Conclusions and recommendations
Conduct of our work
1. The
timetable for scrutinising the draft Bill which was arbitrarily
dictated by the Government has meant that we have been unable
to do justice to all of the issues which arise out of the draft
Bill and related policy measures. We are concerned that the Government
has constrained the ability of Parliament to conduct full scrutiny
of a Bill of such vital importance. (Paragraph 12)
The overall case for separation
2. The
Commission finds the evidence that it has received on the benefits
for financial stability of some form of separation convincing.
The evidence that there has been damage to standards and culture
by having these activities side by side, an area not examined
by the ICB, is comprehensive and a crucial consideration. There
is evidence to suggest that, as well as supporting financial stability
and reducing the risk to the taxpayer, separation has the potential
to change the culture of banks for the better and to make banks
simpler and easier to monitor. These are propositions to which
the Commission expects to return in the New Year. (Paragraph 45)
The next banking crisis
3. The
characteristics of financial crises and the nexus between banks,
politicians and regulators together pose fundamental challenges
for the design and implementation of structural separation. Any
framework will need to be sufficiently robust and durable to withstand
the pro-cyclical pressures in a future banking cycle. Those pressures
will include the siren voices of those who contend that structural
separation as implemented represents a barrier to financial innovation
and growth. Politicians need to face up to the possibility that
they may prefer those siren voices to the precautionary approach
of regulators, particularly if, once again, it appears that banks
are performing alchemy. In the chapters that follow, we consider
the approach needed best to ensure that structural separation
is able to withstand these challenges. (Paragraph 78)
Structural separation in the first instance
4. There
is widespread, but not universal, support for structural separation
in some form. However, views in evidence to the Commission about
how separation should operate, where a ring-fence should be placed
and indeed whether ring-fencing can achieve the desired policy
aims, fell well short of consensus. (Paragraph 80)
5. Whatever
their views on arguments for and against full separation, which
are finely balanced, the majority of witnesses told the Commission
that the partial structural separation of the ring-fence would
probably bring significant benefits for public policy and for
banking. The Commission therefore welcomes the Government's action
to bring forward legislation to implement a ring-fence. (Paragraph
93)
6. The
ICB's proposals should be the starting point for proposals for
legislation for implementation of structural separation. However,
that does not mean that they should be the final destination.
The current proposals may not be sufficient. In addition to concerns
about proprietary trading, the case that a ring-fence will in
practice be able to achieve the necessary level of separation
remains unproven. The ring-fence may also be tested and eroded
over time. The Commission considers it essential that steps are
taken to reinforce the ring-fence, and makes specific recommendations
to this effect in chapter 9. (Paragraph 94)
7. There
is evidence to suggest that proprietary trading, which under the
current proposals could still take place within the non-ring-fenced
part of banking groups, is an activity which is incompatible with
maintaining the required integrity of customer-facing banking
and which could have harmful cultural effects if permitted to
continue. This was the primary concern of Paul Volcker in suggesting
the prohibition of such activity in US banks. (Paragraph 95)
8. The
Commission has not considered fully the ramifications and practical
issues of supplementing the proposed UK ring-fence with something
akin to the Volcker rule. The Commission intends to take further
evidence on this in the New Year. The Bill which the Government
will shortly introduce provides the appropriate vehicle for establishing
the future structural form of the UK banking industry. (Paragraph
96)
9. The
Commission will consider further the implications of introducing
a prohibition on groups containing a ring-fenced bank from engaging
in proprietary trading and, in particular, the contribution such
a prohibition could make to the changes needed to banking culture
and standards. The Commission expects to report in good time in
order that legislative effect to any recommendations can be given
as the Bill progresses. (Paragraph 97)
10. Measures
to tighten the regulation of UK banks beyond international norms
should be assessed for their potential to cause an unwelcome shift
of activity abroad. However, concerns about relocation of banks
may be over-stated. They should not be allowed to dominate the
decision on the measures necessary to remove the implicit guarantee
and ensure the banking system serves the UK economy. We will address
this in our final Report. (Paragraph 98)
Making banks more resolvable
11. A
guarantee, whether implicit or explicit, distorts incentives of
managers and creditors, encouraging them to pursue excessive risk
and leverage. It also distorts competition, and the allocation
of resources, away from smaller banks to those large enough to
be regarded as systemic. These problems are not removed simply
by limiting guarantees to ring-fenced banks. While ring-fenced
banks will carry out the majority of essential economic functions
which need protecting, it is important to be clear that it is
these functions that enjoy protection and not the bank itself
or its shareholders or creditors. There should be no government
guarantee of ring-fenced banks, nor perception of one. Neither
does ring-fencing mean that risks from non-ring-fenced banks can
be ignored, as such institutions will remain systemic and difficult
to resolve. The stated aim of public policy, endorsed by the Commission,
