Banking Standards Joint Committee Contents


11  Capital and loss absorbency

Introduction

231. The ICB recommended a package of reforms to make the banking system more stable and make banks easier to resolve. The ring-fence is a part of this package, but it is not sufficient, as discussed in Chapter 6. In addition to the ring-fence, the success of the proposed reforms to the banking system hinges on whether capital and loss absorbency measures can be put in place which reduce the likelihood of banks failing, and ensure that, if banks do fail, the losses from failure are better aligned with the rewards for success.

Bail-in

232. As set out in Chapter 2, the special characteristics of banks necessitate treating them differently from other companies when they are at or close to insolvency. The special resolution regime created in the Banking Act 2009 provides some alternative tools for dealing with failing banks, but as discussed in Chapter 2 the failure of a large and complex bank would pose a considerable challenge for this regime and could pose an unacceptable risk to public funds.

233. This means that a further tool is needed—a so-called 'bail-in regime'. This is a set of legal changes that bestow powers on the resolution authority to put a bank through a special, ultra-fast form of insolvency procedure, imposing losses on bank creditors over a weekend rather than over weeks or months and maintaining the continuity of provision of essential services. This approach was recommended by the ICB and accepted by the Government.[330]

234. There was broad agreement among witnesses that further reforms were necessary to ensure that bank creditors bear losses to preclude the need for the taxpayer to bail out banks in future. Andrew Bailey explained that:

if you strip it back, all you are really saying about bail-in is that you are asking to deal with the resolution of a bank as you do any other company. Companies get refinanced by their creditors. The point about banks is that, because of the confidence issue, you have to do it very quickly. You only get a weekend to do it. Therefore, you need legislation to effect something.[331]

235. The Bank of England now sees bail-in a central part of its strategy for dealing with failing banks:

[T]he size and complexity of the books of most global wholesale banks greatly increases the challenge in rapidly separating the critical economic functions in this manner without causing severe systemic disruption... This is what led to the development of the concept of bail-in resolution strategies, in order to ensure that unsecured creditors are exposed to loss without having over a resolution weekend to split up a bank into critical and other parts that go into liquidation.[332]

236. 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.

237. One concern about relying on bail-in to make banks resolvable is whether it is realistic to expect that in a crisis the authorities will be willing to exercise their powers to impose losses on creditors. Professor Rosa Lastra warned that bail-in still needed to be shown to be a credible tool:

bail-in is a very useful instrument and the only problem with it is that it still needs to be tested. It needs to pass the market test of credibility and of not being stigmatised. [...] The [European] Commission, when it was negotiating the Recovery and Resolution Directive, had a group of legal experts discussing the bail-in. It is clear that the 'bail-inable' instruments when bailing in, the trigger points, the credibility and the stigma are issues that need to be resolved.[333]

Jessica Ground also expressed the concern that bail-in "is one of those things that looks fantastic on paper", but that when it came to the choice of "pushing the button", authorities might not be willing to take the risk of triggering a bail-in in a crisis because of the risk of contagion. She added: "Bail-in [bonds] could be very good investments, but whether they are that helpful at the end of the day in dividing up risk and assigning the risk to that group of security holders, I remain less convinced about."[334]

238. Lord Turner noted that regulators were more likely to exercise their bail-in powers when this does not involve imposing losses on other banks:

this stuff [bail-inable debt] also has to be held outside the banking system. If in those circumstances we press the bail-in button, but we are worried that all this bail-in debt is held by another bank, we will never be willing to do it. We will be terrified that we are just setting off a domino set which is going to keel over. That is a missing bit of it.[335]

239. To make bail-in powers more usable and more credible, it is proposed that banks must hold a certain amount of debt that can easily absorb losses; the next section considers how this might be implemented. As Sir John Vickers explained:

Can one move to a situation where it is absolutely certain that the bondholders would bear loss? I think that total certainty is, perhaps, not to be had, but I believe that one can increase enormously the chance that bondholders would bear loss, and our proposals were crafted with a view to maximising that probability. You need the bail-in power of the regulator and a significant or substantial slab of such debt [...] It needs to be unsecured debt with appropriate maturity and the rest.[336]

240. Some witnesses expressed concern that there would not be sufficient demand for this kind of debt. For example, Jessica Ground said:

A lot of traditional fixed-income investors are very worried about them because of the potential for bail-in. A lot of equity investors are not natural holders of these [bail-in bonds], because your upside is capped. This is uncharted territory, and the market, as far as I understand it, is very small.[337]

John Grout agreed, indicating that he struggled to identify potential buyers of bail-in debt:

It looks as though insurers and pension schemes may not be suitable holders of bail-in bonds. That leaves you with hedge funds, wealthy families, sovereign wealth funds—I sort of run out when I get beyond that.[338]

241. Others were more sanguine about the size of the market for loss-absorbing debt. Erkki Liikanen told us that investors would buy the debt in the right conditions,[339] while Paul Tucker said that:

The point you make about pension funds, and one could say the same about life companies, is whether they should be allowed to own regular senior unsecured bonds issued by banks. I do not see why not, as long as they did not have concentrated exposures. They own corporate bonds, and they sometimes default. Insurance companies and pension funds do not only hold risk-free assets. They lose money on their bond holdings, and their equity portfolios go up and down in value.

