4 Capital and loss absorbency |
56. It is easy for legislators to succumb to
the lure of legislative action, and assume that the main structural
changes to be embodied in the new legislation represent a self-contained
solution to the systemic risks to the banking system. In our First
Report, we made clear that the limits of legislative action must
be properly understood and that the specific proposals for ring-fencing
would need to judged alongside other measures flowing from the
ICB recommendations, a number of which do not necessarily require
a domestic legislative response. In particular, we emphasised
- Ring-fenced banks must not
be seen as beneficiaries of a Government guarantee, and it needs
to be understood that the policy is designed to ensure a continuity
of critical banking services, not a safety net to prevent individual
- There will remain substantial systemic risks
associated with banks outside the ring-fence and outside the UK;
- The ring-fence is a necessary component of reform,
but not sufficient, and has to be considered alongside measures
to improve loss absorbency, as well as wider measures to address
the problems of institutions that remain too big to fail.
57. In its response, the Government has stated
that regulatory objectives in this area apply to "core services
in the UK, not to individual institutions".
The Government has also confirmed its recognition that "ring-fencing
will not solve all of the problems in the financial sector"
and had to be seen alongside other reforms.
58. Sir John Vickers characterised the recommendations
of the ICB as envisaging a series of buffers for banks that posed
a wider risk to the economy, including capital requirements and
bail-in as well as structural reforms.
In this chapter we consider the Government's response to our recommendations
in these areas.
59. One of the most debilitating aspects of the
banking crisis of 2007 to 2009 from the point of view of the taxpayer
was that the bank creditors who had benefited from the good years
did not bear any of the loss when things turned bad. 'Bail-in'
amounts to a set of legal changes giving the authorities powers
to impose losses on creditors of a failing bank. It would apply
to non-ring-fenced banks as well as ring-fenced banks and is seen
by the Bank of England as being crucial to effective resolution
of a failing bank without recourse to the public purse.
The development of an effective bail-in regime was a key recommendation
of the ICB, which has been supported by other witnesses.
An effective and credible bail-in tool would represent
a major step towards eliminating the implicit guarantee and ensuring
that the costs of resolving a failing bank are not borne by the
taxpayer. It is notable that bail-in is at the heart of the resolution
strategies currently being designed for large systemically important
banks, and will remain important even after the ring-fence is
60. We nevertheless pointed to the difficulties
of establishing a new bail-in regime. It would first be tested
under stressed conditions, when politicians and regulators would
face pressure to resort to the better-understood tool of taxpayer
bailout. In order to provide assurance that the new system would
not be a "paper tiger", we recommended that the Bank
of England should be required to report annually on the development
and subsequent operation of bail-in.
We also called for the Government to make provision for such a
regime at UK level in case progress on European legislation stalled.
61. In evidence in January, Sir John Vickers
emphasised the novelty of bail-in:
The idea that bank bondholders might take a loss
is new territory. It is very uncertain. It is a new world.
He saw advantages in engaging bondholders through
a bail-in regime, because they were likely to be more attentive
to downside risks than holders of equity; he thought that there
was a reasonable prospect of a market for bonds subject to bail-in
our recommendation for legislation at national level, he agreed
that it would be worthwhile to implement such changes "in
any event" given the UK's position as the most important
financial centre in Europe, but remained confident about the prospects
for a satisfactory agreement at European level.
62. Dr Carney told the Treasury Committee that
he saw an effective bail-in regime as "critical", but
In other words, it does not assure that the taxpayer
is not on the hook but it is essential to have a credible bail-in
regime, and further, it is highly desirable to have identifiable
tranches of bail-in-able debt. It does not have to be from the
class of debt but identifiable tranches of bail-in-able debt in
sufficient size to address historic experience of banking shocks
in order to provide market discipline that will make the full
power of the instrument be felt.
He was confident that developments internationally
were moving in the right direction, but emphasised the importance
of some form of reporting if confidence in the development of
bail-in started to be shaken.
63. In its response, the Government has agreed
about the importance of an effective and credible bail-in power.
It has emphasised the importance of international cooperation
to ensure effective actions across borders in a crisis, to reduce
the opportunities for regulatory arbitrage and to minimise the
risks of UK banks being at a competitive disadvantage.
The Government has said that it remains confident about the prospects
for progress at European level.
While accepting the appropriateness of Parliament having assurance
about a bail-in regime's effectiveness and credibility, the Government
has placed reliance on reporting by international institutions
rather than the Bank of England.
