Banking Standards Joint Committee

Banking Standards Joint Committee Contents

9 Reinforcing the ring-fence

Introduction

126. In previous chapters we have indicated how the approach taken by the Government to give effect to a ring-fence leaves that ring-fence especially vulnerable to erosion over time. The Commission has also identified the propensity of regulated firms to seek to press at the limits of permitted activities for short-term economic gain, and the risks that such efforts might be supported by pressure on politicians to agree to convenient changes which reduce the long-term effectiveness of the ring-fence. The Commission has also concluded that the ring-fence requires reinforcement if it is withstand pressures in the long-term. This chapter makes specific recommendations for reinforcement.

Objectives in primary legislation

127. The legislation begins by setting a continuity objective for the regulator described as "protecting the continuity of the provision in the United Kingdom of core services".[198] Barclays pointed out that the continuity of core services objective is "subjective and hard to measure".[199] Chapter 3 illustrated the wide range of options for structural separation in addition to the ICB's proposals, intended in part to provide for continuity of core services. Therefore it could leave the regulator able to use these powers to pursue a wide range of approaches. This could be all the more concerning, given the vulnerability of the regulators and the banking community to fashionable mantras. The legislation's lack of clear objectives leaves its future operation vulnerable to changing attitudes over time.

128. Andrew Bailey identified how specifying objectives more clearly could also help provide greater legitimacy:

in the context of the legislation that you are scrutinising, we need to have the objectives and the powers set out very clearly. I think it needs to go a step further than it has gone in the draft that we have today, which is a bit too enabling without specifying how the objectives work. Fitted together, that would be a big step forward because it creates a much greater sense of legitimacy.[200]

Andrew Bailey has also requested "better narrative regarding how the PRA's safety and soundness and continuity objectives interact." The FSA believe that, as currently drafted, the draft Bill "implies that if there is a clash, the [PRA's] continuity objective would prevail over the safety and soundness objective".[201]

129. The Chancellor of the Exchequer, when challenged on the lack of objectives in the draft Bill, argued that the continuity objective was all that is needed:

there is a very clear objective in the Bill, which is that the regulators and the Government of the day can continue the provision of core services in the banking industry in the situation in which a bank is failing. [...] If we crack that, I would say that we will have cracked one of the significant problems—not the only problem—that arose during the banking crisis.[202]

He also expressed concern that adding other objectives would reduce rather than enhance clarity:

I do not think that adding a load of further objectives would clarify the situation; I think that it would add to the complexity of what we are asking to be done. [...] I think it is important to have a very clear focus on the objective, rather than a load of objectives, and the objective is to allow core services to continue even when we allow a bank to fail. You would muddy the waters if we created more objectives in this legislation.[203]

In a written response to Andrew Bailey's request for clarity, the Chancellor of the Exchequer confirmed that:

The draft Bill currently sets out how the PRA's objective for ring-fencing and its general objective interact. When the PRA is acting in relation to matters related to ring-fencing, and only then, the PRA is required to act at all times compatibly with its continuity objective. [204]

130. The ICB final report sets out three, not one, objectives for the ring-fence. These are:

make it easier to sort out both ring-fenced banks and non-ring-fenced banks which get into trouble, without the provision of taxpayer-funded solvency support;
insulate vital banking services on which households and SMEs depend from problems elsewhere in the financial system; and
curtail government guarantees, reducing the risk to the public finances and making it less likely that banks will run excessive risks in the first place.

The continuity objective does not adequately reflect these. In order to anchor implementation of the ring-fence more securely to the ICB's proposals, the Commission recommends that the Bill as introduced imposes additional requirements under the new section 2BA(4) of FSMA to ensure that in advancing the continuity objective, the PRA must also seek to meet the following requirements as set out in paragraph 1.3 of the policy paper accompanying the draft Bill, namely:

Making banks better able to absorb losses;
Making it easier and less costly to sort out banks that still get into trouble; and
Curbing incentives for excessive risk-taking.

The continuity objective must be properly understood as being about protecting the continuity of the provision of core services, not about the continuity of institutions. The regulator seeks clarity about how the continuity objective relates to the other objectives of the regulator when exercising powers in relation to the ring-fence. The Commission will take further evidence and report on this matter in the New Year.

