contending that the duty to
comply with ring-fencing rules was compatible with the wider fiduciary
duty, but has undertaken to take account of any further recommendations
we make in relation to directors' liability and sanctions.
The Commission welcomes the
explicit provision in the Bill to enable the regulator to assign
legal responsibilities on directors of ring-fenced banks in relation
to its independence. We will consider further steps that might
be appropriate in this area in our final Report.
Relationship between the ring-fenced
bank and the holding company
51. In evidence last year, Sir John Vickers,
Martin Taylor and the FSA all made the case for there being a
power to prevent a non-ring-fenced bank directly owning a ring-fenced
bank. This was not supported by Barclays or Santander, but we
found the case for prohibiting such a 'parent-child' relationship
persuasive. We recommended accordingly that "the regulator
be given the power to require a sibling structure between a ring-fenced
and non-ring-fenced bank, with a holding company".
Sir John Vickers in his evidence in January said that "the
standards and cultural issues that have come to light" since
the ICB reported had made him re-think the idea that an investment
bank should be enabled to own a ring-fenced bank. He supported
our proposal to give the regulator a reserve power to require
a sibling structure between those entities.
52. The Government has agreed that the corporate
structures of banking groups should not undermine the effectiveness
of the ring-fence, or the resolvability of the bank, but pointed
to the first reserve power and to the forthcoming powers under
European legislation to require reorganisations necessary to achieve
resolvability as relevant enhancements of the regulatory toolkit.
In consequence, "the Government does not at this stage believe
it necessary to provide for further powers (beyond those recommended
by the ICB) to restrict groups' corporate structure".
53. The Commission finds it disappointing
that the Government should seek to fall back on the original position
of the ICB on a possible 'parent-child' relationship between an
investment bank and a ring-fenced bank when the Chairman of the
ICB has moved on from that position. Sir John Vickers has emphasised
the problems of culture and standards which have come to the fore
since the ICB reported as reasons for now supporting a prohibition
on such a relationship, as have we. The Chancellor of the Exchequer,
too, has stressed the need for independence of ring-fenced banks
from investment banks, yet seems curiously reluctant to implement
a straightforward structural reform to buttress it. We invite
the two Houses of Parliament to consider Amendment R, intended
to give the regulator a duty to require a ring-fenced bank to
be owned by a holding company.
54. In our First Report we highlighted the risk,
however small, that the creation of ring-fenced banks might be
used as an opportunity to shift liabilities between entities within
a group in an artificial way and recommended that the regulator
be required to set rules to prevent this.
In its response, the Government has indicated that it views this
as sufficiently unlikely as to need no further safeguard.
evidence that we have received about the capacity of the banking
sector for creative accounting alongside restructuring in the
past, we believe that even a small risk should, where it has been
identified, be addressed through legislation. We invite the two
Houses to consider further whether adequate safeguards are in
place to prevent artificial redistribution of liabilities when
a ring-fenced entity is created; Amendment S in the Appendix provides
an opportunity for debate on this matter.
55. The potential artificial distribution of
liabilities also gives rise to another concern, about the scope
for a bank providing that fines relating to conduct outside the
retail banking sphere, for example in relation to LIBOR manipulation,
should be met by a ring-fenced bank. We
consider it vital that the allocation of fines for conduct issues
prior to the establishment of the ring-fence is addressed by the
Treasury and the regulator prior to the implementation of the
ring-fence. We consider that there may be a case for the regulator
being given a duty to approve any such allocation. We therefore
recommend that the Government, in its response to this Report,
set out its views on this matter.
89 First Report, paras 174-175 Back
First Report, paras 191-195 Back
Q 2934 Back
Q 2885 Back
Q 2574 Back
Q 2576 Back
Q 2574 Back
Qq 3678 - 3679 Back
Q 3678 Back
Q 3679 Back
Q 3680 Back
HC Deb, 4 February 2013, col 34 Back
Banking reform, para 2.30 Back
First Report, para 194 Back
Bill 130, Clause 6 (amendment of paragraph 19 of Schedule 1ZB
to FSMA) Back
First Report, paras 196-200 Back
Banking reform, para 2.34 Back
First Report, paras 61-62 Back
Ibid., para 139 Back
Banking reform, para 2.10; Bill 130, Clause 4 (new section
Banking reform, para 2.17 Back
First Report, para 217 Back
Ibid., para 224. Back
Banking reform, para 2.17; Bill 130, Clause 4 (section
142H(5) of FSMA) Back
Chancellor's Banking Reform speech Back
First Report, para 222 Back
Q 2578 Back
First Report, para 223 Back
Banking reform, para 2.27 Back
Banking reform, para 2.27; Bill 130, Clause 5 (amending
section 59 of FSMA) Back
Banking reform, paras 2.28, 2.27 Back
First Report, paras 225-228 Back
Q 2578 Back
Banking reform, para 2.25 Back
First Report, para 230 Back
Banking reform, para 2.50 Back