Separation that can stand the tests of time
Investigations into LIBOR have exposed a culture of culpable greed far removed from the interests of bank customers, corroding trust in the whole financial sector. The separation of deposit-taking from certain investment banking activities can offer benefits not just for financial stability, but also in helping to address the damage done to standards and culture in banking. The Government has proposed a ring-fence to achieve separation, but any ring-fence risks being tested and eroded over time. Pressure will come from many quarters. Any new framework will need to be sufficiently robust and durable to withstand the pressures of a future banking cycle. The precautionary approach of regulators will come under pressure from bank lobbying, possibly supported by politicians. Additional steps 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.
Electrifying the ring-fence
The Commission recommends that the ring-fence should be electrified - that banks be given a disincentive to test the limits of the ring-fence. This should take the form of two measures, set out in statute from the start, which could lead to full separation. First, if the regulator has concluded that the conduct of a banking group is such as to create a significant risk that the objectives of the ring-fence would not be met in respect of a particular bank, it should have the power (subject to a Treasury override) to require a banking group to implement full separation. Second, there should be a periodic, independent review of the effectiveness of the ring-fence across all banks, with the first such review to take place four years after implementation. Each review should be required to determine whether ring-fencing is achieving the objectives set out in legislation, and to advise whether a move to full separation across the banking sector as a whole is necessary to meet those objectives.
The approach to legislating
The draft Bill relies too heavily on secondary legislation, the absence of drafts of which has seriously impeded the Commission in assessing the Government's reforms. The jury is still out on the question of how faithfully the Bill will implement the ICB recommendations. Furthermore, reliance on secondary legislation reinforces the risks to the durability of the ring-fence. It creates uncertainty for the regulators who will be charged with making the new framework operational and for the banks required to operate within it. The draft Bill proposes to leave the Government with too much scope to redefine the location of the ring-fence arbitrarily. Not only is the scrutiny provided for this inadequate, it will also provide an incentive for bank lobbying. The powers to re-define the ring-fence through secondary legislation need to be subject to more rigorous scrutiny, with changes to the location of the ring-fence to be considered by a small ad hoc joint committee of both Houses of Parliament before formal measures are brought forward.
The independence of ring-fenced banks
The draft Bill does not make adequate provision to ensure the independence of ring-fenced banks from other parts of the same banking group. Several steps must be taken to reinforce that independence. The discretion granted to the regulator to set the rules on this is too great, as the regulators themselves have noted. Their mandate should be defined more clearly. The regulator should have a duty of ensuring independence for the ring-fenced bank in respect of governance, risk management, treasury management, human resourcing, capital and liquidity. An element of conflict between the duties of the directors of the ring-fenced bank to that entity and their duties to the wider group may be unavoidable, and this will constitute a permanent challenge for any structural solution which falls short of full structural separation. There should be a legal duty on directors to preserve the integrity of the ring-fence. The regulator should have the power, which the Commission expects to be exercised, to require a sibling structure between a ring-fenced and non-ring-fenced bank, with a holding company, so as to prevent a non-ring-fenced bank owning a ring-fenced bank.
Limits on derivatives and the ring-fence
The sale of derivatives within the ring-fence poses a risk to the success of the ring-fence. The possible cost to customers from excluding derivatives, combined with proposed measures to mitigate this risk mean that there is a case in principle for permitting the sale of simple derivatives within the ring-fence. However, this should be subject to adequate safeguards against mis-selling. "Simple" derivatives should be defined in a way which is limited and durable. In addition to the elements of a "simple" derivative already identified by the Treasury, it is essential that the size, maturity and basis of simple products should be limited to hedging the underlying client risk. A large derivatives portfolio would still pose an unacceptable risk to the stability and resolvability of ring-fenced banks, even if it is supposedly hedged and collateralised. The Government should also impose an additional cap on the gross volume of derivative sales for ring-fenced banks in legislation.
Bail-in that works
A ring-fence alone does not make banks resolvable. Without wider reforms, it is possible that a ring-fence would simply result in one too-big-to-fail bank becoming two such banks, the failure of either of which would require taxpayer support to avoid major disruption. The challenge of resolving non-ring-fenced banks also needs careful attention. Bail-in will be a crucial tool for the resolution of banks. Concerns remain about the design of a bail-in regime and whether it will provide confidence that the authorities would use their powers in the event of a crisis. Parliament will need assurance that bail-in is not a paper tiger, as will the markets. This assurance should be based on a regular report to Parliament on the development and subsequent operation of bail-in by the Bank of England.
Capital and leverage
It is essential that the ring-fence should be supported by tougher capital requirements, including a leverage ratio. Determining the leverage ratio is a complex and technical decision, and one which is best made by the regulator. The Financial Policy Committee (FPC) cannot be expected to work with one hand tied behind its back. The FPC should be given the duty of setting the leverage ratio from Spring 2013. The Commission would expect the leverage ratio to be set substantially higher than the 3 per cent minimum required under Basel III.
Our next steps
This Report is only the first step in the Commission's work to identify steps to tackle the crisis in banking standards and culture. In the New Year, the Commission will return to a number of issues arising from this Report, including:
- The case for prohibiting groups containing a ring-fenced bank from engaging in proprietary trading, and in particular the contribution that this could make to the changes needed to banking culture and standards;
- How the structural changes will affect standards and culture in the long run;
- How to assess bank suggestions that setting the necessary standards for banking in UK might lead to a flight abroad;
- Whether the sale of derivatives inside the ring-fence has a bearing on measures to prevent future mis-selling of such products; and
- The wider issues of competition and transparency raised by the ICB.
The Commission will also consider further the themes of:
- How banks compete;
- How banks run themselves;
- How banks are supervised and regulated;
- How the law, including criminal and civil sanctions, applies to banks and bankers.