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

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

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.[89]

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 mis-selling;

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.[90]

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 straight away".[91] 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".[92] 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.[93]

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.[94] 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.[95] 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.[96]

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.[97] 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 banks—or corporations for that matter—to effectively move around value and cash from one place to another in ways that cannot easily be tracked.[98]

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.[99]

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.[100]

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.[101]

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.[102] 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 final Report.

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.[103] 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.[104] We commend 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.[105]

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.[106] 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 threshold.

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 independence—the 'height' of the ring-fence—should be set by the regulator.[107] 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.[108]

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.[109] The Government has also indicated its intention to create a power to clarify the parameters further through secondary legislation.[110] 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 resourcing.[111]

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.[112] We recommended that these elements of separateness be required in the initial secondary legislation to set parameters for the ring-fence rules.[113]

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.[114] 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".[115]

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 banks.

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.[116] This recommendation was welcomed by Sir John Vickers.[117] 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".[118]

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". [119]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".[120] 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.[121] 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".[122] 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.[123]

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".[124]

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.

Liabilities

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.[125] In its response, the Government has indicated that it views this as sufficiently unlikely as to need no further safeguard.[126] Given the 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

90 First Report, paras 191-195 Back

91 Q 2934 Back

92 Ibid. Back

93 Q 2885 Back

94 Q 2574 Back

95 Q 2576 Back

96 Q 2574 Back

97 Qq 3678 - 3679 Back

98 Q 3678 Back

99 Q 3679 Back

100 Q 3680 Back