It is quite important not to think about the world investor base as completely averse to default risk. When I have talked to some of the biggest asset managers in the world and have put this to them as a question, they have said that they would rather be able to take losses on their bank bond holdings if that helped to insulate them from the mayhem caused by the latest financial crisis, which devastated the value of their overall portfolios.[340]

242. Concerns remain about the design of a bail-in regime and whether it will provide confidence that the authorities would actually use their powers in the event of a crisis. The new tool risks being of particularly limited utility if the authorities were required to impose losses beyond the holders of specifically "bail-inable" debt and move up the chain to, say, corporate depositors. The legal and economic implications of bailing in a bank's creditors will never be known until it is tried for the first time under stressed conditions, and politicians and regulators will always face pressure to incur the better-understood costs of a taxpayer bailout instead. It should be a requirement that bail-inable debt is held outside the banking system, to reduce contagion risks within the banking system. The regulator should make early proposals on how best to accomplish this. Uncertainty about the size and nature of market for loss-absorbing debt will also mean that doubts will remain over whether bail-in will function as intended and what its costs will be. Parliament will need assurance that bail-in is not a paper tiger, as will the markets. The Commission recommends accordingly that the Bank of England be subject to a statutory requirement under the new legislation to produce an annual report to Parliament on the development and subsequent operation of bail-in to assist in assessment of its feasibility, which should be required to cover in particular:

  • The quantity of issued debt with characteristics which make it easily subject to bail in;
  • Whether bail-inable debt is being issued out of the correct corporate entity within a banking group to facilitate the preferred bail-in strategy;
  • The distribution of holdings of bail-inable bank debt within the rest of the financial system;
  • The feasibility of mechanisms for bailing in creditors other than long-term unsecured bonds, such as corporate depositors, uninsured household depositors and derivative counterparties;
  • Progress towards addressing international legal barriers to the recognition of bail-in actions.

243. It is expected that a bail-in regime will be introduced when the EU Directive on Recovery and Resolution (the 'RRD'), which is currently in draft, is implemented in UK law.[341] Several respondents noted the desirability of seeking agreement on bail-in at a European or international level. For example, Santander told us that:

Like other UK banks, Santander UK raises its funding in international markets. Therefore, a UK-only statutory bail-in power would not give clarity to market participants, many of whom would be operating outside of the UK's jurisdiction. A bail-in instrument of the kind described in the Government's White Paper can only be viable if it is internationally agreed and implemented.[342]

EU law also means that it would currently be difficult for the UK to implement a bail-in regime unilaterally, because the RRD "will remove some impediments to resolution arising currently from other EU directives".[343]

244. Martin Taylor urged the UK to go it alone should international agreement founder:

I would certainly recommend to Parliament that, if for any reason the European supervisors lose their nerve on bail-in debt, Britain itself does something. There ought to be an international standard there. A common international standard is also very desirable. If we can do that through the European work, that would be the best answer for that.[344]

245. The Commission supports the Government's endeavours to implement a bail-in regime in the UK. The Government should also continue to negotiate for a broad bail-in power to be applied across the EU. Bail-in is an important tool for resolving bank failures in a way that prevents the huge costs. The Commission is concerned at the risk that the development of such a tool might be delayed or watered down through negotiations at EU level and, given the size of the financial services sector relative to the UK economy, the Commission believes the Government should act at a UK level in the event of EU discussions not resulting in the desired protection for the taxpayer that bail-in aims to ensure. The Commission recommends that the Government make provision in the forthcoming legislation for bail-in powers at national level which could come into force if the EU proposals were delayed or inadequate, on the understanding that negotiations at European level would need to secure the subsequent removal of any existing or prospective European legal obstacles to the use of a more wider-ranging power at national level.

PLAC

THE MAIN PLAC REQUIREMENTS

246. For a bail-in regime to work, it must be possible for the authorities to impose losses on a bank's creditors without excessive disruption to that bank's operations or to the rest of the market. A deciding factor in whether this is the case is the nature of the bank's liabilities, and in particular whether there is enough unsecured debt of sufficiently long term to cover bail-in requirements. If long-term debt is available to absorb losses, short-term creditors are less likely to risk a run on the bank by demanding their money back.

247. To this end, the ICB recommended 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 primary loss-absorbing capacity (PLAC). RWAs are calculated by multiplying each type of asset on a bank's balance sheet—government bonds, mortgages, derivatives and so on—by a 'risk-weight' (for example, 0 per cent for assets considered to be very safe, like OECD government bonds; and 100 per cent for assets judged to be riskier, such corporate loans), then adding them up. When calculating the 17 per cent requirement, the denominator is the total of RWAs. Therefore the riskier the assets on a bank's balance sheet, the more PLAC a bank needs to issue to achieve the 17 per cent.

248. PLAC is defined by the ICB as:

those liabilities that can be regarded as constituting the best quality loss absorbing capacity. 'Primary loss-absorbing capacity' is 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.[345]

Banks affected by the ICB's recommendations on capital would also have minimum requirements on the components (i) and (ii) of PLAC above, which would mean that they would have to hold at most 6.5 per cent of RWAs as bail-in bonds to bring total PLAC up to 17 per cent, and in fact more likely 3-3.5 per cent given that most large banks will be subject to additional requirements on equity. The Government has agreed with the ICB's PLAC recommendation, defining PLAC as "regulatory capital and subordinated debt and senior unsecured debt with at least twelve months' term remaining and which the resolution authorities are confident could be bailed in".[346]

249. The Government expects the forthcoming EU Directive on Recovery and Resolution to include a minimum eligible liabilities requirement as an adjunct to the bail-in powers it mandates, which would have a similar effect to a PLAC requirement.[347] In anticipation of this, the draft Bill inserts a new section 142J of FSMA which would give the Government powers to instruct the regulator how to impose debt requirements on banks.[348]

PROPOSED EXEMPTION FROM PLAC REQUIREMENTS

250. The logic for making UK-headquartered banks hold PLAC over and above the internationally agreed capital requirements is that this provides an extra cushion on which the UK authorities could impose losses if such a bank fails and needs resolving. The Government has argued that it would not be appropriate to impose this additional requirement on the overseas operations of UK headquartered banks "where these do not pose a risk to UK and/or EEA financial stability",[349] because the UK authorities would not be responsible for resolving such entities. They argue that this would be "disproportionate", presumably on the grounds that it would impose an unnecessary cost on such operations that other international banks would not face. The Chancellor of the Exchequer also warned that imposing such a requirement would risk creating the perception that the UK authorities would stand behind overseas operations of UK banks:

Let us imagine you have a large bank in the UK that has a very large operation in Hong Kong, say. If you say that that bank has to provide loss-absorbing capacity against the failure of the Hong Kong operation then, by the way, the implication is that if the Hong Kong operation fails, we are going to be on the hook for it. I want it to be very clear we are not on the hook for the failure of the Hong Kong operation.[350]

In addition to using the powers in proposed section 142J to define PLAC, the Government also therefore intends to use them to set out the conditions under which UK-headquartered banks are exempted from holding PLAC in excess of international minima against non-EEA assets.

