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


4  Capital and loss absorbency

Introduction

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 that:

  • 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 banks failing;[127]
  • There will remain substantial systemic risks associated with banks outside the ring-fence and outside the UK;[128]
  • 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.[129]

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".[130] 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.[131]

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.[132] In this chapter we consider the Government's response to our recommendations in these areas.

Bail-in

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.[133] The development of an effective bail-in regime was a key recommendation of the ICB, which has been supported by other witnesses.[134] We concluded:

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 introduced.[135]

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.[136] We also called for the Government to make provision for such a regime at UK level in case progress on European legislation stalled.[137]

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.[138]

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 developing.[139] On 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.[140]

62.  Dr Carney told the Treasury Committee that he saw an effective bail-in regime as "critical", but not "decisive":

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.[141]

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.[142]

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.[143] The Government has said that it remains confident about the prospects for progress at European level.[144] 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.[145]

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 matters.

Primary Loss Absorbing Capital (PLAC)

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.[146] 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 on banks.[147]

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 PLAC requirements.[148] 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 resolution procedure.[149] 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.[150] 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.[151]

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.[152]

69.  We asked Douglas Flint whether HSBC supported our proposal for the burden of proof to lie on the bank and he replied:

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.[153]

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.[154] 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').[155] 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.[156]

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.[157] 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.[158]

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.[159] 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.[160]

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 risk-weighting.[161]

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.[162] 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.[163] 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.[164] 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 banks".[165]

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.[166] 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 financial crisis.[167] He said that it was "essential to have a leverage ratio as a backstop to a risk-based capital regime".[168]

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".[169] 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".[170] In view of the ongoing international work to review risk-weights, the Government has rejected the case for a UK-specific assessment.[171] 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.[172] 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".[173] 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.[174]

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 assessment.

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 Report.



127   First Report, paras 102-104 Back

128   Ibid., paras 25, 103, 104, 107 Back

129   Ibid., paras 99, 107 Back

130   Banking reform., para 2.7 Back

131   Ibid., para 2.8 Back

132   Q 2596 Back

133   First Report, paras 233, 106 Back

134   Ibid., paras 233 - 235 Back

135   Ibid., para 236 Back

136   Ibid., para 242 Back

137   Ibid., para 245 Back

138   Q 2597 Back

139   Qq 2598, 2614 Back

140   Qq 2599 - 2601 Back

141   HC (2012-13) 944, Q 130 Back

142   IbidBack

143   Banking reform, para 2.40 Back

144   Ibid., para 2.41 Back

145   Ibid., para 2.42 Back

146   First Report, paras 247 - 248 Back

147   Ibid., para 249 Back

148   Ibid., paras 262 - 263 Back

149   Banking reform, paras 2.43 - 2.45 Back

150   First Report, paras 250 - 257 Back

151   Ibid., para 258 Back

152   Banking reform, para 2.44 Back

153   Q 3769 Back

154   Qq 3770 - 3771 Back

155   First Report, paras 280 - 285. For a short definition of RWAs, see First Report, para 247 Back

156   Ibid., paras 284 - 285 Back

157   Ibid., paras 286 - 290 Back

158   Bank for International Settlements, Regulatory consistency assessment programme (RCAP) - Analysis of risk-weighted assets for market risk, January 2013, p 6 Back

159   First Report, paras 286, 294 Back

160   Ibid., para 294 Back

161   Ibid., paras 295 - 296 Back

162   Qq 2572, 2888 Back

163   Q 3676 Back

164   Qq 3676 - 3677 Back

165   Q 3677 Back

166   HC (2012 - 13) 966, Q 128 Back

167   Ibid., Q 129 Back

168   IbidBack

169   Banking reform, para 2.37 Back

170   Ibid., para 2.38 Back

171   Ibid., para 2.39 Back

172   Q4321 Back

173   Q 4320 Back

174   Q 4324 Back


 
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Prepared 11 March 2013