64. An effective bail-in regime
is widely-acknowledged as having a crucial role in insulating
the taxpayer from losses in future banking crises and ensuring
that bondholders bear their share of the downside risk when banks
get into trouble in the future, and therefore pay greater heed
to the conduct and performance of banks. The Commission is disappointed
by the Government's reliance on reporting by international institutions
and by its reluctance to consider the benefits of regular reporting
at national level on progress (or the lack of it) in this area.
We are similarly disappointed by the Government's apparent rejection
of the case for a domestic legislative initiative as a safety
net in the event that progress at European level proves inadequate.
This is a particularly concerning signal in the light of the number
of other important reforms which currently depend on action at
a European level, a matter to which we will return in our final
Report. The Commission invites the two Houses to consider Amendments
T, U and V in the Appendix, which facilitate debate on these crucial
Primary Loss Absorbing Capital
65. The ICB stressed the importance of banks
being able to absorb losses by having sufficient 'Primary Loss
Absorbing Capital' 'PLAC' - that is, equity and potentially loss-absorbing
liabilities. A bank could continue to operate provided its losses
did not exceed its PLAC, so the larger its PLAC, the more resilient
it would be. The ICB proposed a requirement that large ring-fenced
banks and UK-headquartered global banks issue the equivalent of
at least 17 per cent of their risk-weighted assets (RWAs) in the
form of PLAC, made up of (i) equity, (ii) non-equity capital and
(iii) (to reflect the fact that short-term liabilities are less
reliable as loss-absorbing capacity) those bail-in bonds with
a remaining term of at least 12 months.
The Government accepted this recommendation of the ICB, using
a broadly similar definition of PLAC, proposing to give effect
to it through European legislation supported by a power in the
Bill to instruct the regulators on how to impose debt requirements
66. In our First Report, we expressed concern
about the range of the powers the Government was proposing Parliament
grant to the Treasury to direct the regulator in relation to the
In its response, the Government has agreed to remove the power
to direct the regulator by reference to specific banking groups
and to make relevant secondary legislation subject to the affirmative
The Commission welcomes the
Government's decision, in line with our recommendations, to revise
and limit the Treasury's proposed powers over the regulator in
relation to loss-absorbency requirements.
67. The ICB recommendation was intended to create
a requirement above and beyond internationally-agreed capital
requirements on UK-headquartered banks with global operations
because of the possible exposure of UK taxpayers in the event
of a failure of those operations. Members of the ICB have accepted
the logic of an exemption for non-EEA assets if the entities holding
those assets are separately resolvable without posing a risk to
UK financial stability or the UK taxpayer, but Sir John Vickers
and current and prospective regulators emphasised that the burden
of proof for any exemption should be on the bank, not the regulator.
We recommended that the legislation
place the burden of proof for any exemption from
PLAC requirements on the bank seeking the exemption, rather than
on the regulator. This would mean that the regulator would only
grant an exemption if a bank had demonstrated to the regulator's
satisfaction that there was no risk to stability, rather than
merely if the regulator could not show that a risk existed, providing
a greater level of protection to the taxpayer. This should include
the bank showing that the resolution authorities in the areas
in which they operate outside the EEA would assume lead responsibility
for resolving the operations in those overseas territories in
the event of the bank's failure, in order to protect the UK taxpayer.
The decision on whether to grant an exemption should be made by
the regulator with reference to clear objectives, although in
all cases it will need to involve an exercise of judgment by the
regulator. Decisions should be subject to the same review and
appeals processes as any other decision by the regulator. The
existence of exemptions should be publicly disclosed.
68. In its response, the Government has accepted
that there might be merit in our proposal to place the burden
of proof on the bank, "provided that the regulator exercises
its judgement in a reasonable way". The Government has agreed
to publish a draft of the secondary legislation to set the framework
for this exemption.
69. We asked Douglas Flint whether HSBC supported
our proposal for the burden of proof to lie on the bank and he
On reflection, yes we do. It is clearly going to
be a dialogue between the institution, the regulator and the Treasury.