251. The PLAC exemption was not considered in the ICB's final report, although both Martin Taylor and Sir John Vickers said in their evidence that they accepted the logic of the Government's argument. [351] However, they did warn that care should be taken in designing the conditions for exemption, Martin Taylor warning that "we wait to see whether that is done properly. I would hold feet to the fire on that one, if I were in Parliament."[352]

EXEMPTION FROM PLAC REQUIREMENTS: BURDEN OF PROOF

252. Sir John Vickers said that, while the correct test for a PLAC exemption was whether a bank's overseas operations were resolvable without posing a risk to UK financial stability or the UK taxpayer, the burden of proof for demonstrating whether that this test had been met ought to lie with the bank rather than the regulator:

In its December response to our report, the Government made the totally reasonable point that if a bank can demonstrate that it was resolvable, etc [...] it would be disproportionate to place that requirement on the bank. The logic of that seems to me to be impeccable. But note that the onus of proof was on the bank. In the June White Paper, the Government seemed to have changed their position to the onus of proof being on the regulator. I thought that was an unwise step.

In the text preceding the draft legislation in the October document, the Government seem to be somewhere in between their December and June positions. I am not completely sure how to interpret it where it talks about the pros and cons and states that a balance needs to be struck. Again, that is a hard thing to disagree with, but I would flag it up as something to be alert to in the secondary legislation.[353]

253. Barclays also argued that involvement of the host regulator (the regulator in the country where a bank is conducting operations) was key:

Any exemption of assets held in overseas operations must be subject to very stringent tests which require the 'host' regulator to state unequivocally that the UK is in no way liable if the entity of the relevant bank needs to be independently resolved and that, in such circumstances, the parent bank cannot take steps to rescue that unit that would in any way jeopardise the overall banking group.[354]

254. Standard Chartered, a UK-headquartered bank which conducts the overwhelming majority of its operations abroad, argued that the global PLAC exemption should be at the discretion of the regulator:

there are instances where the application of the exemption renders the orderly wind-down of an international bank's operations in resolution potentially unworkable. For instance where the exemption has an impact on the UK's reputation or the ability of the home regulator/resolution authority to discharge its obligations to provide a coordinated resolution of a troubled bank. Our view is that the exemption should be available for application by the resolution authority on a discretionary basis where these issues are addressed.[355]

Standard Chartered also indicated that it would most likely not take advantage of any exemption, preferring instead a UK-based resolution plan. It stated that:

it is logical to give the regulatory authorities scope to exempt banks from applying the PLAC requirement to their international activities where they can demonstrate their failure would not pose a risk to the UK's financial stability. Some international banks will choose to take advantage of the exemption whilst others may not. The choice is likely to be partly dependent on the approach to resolution planning each individual bank develops with the Financial Services Authority and Bank of England. For Standard Chartered, we favour a whole bank resolution approach since we believe this would ensure the optimal outcome in the extremely unlikely event that we were to fail.

255. Witnesses from the Bank of England and the FSA agreed that the burden of proof should be on the bank seeking the exemption. Lord Turner said that:

we are very keen—this is an important point for us on the Bill—that the PRA should not be placed in a position where it has to prove that this exemption from group PLAC creates a risk to the taxpayer; the burden of proof, from our point of view, must be the other way around.[356]

Lord Turner set out two additional conditions he believed should be required before an exemption is granted, using the example of HSBC:

Secondly, the resolution plan should be agreed with the resolution authorities across the world. We ought to be agreeing it with the Hong Kong Monetary Authority and the Monetary Authority of Singapore. Thirdly, the fact that those authorities have agreed a regional break-up, rather than a group break-up, should be publicly known and publicised so that the creditors of that bank in the UK and in Hong Kong or Singapore are aware of that.[357]

He also argued that under such conditions, it was quite likely that overseas regulators would themselves require additional capital to be held against local operations, once it was fully clear that they would bear responsibility for resolution in the event of a failure:

the banks involved would not get any benefit from the proposed change to UK law, because I can absolutely predict that we will demand at least 17 per cent of primary loss-absorbing capacity, and so will the HKMA in Hong Kong, the MAS in Singapore and the US authorities.[358]

256. Andy Haldane and Paul Tucker noted that the concept of agreeing a resolution plan with overseas authorities was already part of the international recovery and resolution planning process under the Financial Stability Board. Paul Tucker said: "the UK authorities have an international obligation to ensure that the worldwide group of any UK-domiciled banking group is resolvable. That is not the same as saying we must be the resolver."[359]

257. The Chancellor of the Exchequer did not clarify the Government's position fully, but emphasised that, once a decision had been made, the regulator should not be able to change its position without demonstrating its reasons for doing so:

We are clear that the firm will have to assure us that the costs of the non-EEA bits of it, were they to fail, would not fall on to the UK taxpayer. [...] However, once they have assured us, what I don't want to have is, hanging over some extremely large and important institutions in our country, a constant threat that that judgment might change, that the regulator might suddenly change its judgment, and that has an almost overnight impact on the business. I think once the firm has assured the regulator, it is then the obligation on the regulator, should it change its mind, to demonstrate that it is right in changing its mind.[360]

CONCLUSIONS ON THE PLAC EXEMPTION

258. Exemptions from PLAC increase the risk that, in a crisis, the UK would need to intervene in respect of overseas operations of a UK-based bank, but would lack the level of PLAC necessary to shield the taxpayer. The Commission recommends that the secondary legislation to be made under to section 142J of the draft Bill 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. It will also be important for the regulator to monitor the implications of exemptions in the case of each firm affected on an ongoing basis. We would expect this monitoring to be the subject of regular review by a strengthened Supervisory Board of the Bank of England introduced in accordance with the recommendations of the Treasury Committee.