131. In the light of recent revelations the Commission has taken evidence regarding the ability of the ring-fence to protect and enhance standards and culture in the banks and will consider in our final Report whether an additional objective should be considered to address these concerns.

Regulatory judgement

132. In written evidence, Andy Haldane identified the main steps the regulator could take if it felt a firm were breaching regulatory rules:

Impose higher capital requirements, or tighter liquidity requirements;
Take action under the approved persons regime, potentially including removal of approvals;
Impose a financial penalty;
Remove links to owners and group companies;
Vary a bank's authorisations to limit or prevent activities.[205]

In seeking to exercise these powers and otherwise enforce the ring-fence, the regulator is likely to encounter the difficulties which Sir Mervyn King highlighted:

I have been struck in the last five years, learning more about how the regulatory process worked, by how much of it has turned out to be a negotiation between the regulators on the one hand and banks on the other [...] The big principle is that, to be effective, the regulator has to be able to use judgment. That is what we want to get to. But if judgment ends up simply as a negotiation between the regulator and the regulated bank, there is only one winner in that, and that will be a very bad outcome. Clarity is crucial to enable the regulator to exercise judgment within a very well-defined framework, and the regulator needs to be able to tell banks, "This is the capital requirement you will have", as opposed to merely entering into a negotiation.[206]

133. It is essential that the new framework for the ring-fence and the secondary legislation and rules that flow from it are not seen by the banks merely as a basis for negotiation. The legitimate role of the judgement of the regulator in implementing the framework must be beyond doubt. The regulator's decision-making, in line with its judgement in pursuit of its objective in relation to the ring-fence, should not require it to identify a specific breach of rules in order to take action to maintain the integrity of the ring-fence. The Commission considers that it is of paramount importance that the new legislation is drafted in such a way as to make this clear.

Conditions on the exercise of certain delegated powers

134. The extreme examples included in paragraph 58 illustrate that the design of the conditions which govern the delegated powers are of vital importance. Those examples demonstrate that the subsequent secondary legislation will not be merely technical, but central to the way the ring-fence operates. Previous chapters have demonstrated that the Government's reliance on secondary legislation poses significant risks to the durability of the ring-fence. Two examples of areas where this may of particular concern are the powers under proposed sections 142A(2)b and 142D(2). The first power allows the Treasury to exempt a class of institution from the requirements of the ring-fence. This is intended in particular to allow the introduction of a de minimis test to exempt small deposit-takers, which is considered in chapter 10, but the power is not limited to this purpose. The second power allows the Treasury to change the definition of an excluded activity—one which ring-fenced banks cannot conduct—for example, a particular type of derivative trade. The test that must be met for use of either power is very similar—that the Treasury believe it would "not be likely to have a significant adverse effect on the continuity of the provision in the United Kingdom of core services".[207]

135. In addition to the enhanced scrutiny arrangements recommended later in this chapter, the Commission recommends that the Treasury's delegated powers under proposed sections 142A(2)(b) and 142D(2) be tightened. It is insufficient to require only that exemptions from the ring-fence restrictions do not have a "significant adverse effect on the continuity in the United Kingdom of the provision of core services". The fact that this condition is framed as a negative test could too easily allow a series of exemptions cumulatively to weaken and complicate the ring-fence, even if individually these fall short of risking a "significant adverse effect". The provisions should be tightened by requiring that exemptions should be made only if they:

a) do not pose a risk to the continuity objective; and

b) provide a significant economic or financial stability benefit.

Determining the height of the ring-fence

136. The draft Bill requires the regulator to use its existing rule-making powers to make additional ring-fencing rules, the stated purpose of which is "ensuring

a) that the carrying on of core activities by a ring-fenced body is not adversely affected by the acts or omissions of other persons, and

b) that any ring-fenced body which is a member of a group is able to act independently of other members of the group in carrying on the business of the ring-fenced body."[208]

137. Constructing the ring-fence will entail major corporate restructuring of all the large UK banks. A great deal of judgement will be involved in this process. The regulator largely tasked with making these rules has said that its mandate in the draft Bill is not strong enough to protect it from challenge:

should the PRA choose to make ring-fencing rules that are not mandated in the draft Bill, it could potentially be seen to be acting beyond its remit.