The ultimate risk lies with the Treasury, because in the event
that the institution does bring risk from overseas to this country,
it is the Treasury that ultimately will have to consider what
proportion, if any, of that it will bear. As the contingent risk
is with the Treasury, it seems to me that it is perfectly reasonable
to ask the institution to demonstrate why there is no risk. I
think what we would say is that because of the sensitivity and
the considerable judgment involved, the test should be one not
of absolute risk, because absolute certainty is never going to
be possible as you look far into the future, but of reasonably
foreseeable risk in that the deliberation should take place, in
our view, at the institutional level at board level and at Government
level in the highest levels of the Bank of England, the Prudential
[Regulation] Authority and, indeed, the Treasury. The judgments
will be just as much about the people of whom assurances are being
sought as about the detailed facts and figures that will be presented
by us as an institution and by other institutions that are affected.
He agreed that the regulatory judgement should be
made at a senior level and that it was desirable for a reference
to reasonably foreseeable risk to appear in statute.
We agree with
HSBC that the judgements with respect to the burden of proof would
need to be examined by the regulators at the highest level. We
welcome the broad measure of support for the proposition that
the burden of proof for any exemption from PLAC requirements should
rest with the bank in question, subject to a requirement for the
exercise of a high-level judgement by the regulator based on reasonably
foreseeable risks. We invite the two Houses to consider Amendment
W which seeks to give effect to this. In addition to our original
recommendations, Amendment W also makes provision for any PLAC
exemption to be reported to Parliament.
The leverage ratio and risk-weightings
70. Equity holders bear the cost of any losses
up to the value of the equity in the bank, and holders of bail-in
bonds also suffer if the total losses exceed the bank's equity.
Bail-in bonds are new and their ability to bear losses in a crisis
is untested, so that imposing a minimum requirement on the level
of equity in a bank is a more certain and tested safeguarding
method. The strength of the equity buffer can be measured in two
ways: the ratio between capital and RWAs ('the capital ratio')
and the total amount of capital as a percentage of total un-weighted
assets ('the leverage ratio').
The setting of capital and leverage ratios is in the first instance
a matter for an international authority, the Basel Committee on
Banking Supervision. The next instalment of those international
capital rules (Basel III) is due to be given effect in the EU
through a forthcoming Capital Requirements Directive and Regulation.
As part of this process, capital requirements will be higher than
under Basel II.
71. One of the weaknesses of the capital ratio
is that it relies on the calculation of RWAs, which, in the case
of larger banks, is in part of a matter for the banks themselves.
In December, we highlighted evidence that RWAs represent the fraying
threads of the capital ratio safety net, because of the subjectivity
and variability of measures of RWAs.
This view has been strengthened by a report published by the Basel
Committee on Banking Supervision in January 2013 which notes significant
differences across individual banks in the average risk weighting
of trading assets which are not attributable to differences in
their inherent riskiness alone. One factor in the differences
is the fact that the current Basel framework allows banks to choose
different historical data periods to calculate value-at-risk or
use different methods to arrive at a regulatory capital figure.
72. Partly in response to concerns about the
effectiveness of risk-weightings, the ICB recommended that the
leverage ratio should rise in line with the proposed increase
in the capital ratio under Basel III, so that the leverage ratio
for UK banks would be 25 times rather than 33 times. This recommendation
was rejected by the Government, which proposed to adhere to the
international leverage ratio.
Having noted that high leverage was a significant contributor
to the crisis, we concluded:
The Commission considers it essential that the ring-fence
should be supported by a higher leverage ratio, and would expect
the leverage ratio to be set substantially higher than the 3 per
cent minimum required under Basel III. Not to do so would
reduce the effectiveness of the leverage ratio as a counter-weight
to the weaknesses of risk weighting.
We also recommended that the Financial Policy Committee
(FPC) be given responsibility for setting the leverage ratio earlier
than currently planned, that special transitional arrangements
be put in place for building societies given the relatively low
risk weighting of many of their assets and that the Bank of England
be required to provide an annual assessment of the progress of
73. In evidence in January, Sir John Vickers
stressed his continued support for a higher leverage ratio of
4 per cent by the end of 2018, and supported the recommendation
that the FPC be given the power, as did Martin Taylor.
Bill Winters was also forthright in his support for a limit of
25 times leverage, having previously been sceptical about the
value of that ratio as a method for limiting bank exposure.
He agreed that there might be a case for specific treatment for
institutions such as building societies on which the leverage
ratio acted as the primary binding constraint, although he noted
that such an effect might itself give pause for thought about
the calculation of RWAs, bearing in mind that the building society
model was not always low risk.