ACCOUNTABILITY FOR USE OF POWERS RELATING TO LOSS ABSORBENCY

259. Clause 4 of the draft Bill introduces a new provision in proposed section 142J(4(d)) of FSMA which, after an enabling order has been passed, confers a power on the Treasury to issue further directions to the regulator in relation to loss absorbency. The House of Lords Delegated Powers and Regulatory Reform Committee noted that such an order would:

confer power on the Treasury to give directions, not subject to any Parliamentary control, to the regulators. This is mentioned, but not justified, [... in] the [Treasury's delegated powers] memorandum. We normally require a full and convincing justification for power which may be used to circumvent Parliamentary control and we were not convinced on this occasion.[361]

260. It is also notable that an order made under section 142J(4(c)) could be used by the Treasury to "require the regulator to consult the Treasury before imposing a requirement in accordance with the order in a particular case".[362] This would appear to create the potential for the Treasury to give itself a role in setting PLAC requirements for individual firms, which if used would appear to conflict with the objective of an independent regulator.

261. When asked why there were no principles in the draft Bill to guide the use of the powers in section 142J, the Chancellor of the Exchequer replied:

This is a significant economic decision; it is right that Parliament is involved in that decision. It will be set out in the legislation [...] but I think we are entitled as a Parliament to say, first of all, that PLAC will be applied to certain institutions and, secondly, how we define that PLAC. I am clear it has to be equity or tier 1, tier 2 or unsecured longer-term debt. We have set out in the White Paper what we think those requirements are. But again, it comes down to a broader question: do you give complete freedom to the regulators to make decisions that have a very real economic impact on our constituents, or do you ask Parliament to be involved and consulted on that decision? Here we have tried to get the balance right, where Parliament will prescribe certain minimum requirements and hard definitions, and then it will be up to the regulator to go ahead and impose them.[363]

262. The broad, largely unconstrained powers contained in proposed section 142J of FSMA could be used by the Treasury to set a framework which removes the regulator's discretion over whether to grant a PLAC exemption. There is also a possibility that the Treasury could use the power to intervene in individual decisions on exemptions from PLAC requirements. If this was used to overrule the regulator's decision on individual cases, this would be a highly inappropriate political intervention.

263. The Commission accepts that the Treasury should have certain powers to implement the PLAC requirements, and that secondary legislation is the appropriate vehicle: primary legislation is not appropriate for such technical matters, and the changes will in some cases be too important to be left solely to the discretion of the regulator. However, as drafted, these powers are extremely wide-ranging, are subject only to the negative resolution procedure, and need not be deployed with reference to any particular policy objectives. Furthermore, an order made under these provisions may confer a general power to give further directions to the regulator without further parliamentary oversight. This places an unacceptable level of unconstrained power in the hands of the Treasury. The Commission recommends that:

  • the Bill require the powers of direction the Government acquires under proposed section 142J to be exercised with reference to policy objectives stated on the face of the statutory instrument which grants those powers;
  • the order-making powers under proposed section 142J be subject to the affirmative resolution procedure, rather than the negative resolution procedure, to ensure a greater degree of parliamentary oversight; and
  • the power under proposed section 142J(4)(d) to "confer power on the Treasury to issue directions to the regulator as to specified matters" be removed from the draft Bill altogether.

The Commission also notes that the remaining powers of the Treasury to direct the regulator in relation to the implementation of the PLAC requirements will need very careful monitoring.

Depositor preference

THE CONCEPT OF DEPOSITOR PREFERENCE

264. When a company goes into insolvency, its creditors queue up to be paid out of the assets remaining in the firm. Preferring one group of creditors means moving them toward the front of this queue. Depositor preference is therefore relative: moving one creditor towards the front necessarily pushes others back. Depositor preference always favouring some depositors at the expense of others. Depositor preference can, in principle, be applied to certain categories of depositors (for example, households or SMEs) or to certain deposits (such as deposits insured through the Financial Services Compensation Scheme (FSCS)).

265. The ICB recommended in their final report that "in insolvency (and so also in resolution), all insured depositors should rank ahead of other creditors to the extent that those creditors are either unsecured or only secured with a floating charge".[364] In the White Paper preceding the draft Bill, the Government consulted on whether certain other categories of debts[365] should be preferred alongside insured deposits.[366] Following the consultation, the Government has decided to propose that only insured deposits should be preferred and proposals to give effect to this are set out in Clauses 7 and 8 of the draft Bill.[367]

266. In the UK, the deposits of households and small businesses up to £85,000 are insured by the Financial Services Compensation Scheme (FSCS), a body funded by the financial services industry with a backstop from the Government. As the Institute for Chartered Accountants pointed out, when only insured deposits are preferred this does not benefit insured depositors themselves:

The Financial Services Compensation Scheme protects individual deposits up to £85,000. So the proposals do not affect the position of most individuals. Rather, insured-depositor preference protects those who stand behind the FSCS scheme—the banks and, in some scenarios, HM Treasury.[368]

The uninsured depositor loses at the expense of the FSCS.

ARGUMENTS FOR INSURED DEPOSITOR PREFERENCE

267. Uninsured creditors would currently bear losses at the same rate as insured deposits if a bank failed. However, as the ICB final report pointed out, "insured depositors are not well-placed to exert market discipline on banks, and in any case have no incentive to do so".[369] By moving insured deposits ahead of uninsured depositors in the queue, depositor preference as proposed in the draft Bill concentrates losses on uninsured creditors, "many of whom are better able to exert such discipline by demanding higher returns if a bank pursues riskier activities".[370] The measure is thus intended to create an incentive on uninsured depositors to exercise an influence on the risk profile of banks.

268. If a bank does fail then any costs borne by the FSCS—for example in compensating depositors—are passed on to other banks through the FSCS levy. The ICB final report noted:

This requires safe, well-run banks that survive a crisis to pay for the failure of risky banks (perhaps over a number of years), and in so doing acts as a channel for contagion. If surviving banks are unable to bear these costs, they will ultimately fall on the taxpayer.[371]

The risk to the taxpayer arises because in practice the FSCS and its members do not have the financial capacity to fund a sizeable resolution up front, so instead are likely to be reliant on a loan from the Treasury. As of April 2012, the FSCS still had obligations to repay the Treasury almost £18bn as a result of bank failures in the recent crisis where it made payouts or funded the transfer of deposits in resolution.[372] Insured depositor preference could reduce the risk to public funds from any loans made to the FSCS by making it more likely that full recovery will be made from the failed bank.