In our view the draft Bill should provide 'parameters' within which the PRA is given a statutory mandate to make rules to enforce the appropriate degree of separation between the RFB and the NRFB in the event that it needs to exercise its rule-making powers in ways not specified in the draft Bill.[209]

Andrew Bailey expanded on this in his oral evidence:

What we have to get right is the balance between giving us the job of implementing a rule book essentially—the short version of it—and Parliament having sufficient hands on in terms of the objectives so that the legitimacy and authority of Parliament is very clearly behind it. That is a balance. At the moment, this is a very short piece of legislation in a sense. It says, "We'll define some objectives and then send you off to police them." I think we have to get the balance right in terms of being a very clear statement of Parliament's intent here.[210]

Paul Tucker concurred, adding that:

We are clear, and I think that if Adair and Andrew were here they would say the same, that it is important that the meat of the regime is set out in secondary legislation; that the PRA board does not become a quasi-legislative body. I completely agree with Andy that the things that he has set out, and that type of thing, should be in the secondary legislation.[211]

Paul Tucker also summarised the concerns that arose from this approach:

I think what the FSA is concerned about, and certainly what we are concerned about, is that as drafted, the primary legislation allows the meat of the regime to be set out in secondary legislation, or in PRA rules, or in a combination of the two. Technically, therefore, it would be possible for the secondary legislation to be almost silent, leaving the whole of the regime to be set out in the PRA rules. We are clear [..] that it is important that the meat of the regime is set out in secondary legislation; that the PRA board does not become a quasi-legislative body.[212]

138. The Chancellor of the Exchequer told us that "the rules will ensure the economic and operational independence of ring-fenced banks from the rest of the group in which they sit. The regulator is best placed to deal with these matters but the outcome and objective will be clearly expressed in legislation."[213]

139. The Commission is extremely concerned, as are the regulators themselves, that the key issues determining the height of the ring-fence are proposed to be a matter for determination by the regulator alone. A regulator enforcing rules of its own creation will have less authority in doing so than a regulator giving effect to a clear mandate in legislation with parliamentary authorisation. There is a compelling case for strengthening the regulator's hand when it makes ring-fencing rules through such a mandate. The Commission recommends accordingly that proposed section 142H of FSMA be amended either to define the parameters of the rules to be set by the regulator more fully or to require that secondary legislation made by the Treasury and subject to the affirmative resolution procedure defines the parameters. The objective of this legislation should be to empower the regulator to police and enforce the ring-fence. The Commission considers in chapter 10 what the legislative parameters should be.

Scrutiny

140. The Commission received a very helpful memorandum from the House of Lords Delegated Powers and Regulatory Reform Committee in response to our request that they consider the appropriateness of, and scrutiny arrangements for, the delegated powers in the draft Bill. In its submission, that Committee identified two consistent themes: "a lack of appropriate Parliamentary control; and a lack of explanation for some significant powers contained in the draft Bill".[214]

141. The draft Bill proposes only the weakest form of Parliamentary scrutiny—the negative resolution procedure—for all but one of the delegated powers which it gives the Government. Under this procedure, secondary legislation can be made and comes into effect immediately, and only ceases to have effect in the exceptionally rare cases where one House of Parliament passes a resolution requiring it to be annulled. In the House of Commons, even a debate on the secondary legislation in question can only be secured with the agreement of the Government. This procedure is often held to be appropriate in circumstances where delegated powers provide technical detail which implements policy, but does not have the ability to change its direction.

142. The only power relating to the design of the ring-fence where secondary legislation will be subject to the affirmative resolution procedure is the one under proposed section 142A(2)(b) (the power to exempt classes of institution from the ring-fence). Under the affirmative procedure, secondary legislation can only come into force (or, in certain urgent cases, remain in force) if both Houses of Parliament agree to this after a debate, usually in a Delegated Legislation Committee in the House of Commons and in Grand Committee in the House of Lords.