He acknowledged that a higher leverage ratio would increase the
cost of capital for banks, but thought that such a cost being
borne by shareholders or by consumers was worthwhile in the context
of the "value that we get as a society from having safer
74. Giving evidence to the Treasury Committee,
Dr Carney has also pointed to the value of a higher leverage ratio
as a backstop for inappropriate risk weightings, while recognising
the specific considerations that might apply to building societies.
Although he emphasised that the precise leverage ratios for Canadian
banks were not directly comparable to those under consideration
in a UK context, he viewed lower leverage as a crucial factor
in the relative strong performance of Canadian banks during the
He said that it was "essential to have a leverage ratio as
a backstop to a risk-based capital regime".
75. In its response to our Report, the Government
has expressed concern about the proposition that a leverage ratio
should be "the primary capital constraint on banks, rather
than a backstop to risk-weighted capital requirements", and
has re-stated its opposition to "the case for permanently
raising the leverage ratio beyond the Basel III standard".
The Government has stated that it continues to envisage providing
the FPC with "a time-varying ratio direction-making tool,
but no earlier than 2018 and subject to a review in 2017 to assess
progress on international standards".
In view of the ongoing international work to review risk-weights,
the Government has rejected the case for a UK-specific assessment.
In oral evidence in February, the Chancellor of the Exchequer
called for "caution" in considering the case for acting
unilaterally in relation to leverage ratios.
He re-stated the Government's view that a 4 per cent leverage
ratio might serve as a "front-stop" rather than a "back-stop"
for some "lower risk institutions".
He offered to share with the Commission some of the representations
that the Treasury had received on the likely impact of a 4 per
cent leverage ratio.
76. The changes to capital ratios,
proposed as a result of the international capital rules under
Basel III and the revised Capital Requirements Directive that
will flow from it, will not adequately address the problems of
risk-weightings. The framework for risk-weighting under Basel
II was profoundly flawed, permitting certain banks to rely on
their own subjective and variable risk-weighting methodologies
as a basis for weakening their capital buffers, when they should
have been strengthening them. There are already signs that many
of these flaws will be carried through into the Basel III framework.
We are therefore particularly disappointed that the Government
has rejected the Commission's proposal for an annual assessment
by the Bank of England of progress of work to improve risk-weighting.
We invite both Houses to consider the proposition set out in Amendments
X and Y in the Appendix which would require there to be such an
77. The historic and prospective
ineffectiveness of risk-weighting makes leverage ratios at the
appropriate level all the more important as a backstop. The case
for leaving the leverage requirement unchanged at 33 times when
the capital requirement on banks is to be increased in line with
the ICB's recommendation is therefore extremely weak. The Commission
remains wholly unconvinced by the case made by the Government
against a higher leverage ratio for UK banks by reference to international
requirements. We propose to consider this further in our final
127 First Report, paras 102-104 Back
Ibid., paras 25, 103, 104, 107 Back
Ibid., paras 99, 107 Back
Banking reform., para 2.7 Back
Ibid., para 2.8 Back
Q 2596 Back
First Report, paras 233, 106 Back
Ibid., paras 233 - 235 Back
Ibid., para 236 Back
Ibid., para 242 Back
Ibid., para 245 Back
Q 2597 Back
Qq 2598, 2614 Back
Qq 2599 - 2601 Back
HC (2012-13) 944, Q 130 Back
Banking reform, para 2.40 Back
Ibid., para 2.41 Back
Ibid., para 2.42 Back
First Report, paras 247 - 248 Back
Ibid., para 249 Back
Ibid., paras 262 - 263 Back
Banking reform, paras 2.43 - 2.45 Back
First Report, paras 250 - 257 Back
Ibid., para 258 Back
Banking reform, para 2.44 Back
Q 3769 Back
Qq 3770 - 3771 Back
First Report, paras 280 - 285. For a short definition of RWAs,
see First Report, para 247 Back
Ibid., paras 284 - 285 Back
Ibid., paras 286 - 290 Back
Bank for International Settlements, Regulatory consistency
assessment programme (RCAP) - Analysis of risk-weighted assets
for market risk, January 2013, p 6 Back
First Report, paras 286, 294 Back
Ibid., para 294 Back
Ibid., paras 295 - 296 Back
Qq 2572, 2888 Back
Q 3676 Back
Qq 3676 - 3677 Back
Q 3677 Back
HC (2012 - 13) 966, Q 128 Back
Ibid., Q 129 Back
Banking reform, para 2.37 Back
Ibid., para 2.38 Back
Ibid., para 2.39 Back
Q 4320 Back
Q 4324 Back