EXTENDING DEPOSITOR PREFERENCE BEYOND INSURED DEPOSITS

269. Giving preference to insured deposits will result in higher rates of loss in insolvency for other liabilities which have been pushed down the creditor hierarchy. As an illustration, in the case of a bank with £10bn of insured deposits and £10bn of other deposits, these would currently rank equally in insolvency. If the bank fails and there are £4bn of losses left over after equity and any subordinated debt has been wiped out, then both the FSCS faces a loss of £2bn and uninsured depositors face a loss of £2bn—20 per cent of their claim. With insured depositor preference, all £4bn of losses fall on uninsured depositors who lose 40 per cent of their claim, while the FSCS faces no loss at all.

270. Some witnesses argued for extending preference beyond insured deposits, to categories such as all retail deposits or charities' deposits. A group of charity representatives argued for extending preference to charities' deposits on the grounds that the current proposals would place a greater and inappropriate burden on charities:

The vast majority of charities manage their finances and risk extremely well, yet most simply do not have the same level of technical banking knowledge and expertise as other creditors of comparable size. Managing increased banking risk is extremely resource-heavy and investing in up-to-the-minute treasury management diverts funds away from frontline services. It is therefore difficult to justify using substantial charitable funds for this purpose, particularly given the challenging funding environment.[373]

They added that the nature of charity funding and banking was unique and that "charities typically hold large amounts on deposit (approximately £18bn across the sector) as they require quick and easy access to cash".

271. Nationwide stated that it had "consistently argued that all retail deposits in all ring-fenced institutions should carry creditor priority, not just those up to the FSCS limit". It added:

We are doubtful that this would have a material impact on the cost of wholesale funding and believe that the consumer message is much more powerful and comprehensible without qualification.[374]

The Building Societies Association also said that it "continues to support full retail depositor preference, going beyond the FSCS coverage limit".[375]

272. The Treasury stated that it had considered these arguments in coming to its decision, and cited drawbacks of extending depositor preference "such as the dilution of the benefits of preference to the FSCS, and the effect of increasing the exposure of other non-preferred groups to losses in the event the bank fail". It argued that "no group or sector stands out as an exceptional case".[376] It also noted:

it is expected that FSCS coverage will be extended (under the Proposal for a Directive on Deposit Guarantee Schemes) to include currently uncovered deposits. This will mean that all individuals and most organisations will be eligible for FSCS protection for amounts deposited up to the coverage limit.[377]

Barclays similarly argued that extending to other kinds of deposits was "a wholly inappropriate outcome" for several reasons:

First, it is not equivalent to the insurance protection provided to other depositors, as it will not guarantee payment. Second, it creates a material communication issue with depositors as to the nature of any protection to which they are exposed. Third, in the context of communications, understanding how depositor preference without insurance will work will require significant sophistication on the part of customers. We believe that any expansion of depositor protection should be dealt with best through changes to the relevant insurance schemes and carefully coordinated across at least Europe.[378]

273. An additional reason for banks to oppose the extension of depositor preference is that it is likely to increase their costs. The Treasury impact assessment estimates that insured depositor preference would cost UK banks between £0.3bn and £0.7bn on aggregate each year, as a result of having to pay higher interest rates to funding sources that would find themselves subordinated, such as corporate deposits or unsecured bonds.[379] No estimates have been published by the Treasury of the funding cost implications for banks of extended depositor preference, but this cost could reasonably be expected to be higher because the remaining corporate deposit holders and unsecured bond holders would carry an even greater proportion of losses in the event of failure.

POTENTIAL PROBLEMS WITH DEPOSITOR PREFERENCE

274. The ICAEW argued that many of the creditors who would find themselves subordinated as a result of insured depositor preference were not really the type of creditors who it would be desirable to force losses upon:

The price of protecting the banks and, possibly, the taxpayer would be borne by institutions such as larger charities, hospitals, schools, local authorities, universities and lawyer/accountants' client money accounts (which often temporarily hold, for example, clients' deposits on house purchases), as well as mid-sized companies. They will not be able to use ring-fenced banks with confidence [...].

There are three ways this could be solved. Firstly, extend the FSCS coverage to all 'end-user' of the banking system. Secondly, extend depositor preference to all end-users. Or, drop the 'depositor preference' proposal altogether.[380]

Which? noted that uninsured retail depositors would include those who have temporary high balances above the £85,000 level:

It is also clear to us that there are many occasions during a person's life when they need to hold deposits above the level set by the FSCS. These could include house purchase/sale, receiving an insurance pay-out, inheritance or pension lump-sum. We believe that at such times, retail depositors are not well placed to impose market discipline on banks and the loss of a deposit would risk having a catastrophic effect on the individual.[381]

275. The Treasury considered that it was appropriate for such depositors to face the risk of losses:

Where individuals and organisations hold sums beyond the FSCS limit, the Government believes it is right that they should monitor and manage the risk in where they place deposits, as all other unsecured creditors must do (including individuals and small businesses).[382]

276. Sir Mervyn King pointed out that it could be politically difficult for the authorities to impose losses on uninsured depositors, especially those with temporary high balances:

On any given day you will find thousands of people in that position, and this is when I would understand if you in Parliament stood up and said, "This is deeply unfair." We have no means at present of handling that [...]