143. The other five powers listed in paragraph 57, which together give the Treasury the ability to add or exempt activities which must or cannot be done in a ring-fenced bank, are only subject to negative resolution. The Treasury's delegated powers memorandum attempts to justify the choice of procedure for several of the powers by reference to the fact that the power is likely to be technical or that there are restrictions on the use of the power.[215] As discussed in chapter 4, while these powers may well be technical in content, their scope is not confined just to matters of detail but can have important policy implications, and allow for a wider departure from the ring-fence as currently planned.

144. The assessment of the Delegated Powers and Regulatory Reform Committee was that all six powers listed in paragraph 57, which together define the ring-fence, should be subject to affirmative procedure, not just that under proposed section 142A(2)(b). That Committee questioned in particular one of the justifications given in the delegated powers memorandum for the choice of procedure for the power under proposed section 142B(2), which is the power to define when accepting deposits is not to be regarded as a "core activity". The justification referred to "the fact that the effect of the power will be to narrow the range of cases where a person who accepts deposits must be a ring-fenced bank or an exempt bank".[216] As the Committee noted, this is "based on the assumption that removing control needs a lower level of Parliamentary scrutiny than imposing it and we do not consider that the assumption may be so easily made here where important issues of public policy may be at stake".[217]

145. Another justification for negative resolution which the Committee challenged was that given for the power to create new core activities (under proposed section 142B(5)), where the Treasury referred to the fact that it is possible that it might in some cases be desirable to take urgent action to protect the activity in question.[218] The Committee noted that "the possible need for urgency [...] cannot be accepted as a justification, since FSMA itself deals with urgency in other affirmative cases by means of the 28-day 'made affirmative' procedure (i.e. in force immediately but lapses if not approved within 28 days)."[219]

146. The scrutiny arrangements for secondary legislation as specified in the draft Bill are unacceptably weak. Many of the delegated powers may involve significant policy choices, not merely implementation decisions of a technical nature. The Commission recommends that use of each of the delegated powers under proposed new sections 142B(5), 142D(2), 142D(4) and 142E should be subject to the affirmative resolution procedure.

147. The Delegated Powers and Regulatory Reform Committee also noted the significance of the powers under proposed section 142F. According to the Delegated Powers Memorandum, these are supplementary powers which enable the Treasury to "give the regulator power to make technical provisions related to core activities and excluded activities, in areas which are generally treated as the preserve of the regulator".[220] In other words they permit the Treasury to delegate responsibility for some of the technical detail to the regulator rather than this all needing to be set out in secondary legislation. However, the Committee explained to us that section 142F also "enables an order:

to confer powers on the Treasury or on a regulator;
to require the regulator to make rules;
to authorise the making (by anybody) of other instruments for purposes connected with any provision of the order; and
if the Treasury authorises the regulator to make rules, to enable the Treasury to control the content of the rules."

The Committee concluded that as a result of this

for example, an order could authorise the Treasury to make regulations or give directions for the purposes of the order, without a need for Parliamentary procedure, thus relegating parts of the material covered by the order to an instrument free of any Parliamentary control. We were not convinced that this is appropriate.[221]

148. In response to the concerns expressed, the Treasury stressed that the power under section 142F was a subsidiary one, and that it would not enable the Treasury to give itself the power to create new excluded activities or core activities, or to provide for exceptions to the core and excluded activities provided for on the face of the Bill without following the parliamentary procedure laid down under the earlier sections.[222]

149. The Commission has concluded that the range of powers available to the Treasury under proposed section 142F is unacceptably wide. As a first step, the Commission recommends that the power of the Treasury to give itself further order-making powers be more fully circumscribed. In particular, there should be a requirement that the power further to delegate under secondary legislation a power to make what might be termed tertiary legislation should be subject to the same parliamentary procedure as the instrument by which the power to make it is delegated. The Commission also recommends that, in the delegated powers memorandum accompanying the Bill itself, the Government set out in more detail the proposed use of each of the additional delegated powers it is seeking in section 142F.

150. The concerns expressed about certain delegated powers are magnified in many ways by the underlying concern that has run through our consideration of the ring-fence proposals, namely that, even if the ring-fence is faithfully implemented at first in accordance with the firm commitment of the current Chancellor of the Exchequer, it risks being eroded over time. We have therefore considered what additional parliamentary bulwark could be established to prevent, or at least highlight, such erosion.

151. The Commission has concluded that a necessary form of parliamentary bulwark against erosion is the creation of a specific statutory provision for enhanced parliamentary scrutiny of the proposed use of delegated powers which have the potential to change the location of the ring-fence in a significant way. This would apply to all uses of the powers referred to in paragraph 146, subject to exceptions for secondary legislation of an urgent nature, which should be subject to the 'made affirmative' procedure. This scrutiny would be undertaken by a small ad hoc joint committee of both Houses of Parliament, to be established on each occasion subsequent to the first use of each delegated power when the Treasury proposes to exercise one of those delegated powers. Although the membership of the joint committee would be determined by decisions of the two Houses, there should be a statutory requirement for the Chairman of the House of Commons Treasury Committee to be an ex officio member of it.

152. The Government would be required to publish its case for the proposed new use of the power, alongside a provisional version of the secondary legislation itself. This provisional version would be subject to public consultation. The ad hoc joint committee would be established at the outset of this consultation phase. It would examine and report on the proposal within a specified period. After that report, the Government could proceed with secondary legislation in the usual way, albeit subject to the affirmative resolution procedure in accordance with the Commission's recommendation in paragraph 146, but would do so in a way that secures far greater transparency about the purpose and likely effect of any changes.

Electrifying the ring-fence

EVIDENCE RECEIVED

153. The final element which the Commission has considered to create the best prospects for the long-term effectiveness of the ring-fence is its electrification, by which we mean creating a very significant disincentive for banks to depart from the spirit of the ring-fence by creating full structural separation as a viable alternative.

154. Advocates of a ring-fence did not rule out the possibility of full structural separation in the future. Sir John Vickers told us that, while he was optimistic about the prospects of the ring-fence succeeding, full separation might become necessary:

If the industry turned out to be unreformable, and I am not so pessimistic as to think that, of course it is possible that total separation would turn out in due course to be the better step to take[223]

Martin Taylor identified circumstances in which his preference for a ring-fence might change over time:

The main reason why I would support a full split was if I thought a ring-fence was unworkable. I do not think that—I think a ring-fence is a superior solution—but if a ring-fence were put in place and proved to be unworkable because of attrition, as you call it, there would be a case for going further, but I do not start from that.[224]

155. Referring explicitly to the exchanges between the Chairman of this Commission and Martin Taylor in which the possibility of a contingent power to impose full separation was raised, Andy Haldane developed the proposition further:

I was struck by the point made by you, Chairman, in the testimony provided by Martin Taylor, where you floated the idea of having as a back-stop, perhaps as a legislative back-stop, the possibility of separation if the ring-fence proves permeable or impossible to police. That is an idea that is worth thinking about. I can see some attractions to that from an incentives perspective. What it makes clear is that if for whatever reason the ring-fence does not work as planned, the next step is not to remove it entirely but to go the next step.[225]

Andrew Bailey also voiced his support for such a measure to deter banks from attempting to circumvent the ring-fence, but noted the importance of making this a credible tool:

Get it right, and it is a very sensible deterrent that would make people think twice about tunnelling. My point is that we need to get it right in the sense that we need to construct a deterrent power that the institutions know we could use.[226]

156. Witnesses noted that the way in which a full-separation backstop was designed would be central to its effectiveness, and that there would be important questions about accountability for use of such a tool. Sir John Vickers said:

there are obvious questions about who would exercise that power, if it were there as a reserve power, and under what conditions that power would be exercised. It is not unprecedented for companies in this country to be required to separate, but I believe it is very rare.[227]

Paul Tucker pointed out that the appropriate accountability for the use of a backstop would depend on whether it was intended to trigger full separation across the whole industry or to target an individual firm that was causing problems:

It is important to make a distinction between whether this question is about changing the ring-fencing policy to full separation across the board as a general policy, which should lie with Parliament—we do not want to be legislators—or about specific institutions. [...] In terms of dealing with individual banks burrowing under the ring-fence and rendering themselves unresolvable or not super-resolvable in consequence, the regulator should have the power to say something.[228]