If you have a very small bank that fails and only 12 people hold deposits above £85,000, in three different constituencies, I am convinced that the Chancellor will decide not to intervene. If you have thousands of people involved, I think the pressure on the Chancellor will be enormous. [383]

277. RBS expressed the view that depositor preference was "of questionable benefit", and argued that "the preservation of the creditor hierarchy is an important principle agreed by the industry." It went on to suggest that as an alternative:

deposit guarantee schemes should, as in the EU RRD proposal, be included in a bail-in regime as a senior unsecured creditor, similar to their status in liquidation. This would ensure that the pool of eligible bail-in liabilities is as broad as possible to absorb potential losses. [384]

278. The Bank of England's explanation of how they might expect to resolve a large ring-fenced bank in future also suggested a need to be able to bail in the deposit guarantee scheme,[385] and Paul Tucker also argued for this in a speech in October 2012, saying that bailing in deposit insurers would be a way of ensuring bail-in could work for banks without enough bondholders.[386] HSBC noted that "Depositor preference is [...] inconsistent with the scope for deposit guarantee scheme bail-in",[387] because seniority for the FSCS would mean that it could only be bailed in if uninsured creditors had taken full losses first, otherwise this would represent a departure from the creditor hierarchy. Several witnesses also noted that implementation of depositor preference would require amendment of the Recovery and Resolution Directive, because the draft Directive currently prohibits it.[388]

CONCLUSIONS

279. It is crucial that deposit insurance be designed so as to avoid creating irresistible political pressure for ad hoc extension in the event of bank failure, as was the case in the last crisis. Implementation of the proposal for preference for insured deposits, by increasing prospective losses for others, has the potential to accentuate such pressure. Depositor preference would also appear to be in conflict with one of the resolution strategies favoured by the Bank of England, involving bail-in of the deposit insurance scheme. Both the above points weaken the credibility of the Government's proposal. The Commission considers that the Treasury's case that all non-insured creditors, including charities and small businesses and temporary high deposits of households, would be treated alike in the event of failure, is unconvincing. In view of these problems, the Commission recommends that the Government and Bank of England establish a joint group to prepare and publish a full report on the implications for resolution of depositor preference and of the scope and extent of depositor insurance. This report should, in particular, consider the feasibility of establishing a voluntary scheme of insurance for deposits over £85,000 with arrangements for opt-out. This report should be published at least two weeks before the House of Commons report stage of the Bill.

Leverage ratios

280. Banks fund their assets (such as mortgages) with a mixture of equity and debt (such as customer deposits and bonds). This chapter has so far addressed proposals relating to the debt that a bank issues. These reforms involving bail-in, loss-absorbing debt requirements and depositor preference are all concerned with how debt-holders are treated when a bank approaches or reaches insolvency. Witnesses acknowledged that the reforms are important and promising, but also that they were untested. There remains a chance that they will fail, in the sense that the authorities will either not be willing or not feel able to impose losses on certain classes of creditors when the time comes.[389]

281. The remainder of this chapter addresses measures relating to equity. Imposing a requirement on the level of equity a bank issues is a more certain and tested safeguarding method. The owners of equity (the shareholders) are the residual claimants on the assets of the bank. They are the first to benefit from any profits and, by the same token, the first to suffer any loss. The more equity a bank has, the more money it can lose before it becomes insolvent: equity is a shock-absorber. The prospect of the shareholders bearing more of the losses from risky investments, rather than shifting them to debt holders (or the State, if the bank is bailed out) should dissuade them from taking too much risk in the first place. Bank equity is therefore a stabilising force in the financial system.

282. Requirements on equity are guided by the Basel process. This is a system of international agreements which sets minimum standards for how banks fund themselves. The main measure used by the Basel process is "Tier 1 capital", which includes equity and a limited class of other things.[390]

283. Two types of requirement on capital are used in the regulation of banks. The first is setting a minimum ratio of capital to 'risk-weighted assets', which was considered earlier in this chapter. The second is setting a minimum on the total amount of capital as a percentage of total unweighted assets - a 'leverage ratio'. The leverage ratio treats all assets the same rather than attempting to weight them by their relative riskiness.

284. Capital requirements against risk-weighted assets are being tightened considerably by the Basel 3 process. The Basel 3 rules are being implemented in the UK via the draft EU Capital Requirements Directive and Capital Requirements Regulation IV (CRDIV/CRR). The standards being implemented through CRDIV/CRR require that all banks should issue Tier 1 capital of at least 8.5 per cent of total RWAs. They also set a leverage ratio as an additional requirement, requiring that banks fund themselves with a minimum of 3 per cent of Tier 1 capital relative to total (i.e. unweighted) assets.[391]

285. The leverage ratio which is based on total assets and the capital ratio which is based on RWAs are connected, but not the same. Two banks that had the same ratio of capital to RWAs might easily have different leverage ratios. The bank that had assets judged to be safer, and which therefore had lower risk weights, could have a higher leverage ratio than the bank whose assets were held to be riskier, and which therefore had higher risk weights. If a bank were required to have capital equal to at least 8.5 per cent of its RWA, it would need the average risk rating of its assets to be at least 35 per cent (= 3 divided by 8.5, expressed as a percentage) in order for it also to have a leverage ratio above 3 per cent. The addition of the leverage ratio as a supplement to the capital ratio has the effect of preventing a bank from holding too many assets, even if the assets are judged to be low risk. The assets judged to be low risk do not give rise to a corresponding obligation to issue capital against them. The leverage ratio acts a safety net. If the assets with low risk weightings turn out to be greatly overvalued, an appropriate leverage ratio can ensure that the bank has sufficient capital to absorb the losses.

286. The ICB proposed to raise Tier 1 capital requirements for large ring-fenced banks from 8.5 per cent to 11.5 per cent of RWAs. The Government has agreed to implement this proposal. The ICB also proposed to increase the leverage ratio requirement on these banks by the same proportion, from 3 per cent to 4.06 per cent, so that the backstop has the same effect as under Basel 3. The Government has rejected this latter proposal.

287. Some witnesses questioned whether the Government's decision not to increase the leverage ratio in line with the ICB's recommendation was the right one. One argument against the Government's position was that measures using RWAs are held to be deeply flawed. A robust back-stop was therefore needed. Andy Haldane told us that "both Basel II and Basel III are built on the shakiest of foundations, because on the denominator of that capital ratio is a measure of the assets of the bank, weighted by risk".[392] Setting risk-weights is not an exact science: for example, both German and Greek government bonds could be assigned zero risk weights under Basel II, so that a capital requirement based on risk-weighted assets would require no capital at all to be held against either.