157. Andrew Bailey explored further the idea of a regulatory tool that could be used against individual institutions:

if you found that the institution was misbehaving in the sense that it was tunnelling under the ring-fence, that it was masquerading things one side of the ring-fence that should be the other side of the ring-fence, that would risk invalidating your resolution plans. [...] at which point you would say, "I am sorry but you have effectively voided the right to operate this system because we cannot be sure that we could actually resolve you in that situation because you seem to be so tricky to deal with that we could not be sure that the plans were actually operable."[229]

Sir John Vickers noted that the requirement for full separation in the case of individual banks would not pose the same risk to diversification as requiring this for the sector as a whole:

One reason why I, and we, were wary of mandating a full split for the sector as a whole was that it could create a sector of stand-alone, rather similar, undiversified, highly correlated institutions, whereas if a power were deployed in relation to one or two banks, but not the others, that loss of diversity point would not have such traction.[230]

158. Andy Haldane pointed out that it would take "further legal work to see whether that ultimate sanction was practical",[231] but pre-empted one argument that he expected might be deployed against it:

I would be resistant to the notion that merely having this sanction power would cause banks to look inward—to hoard capital and not lend. We have heard that argument far too much over the last few years, and we must not be held hostage, in doing the right thing, by the notion that the banks will stop lending.

He also recommended that the way to "avoid any adverse behavioural consequences" arising from the existence of such a backstop sanction would be to "seek absolute clarity about where the boundaries of the ring-fence were drawn":

If there is ambiguity, blurriness or greyness in where the boundary lies, that could legitimately cause banks to hold back and to worry about getting on the wrong side of the line and then facing the ultimate sanction. The greater the clarity about where that line is drawn, the less the chances of adverse behavioural consequences from the ring-fence.[232]

RELEVANT EXISTING AND PROSPECTIVE POWERS

159. In examining the likely form and effectiveness of a back-stop power of the kind that was canvassed in evidence, it is necessary to consider the relevant existing powers of the regulator. We noted earlier the range of powers listed by Andy Haldane.[233] One of these powers was to the power to vary or cancel a firm's permission to carry on regulated business under section 45 of FSMA. This power might notionally be used to prevent a ring-fenced bank from carrying on certain specified regulated activities, which might amount to all activities that fall outside the ring-fence. However, it stops short of being a power to require a restructuring or reorganisation of the business of a bank breaching the ring-fence.

160. There a number of safeguards for the exercise of the power under section 45 of FSMA. First, the regulator may only exercise this power in pursuance of its regulatory objectives, which for these purposes will include the continuity objective that we have discussed in the previous section when the relevant legislation comes into force.[234] Second, any restriction imposed upon a firm must be proportionate to the objectives the FSA is seeking to achieve.[235] Third, a regulator must give the regulated firm written notice of any proposal to exercise the power, provide that firm with a chance to make representations (whether or not the firm has referred the matter to the Tax and Chancery Chamber of the Upper Tribunal (Upper Tribunal)) and inform the firm of the right to refer the matter to the Upper Tribunal. Fourth, if having considered the representations the regulator decides to proceed, it must provide the firm with written notice which confirms the decision and informs the firm of the right to refer the matter to the Upper Tribunal. Where a firm does refer a matter to the Upper Tribunal, the case will be heard by at least one High Court judge sitting with one or two non-legal experts. Fifth, an appeal may be made, with leave, from the Upper Tribunal to the Court of Appeal on a point of law.[236]

161. Paul Tucker also drew attention to the fact that the draft Recovery and Resolution Directive (RRD), if passed in its current draft form, would give the regulator

the power to say to a bank, including a ring-fenced bank, that it is not resolvable, "You need to do one of a number of things, including shifting around your organisational structure to ensure that you are resolvable."[237]

Andy Haldane expanded on this possibility in written evidence:

The range of sanctions envisaged in the RRD is extensive, including divestment, limiting or ceasing certain activities and, ultimately, requiring changes to the legal or operational structures of the firm [...] The rationale for a reserve power would be slightly different than in a resolution context (continuity of core service rather than resolvability) but the underlying rationale would be the same (protecting financial stability).[238]

CONCLUSIONS

162. There is a strong case for the proposition that full structural separation would be the wisest course to take. As we noted earlier, Sir Mervyn King told us that he had "always felt that total separation was the right way ultimately to go" and that he was "glad that many more people are now coming on board with the idea that a move to some kind of serious separation is the right thing to do". At the very least, it is essential that it remains a possibility.

163. The ring-fence envisaged by the Government may, in the long run, not provide an adequate degree of separation. Nor may it be adequate to buttress banking standards. The role that separation might play in strengthening standards across the banking sector is a matter to which we will return in the New Year. The inadequacies of the framework may become apparent over time, as banks seek to test the strength of the ring-fence. The evidence received by the Commission from the current regulators, and to which we referred in chapter 5, highlighted the pressure which is likely to be exerted on the regulator by banks and by politicians to take steps consistent with short-term profitability and sectoral development, but inconsistent with the long-term objectives of the ring-fence. Additional powers 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.

RESERVE POWERS IN RESPECT OF INDIVIDUAL BANKING GROUPS

164. The regulator already has powers under section 45 of FSMA to require banks to cease certain activities in specified circumstances. The Commission believes that it is necessary to go further. The Commission recommends that the forthcoming legislation add reserve powers to implement full separation.

165. The first reserve power would be a power exercisable in respect of individual companies. A second reserve power would relate to the sector as a whole and would be exercisable in consequences of the review to which we refer in paragraph 171. With regard to the first reserve power, the Bill should include powers for the regulator to take steps that could lead to a specific banking group affected by the ring-fence being required to divest itself fully of either its ring-fenced or its non-ring-fenced bank. The powers would be exercisable only if the regulator had concluded that the conduct of that banking group was such as to create a significant risk that the objectives of the ring-fence would not be met in respect of that bank. In these circumstances the regulator should consider the group's adherence to the principles and spirit of the ring-fence as well as its compliance with the letter of the law. The Commission recommends that the objectives for this purpose should be aligned with those for the relevant work of the regulator set out on the face of the Bill, as amended from the draft Bill in accordance with our recommendation in paragraph 130.

166. The Commission recommendation is of sufficient significance to require a number of limitations and safeguards. First, in order to allow time for the ring-fence to demonstrate its effectiveness, the Commission recommends that the Bill provides that the powers should not be exercisable by the regulator until after the completion of the first independent review of the effectiveness of the ring-fence that we propose in paragraph 171 and that we envisage should be completed less than four years after the ring-fence comes into force. The opportunity of this delay in commencement should also be taken by the Government to secure amendments to European legislation to ensure that the provisions relating to full structural separation are compatible with European law.

167. The Commission is convinced that there is a need for clarity and certainty about these powers. They should be separately provided for in the legislation which the Government plans to introduce early next year. The Commission considers that the new provisions should set out a series of steps that would have to be taken by the regulator. First, the regulator might be required to inform the banking group concerned of the regulator's intention to take steps which might lead to a requirement for full structural separation of the group. This would provide the group with an opportunity to make representations for remedy. If the regulator wished to proceed, the regulator might be required to propose the appointment of an external reviewer to consider the standards and conduct of the bank and its relationship with the regulator. The involvement of an external reviewer at this stage would be a crucial safeguard against discriminatory conduct by the regulator. The Commission envisages that there would be a statutory requirement modelled on the provisions of paragraph 1(1)(a) of Schedule 1 to the Budget Responsibility and National Audit Act 2011 (on the appointment of the chair of the Office for Budget Responsibility) requiring the consent of the Treasury Committee for the regulator's proposed appointee as external reviewer.

168. In the light of the report of the external reviewer and any representations of the banking group, if the regulator still wished to proceed, it would have the power to recommend that divestment of activities either inside or outside the ring-fence take place. This power would be subject to the same rights of appeal as the power currently exercisable by the regulator under section 45 of FSMA. The Commission has concluded that it would be inappropriate for the regulator, acting alone, to move directly to enforcement of full separation in respect of a banking group. The regulator should therefore make its recommendation known, in the first instance, to the Treasury, which would have the power, in the last resort, to override its implementation. In order to ensure transparency and parliamentary accountability, the recommendation would need to be made public at an appropriate stage. Should the Treasury decide to exercise its override power, that too, together with the Treasury's reasoning, would need to be made public at the same time. If, for reasons of confidentiality and market confidence (amongst other reasons), there is a delay in the publication of the recommendation, the Chairman of the Treasury Committee should be informed in confidence of the final recommendation.