288. Another major problem with measures of RWAs is that Basel II and III both allow some banks to calculate their own risk weights using internal models, subject to some constraints. Andy Haldane told us that "choice over those risk weights moved from the regulator to the firm. The firm was then setting its own standards through the risk models".[393] In 2009, the FSA asked banks to evaluate the capital requirements on a common portfolio of assets. According to Andy Haldane,

the range of reported capital requirements held against this common portfolio was striking. For wholesale exposures to banks, capital requirements differed by a factor of over 100 per cent. For corporate exposures, they differed by a factor of around 150 per cent. And for sovereign exposures, they differed by a factor of up to 280 per cent. Those differences could equate to a confidence interval around reported capital ratios of 2 percentage points or more.[394]

Michael Cohrs echoed this point:

the FSA sent out a portfolio to its constituents and asked them to risk-weight it. It was pretty simple. I think the expectation was that there would be a very narrow spread among the banks when they came back with this relatively simple portfolio. Lo and behold, it came back and there was a massive spread between the bank that was most conservative and the bank that was most aggressive. Risk-weighted assets are at the heart of the Basel ratio system. Therefore, you just throw your hands up. You start from there and say, "It doesn't really work".[395]

In evidence, Paul Tucker drew attention to the progress being made in improving disclosure of the processes underpinning risk weightings:

It is very important that banks have to disclose a lot more about where they are taking risks, because what you described plainly happened and could happen again, and the underlying problem is that the asset management industry is not looking at risk-adjusted returns. I think they could fairly say at the moment that it is quite hard to do that when they cannot see what is inside the banks. The industry has come up with a disclosure framework internationally that goes a lot further than anything the regulators have demanded so far, and we and the international community have welcomed that.[396]

289. Sir Mervyn King joined Andy Haldane in cautioning against "relying too much on risk-weighted assets". He said that risk weights were set using an "international process which is very hard to negotiate and therefore extremely inflexible", that risk weights "change over time" and that in a major financial crisis "it is a time when the things you thought were risky or less risky turn out not to be". He suggested that the leverage ratio turned out to be "a far better predictor of the institutions that failed in the crisis" than measures of risk-weighted assets.[397]

290. The banks and building societies supported the Government's decision not to increase the leverage ratio. HSBC noted that, "when the proposed increased capital requirements for G-SIBs were announced by the Basel Committee and FSB, they did not recommend any changes to the leverage requirements" and went on to say:

the original leverage ratio of 3 per cent devised by the Basel Committee was intended to apply across all banks including universal banks. Therefore it was a blended rate recognising that banks hold low risk liquidity pools and mortgages as well as higher risk-weighted corporate and wholesale banking assets. Applying that blended rate to retail ring-fenced banks, with their concentration of lending to lower risk mortgages and with larger tranches of liquid assets, would in and of itself constitute a more onerous standard. To go beyond this would mean that the leverage ratio would becoming a binding capital restriction rather than the backstop measure which the Basel Committee originally intended.[398]

Related to these points is the contention that a 4 per cent minimum leverage ratio would be tighter than international minimum standards, tilting the playing field against UK banks.

291. In opposition to an increase in the leverage ratio it was also pointed out that a leverage cap would hit certain banks and certain forms of lending—i.e. those with low risk weights—particularly hard. Mortgage lenders who conduct what is widely regarded as low risk lending may be disproportionately affected.[399] This applies particularly to building societies, which cannot raise capital quickly and whose assets often have low risk weights. Nationwide contended that one response might be "perversely, to increase our risk taking".[400] Nationwide argued that if the requirement were tightened to 4 per cent, it should be "calibrated based on institutions' risk profiles [...] The key issue therefore is to determine the extent to which a retail ring-fenced bank and a building society have different risk profiles [...] For building societies, we would anticipate it [the leverage ratio] being no more than 3 per cent, otherwise it will become a primary measure".[401] Nationwide suggested that raising the leverage ratio might restrict lending.[402]

292. Sir Mervyn King addressed the issue of whether mortgage lenders would be hit disproportionately, noting that Northern Rock had a "staggering" degree of leverage before it failed, and that "It would not be sensible to allow a mortgage lender to build up to that degree of leverage. It is important to constrain the degree of leverage."[403] Calibrating an otherwise flat leverage ratio requirement for different institutions works against the premise of the simple leverage ratio—that it is a mistake to rely too heavily on judgements about relative riskiness. It is noteworthy that a number of building societies have been taken over or gone into resolution during the present crisis.[404] On the question of propensity to lend, Sir Mervyn King argued that if as a result of increased leverage ratios a bank was "lending less than it otherwise would, it means that we are minimising the risk that something will go badly wrong."[405]

293. In March 2012, following HM Treasury's earlier request, the interim FPC agreed unanimously a statement outlining its advice on potential powers of Direction for the statutory FPC. This included that the FPC should seek powers of Direction over a countercyclical capital buffer, sectoral capital requirements and a leverage ratio. The Government set out its reply to this request in September 2012. Citing consistency with international standards, the Government stated that it intends to provide the FPC with a time-varying leverage ratio tool, but no earlier than 2018 and subject to a review in 2017 to assess progress on international standards.[406] The precise design of the tool will depend on the provisions of the relevant European legislation and will be set out in secondary legislation to be introduced by the Government at the time.[407]

294. Reliance on capital requirements based on risk weighted assets alone is not sufficient. The leverage ratio is an important part of banks' minimum capital requirements. If a 3 per cent leverage ratio is a backstop when the requirement in terms of RWAs is 8.5 per cent, raising the leverage ratio broadly in line with a higher requirement in terms of RWAs is logical. The Commission is not convinced about the appropriateness of the Government's decision to reject the ICB's recommendation to limit leverage at 25 times rather than 33 times. We believe that high leverage was a significant contributor to the crisis. 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.

295. Determining the leverage ratio is a complex and technical decision, and one which is ultimately best made by the regulator. The 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. An early change to the leverage ratio would pose particular problems for some building societies. In view of their special characteristics, the regulator should carefully consider the case for longer transition arrangements for them. Changes to leverage ratios might be mitigated by changes to the tax treatment of debt and equity for banks, a matter to which we will return in our Report in the New Year. We took little evidence on the effects on regulatory arbitrage and passporting held to be a possible consequence of setting higher capital or leverage ratio at a national level than are required under Basel III. We will consider this as part of our wider work on regulatory arbitrage issues in our final Report.

296. Simple leverage ratios have the drawback that they incentivise banks to hold the highest-yielding and therefore presumably riskiest assets that they can, and to offload as many lower-yielding and safer assets as they can into other companies. Risk-weighting of assets was introduced as a remedy. Risk-weighting has, however, been unsatisfactory and arguably dangerous in practice. Banks were allowed to set their own risk weights using their own models. Some of the weights were much too low. The zero or low weights attached to government securities have encouraged banks to acquire large amounts of what were in some cases very risky assets. Many governments have an incentive not to address this, because of their need to fund large deficits. Parliament needs to be assured that the work to improve risk-weighting is being given the highest priority. The Commission recommends that the new Bill require the Bank of England to provide an annual assessment to be laid before Parliament of progress of risk-weighting and that the assessment should examine in particular the possible operation of floors for risk-weights, and steps taken with regard to simplification of risk-weights and trading exposures. If a more independent and more skilled Supervisory Board of the Bank of England is established in accordance with the recommendations of the Treasury Committee, it would be important for this Board to provide regular oversight of the work by the Bank of England in this area.


330   HM Treasury, Sound banking: delivering reform, Cm 8453, October 2012 p 15 Back

331   Q 1003 Back

332   Ev w181 Back

333   Q 705 Back

334   Q 710 Back

335   Q 1003 Back

336   Q 796 Back

337   Q 716 Back

338   Q 727 Back

339   Q125 Back

340   Q 1169 Back

341   HM Treasury, Sound banking: delivering reform, Cm 8453, October 2012, p 5 Back

342   Ev w127 Back

343   Ev w180 Back

344   Q 443 Back

345   Independent Commission on Banking, Final Report, September 2011, para 4.78 Back

346   HM Treasury, Sound banking: delivering reform, Cm 8453, October 2012, para 2.57 Back

347   Ibid., para 2.56 Back

348   Ibid., para 2.6 Back

349   HM Treasury, Banking reform: delivering stability and supporting a sustainable economy, June 2012, Cm 8356, p 38 Back

350   Q 1100 Back

351   Qq 443, 788 Back

352   Q 443 Back

353   Q 788 Back

354   Ev w33 Back

355   Ev w151 Back

356   Q 986 Back

357   Ibid. Back

358   Ibid. Back

359   Q 1216 Back

360   Q 1099 Back

361   Ev w54 Back

362   Draft Financial Services (Banking Reform) Bill, Clause 4 Back

363   Q 1097 Back

364   Independent Commission on Banking, Final Report, September 2011, para 4.135 Back

365   Banks' liabilities to their own pension schemes, overseas deposits up to the FSCS coverage limit, and deposits placed by groups such as charities or local authorities. Back

366   HM Treasury, Banking reform: delivering stability and supporting a sustainable economy, June 2012, Cm 8356, consultation question 4 Back

367   HM Treasury, Sound banking: delivering reform, Cm 8453, October 2012, para 2.42 Back

368   Ev w70 Back

369   Independent Commission on Banking, Final Report, September 2011, para 4.89 Back

370   Ibid., para 4.89 Back

371   Ibid., para 4.90 Back

372   HC Deb, 16 April 2012, col 2WS [Written Ministerial Statement]  Back

373   Ev w4 Back

374   Ev w95 Back

375   Building Societies Association, Submission to Government Consultation on the Future of Building Societies, para 72 Back

376   HM Treasury, Sound banking: delivering reform, Cm 8453, October 2012, para 2.51 Back

377   Ibid., 2.52 Back

378   Ev w33 Back

379   HM Treasury, Sound banking: delivering reform, Cm 8453, October 2012 Back

380   Ev w70 Back

381   Ev w168 Back

382   HM Treasury, Sound banking: delivering reform, Cm 8453, October 2012, para 2.52 Back

383   Q 1175, Q 1176 Back

384   Ev w108 Back

385   Ev w182, para 11 [Bank of England] Back

386   Bank of England, Speech by Paul Tucker to International Association of Deposit Insurers Annual Conference, 25 October 2012  Back

387   Ev w137 Back

388   Ev w100, para 14 [Professor Rosa M. Lastra]; Ev w137, para 1.71 [HSBC Holdings] Back

389   Qq 705, 710, 727, 728, 731. Back

390   Tier 1 capital includes common shares, retained earnings and other instruments which can absorb losses on a going-concern basis. These other instruments must comply with a range of criteria relating to features such as subordination, coupon payments and redemption. Source: www.bis.gov.uk Back

391   Strictly speaking, the leverage ratio is calculated using 'exposures' rather than 'assets'. Back

392   Q 628 Back

393   Q 629 Back

394   Bank of England, Remarks by Andrew Haldane, 9 January 2011  Back

395   Uncorrected transcript of oral evidence before Parliamentary Commission on Banking Standards Panel on Regulatory Approach on 11 December 2012, HC 821-i, Q 8 Back

396   Q 1214 Back

397   Q 1209 Back

398   Ev w131 Back

399   Ev w42, para 11 [Building Societies Association], para 11 Back

400   Ev w92, para 3 Back

401   Ibid., para 6 Back

402   Ibid., para 3 Back

403   Q 1213 Back

404   See, for example, "Financial Services Authority confirms Chelsea Building Society merger with the Yorkshire Building Society", FSA press notice 050/2010, 19 Mar 2010 Back

405   Q 1213 Back

406   HM Treasury, The Financial Services Bill: the Financial Policy Committee's macro-prudential tools, Cm8434, September 2012 Back

407   Ibid. Back


 
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© Parliamentary copyright 2012
Prepared 21 December 2012