REVIEW MECHANISM

169. The draft Bill currently contains only a narrow review mechanism, which requires the regulator to report on the effectiveness of its own ring-fencing rules after five years and every five years thereafter. That review would not necessarily comment on the wider design of the ring-fence as defined in secondary legislation. For example, it is not obvious that the review could comment on the de-minimis threshold or the exemption for large depositors. The current provisions for the review laid down in proposed section 142I of FSMA also do not prescribe the terms of the review or any follow up mechanism, beyond requirements for the report to be given to the Treasury, laid before Parliament and published.

170. Reliance on the regulator to conduct the review has the advantage that it is likely to have the best understanding of the operation of the ring-fence in practice, through its regular engagement with firms. However, this also carries the risk that that the regulator could be too close to the issues, and could find it hard to provide objective criticism of a set of rules which it had principal responsibility for preparing and implementing. Virgin Money noted that alternative bodies could conduct such a review:

there is a case for the reviews to be carried out by a body other than a body that was involved in setting the rules. If not by the PRA, the reviews could be carried out either by the Treasury Committee and/or by an independent body with appropriate credentials.[239]

Sir Mervyn King favoured the legislation including:

a provision to reconstitute this body, or a successor body, three, four, five years down the road to review how far the ring-fencing of Vickers had worked and whether any amendments were needed. In other words, a definite compulsory review should be built which could not just be avoided and put off; it has to take place in order that there would be an open study of whether or not there had been too much borrowing.[240]

171. The review mechanism currently included in the draft Bill is narrow and unacceptably weak. The Commission recommends an annual report from the PRA on the operation of the ring-fence. This is important to provide transparency on any issues arising between the regulator and banks and will give the regulator a vehicle for exposing attempts to game the system, get round or burrow under the ring-fence. The Commission recommends that the Bill be greatly strengthened. It should require a regular review of the effectiveness of the ring-fence across all banks to which the rules apply. The review body's terms of reference should require it to express a view on whether ring-fencing is achieving the objectives set out in legislation, and to assess the case for a move to full separation across the banking sector as a whole. The terms of reference for the review should be set out in statute, based on the objectives for the ring-fence as laid down in legislation. The review body should have a duty to make recommendations to the regulator and the Treasury about the design and application of secondary legislation and ring-fencing rules. Prior to that review, the Bill should require that the PRA publish a statement which summarises how the ring-fencing rules have been implemented by the industry with specific consideration being given to how the position of the ring-fence has evolved, primarily focusing on what activities and services, in addition to the core activities and core services, sit within the ring-fenced bank and to the type of derivative products are being offered by the ring-fenced banks. The review body should be able to draw upon the work conducted by the regulator as part of its statement on the position as it has evolved by then. If the first review does not lead to full separation, second and subsequent reviews should also draw upon the regulator's accounts of experience in relation to the first reserve power the creation of which the Commission has recommended. Significant use of this reserve power would indicate that full separation across the banking sector would be very likely to be the appropriate step. The independent review should take place within four years of the rules implementing the ring-fence taking effect, and regularly at an interval specified in statute of no more than five years.

172. The review body should be independently-led in order to provide appropriate challenge to the Treasury and PRA, who may otherwise find it difficult to criticise their own involvement in designing the framework. We would expect the body to have a range of backgrounds and views comparable to that of the ICB, although we believe that it should also include a former very senior central banker or regulator.

198 Draft Financial Services (Banking Reform) Bill, Clause 1 Back

199 Ev w29 Back

200 Q 1015 Back

201 Ev w188 Back

202 Q 1044 Back

203 Q 1058 Back

204 Ev w191 Back

205 Ev w198 Back

206 Qq 1144-5 Back

207 Draft Financial Services (Banking Reform) Bill, Clause 4, proposed new section 142A(3). A similar but not identical wording appears in proposed section 142D(3). Back

208 Draft Financial Services (Banking Reform) Bill, Clause 4, proposed new section 142H Back

209 Ev w61 Back