should be to reach a position in which a failing bank, whatever
side of the ring-fence it may be, can be resolved without risk
to financial stability or to public funds. The measures that we
have considered in this Report fall well short of fulfilling this
aim. The issues of banks which are 'too-big-to fail' and of investment
banks in whatever country whose failure would pose systemic risks
to the UK banking system are ones which will require further measures
and to which the Commission will return in the New Year. (Paragraph
104)
12. A
ring-fence alone does not make banks resolvable. Without wider
reforms, it is possible that a ring-fence would simply result
in one too-big-to-fail bank becoming two such banks, the failure
of either of which would require taxpayer support to avoid major
disruption. The resolution challenges of non-ring-fenced banks
in particular should not be ignored. Of the measures still needed
in order to make banks resolvable, ring-fencing and bail-in are
the two most important. The draft Bill seeks to deliver a ring-fence
and introduces some elements which will support bail-in, although
this tool is mostly being delivered through the EU Recovery and
Resolution Directive. (Paragraph 107)
Alignment with European initiatives
13. Compared
with other EU Member States, the banking sector represents a very
large part of the UK economy. It is important that measures to
strengthen the stability and resolvability of UK-based banks are
put in place on a timetable that best meets the need of UK public
policy. The UK cannot wait for or rely on appropriate implementation
of the Liikanen proposals. It is desirable to maximise compatibility
between the banking reforms to be enacted in the UK and the EU.
The task of obtaining agreement across twenty-seven countries
might also lead to a long delay in implementation. This could
create uncertainty for public policy and for banks. The Commission
has therefore concluded that the prospect of EU legislation arising
from the Liikanen proposals should not be a determining factor
in deciding upon the appropriate timetable for or substance of
UK legislation, which should be proceeded with on a timetable
that meets the needs of the UK economy. (Paragraph 111)
The Government's legislative approach
14. There
is a good case for placing technical detail in secondary rather
than primary legislation, in particular because of the importance
of "future proofing" to allow a flexible response to
developments in the banking sector. However, given the evidence
we received about past regulation being too much of a negotiation
between banks and regulators, we do not believe that too much
of the burden of defining the ring-fence should be left to regulators.
It is important that legislation properly equips the regulator
with the clarity and authority necessary to maintain the ring-fence.
The Commission is concerned that the heavy reliance on secondary
legislation leaves open too many questions of significant policy
importance. It would be unacceptable if the Commission's work
in considering the framework were not matched by adequate scrutiny
of the policy detail which follows in secondary legislation. This
is not simply a parliamentary issue; it matters most because it
creates uncertainty for the regulators who will be charged with
making the new framework operational and for the banks required
to operate within it. The Commission considers steps that could
be taken to address these concerns through changes to the primary
legislation in the next chapter. In the meantime, the Commission
welcomes the firm commitment of the Chancellor of the Exchequer
given in evidence to the Commission to "faithfully implement"
the relevant measures of the ICB Report, subject only to previously
identified exceptions. However, Parliament should not be expected
to rely on his assurances alone. It is for this reason that the
Commission makes specific recommendations about the timetable
for parliamentary consideration and scrutiny of the forthcoming
primary legislation and the accompanying draft secondary legislation.
(Paragraph 122)
15. The
absence of secondary legislation has seriously impeded the Commission
in discharging the task which we have been set by the two Houses
of Parliament. In view of the fact that the Treasury has been
committed to publishing the primary legislation to enable effect
to be given to the ring-fence since at least May 2012, the Commission
finds it regrettable that further thought was not given at an
earlier stage to the effects of the timing of draft secondary
legislation on the process of pre-legislative scrutiny and the
wider process of preparing for implementation. Without further
information about the secondary legislation, it is not possible
for this Commission to assess with any certainty how faithfully
the Bill will give effect to the ICB recommendations. The jury
is still out on the question of whether the Bill will implement
those recommendations in letter and spirit. (Paragraph 123)
16. The
Commission notes the commitment to publish the principal secondary
legislation in draft in time for the Commons Committee stage,
but considers it inadequate. The Commission strongly recommends
that the Government publish the principal secondary legislation
giving effect to the ring-fence at the time the Bill itself is
published. This is essential to provide a reasonable opportunity
for its consideration by regulators and by others directly affected,
as well as Parliament. In the absence of their views, parliamentary
consideration by relevant Committees and in the two Chambers will
inevitably be of very limited value. This would be unacceptable
in the case of legislation of such importance. (Paragraph 124)
17. The
Commission has not received evidence to call into question the
appropriateness of a 2019 deadline for full implementation of
the ring-fence. The extended timetable for implementation creates
a risk of erosion even before the ring-fence is first put in place.
This reinforces the need for a high level of transparency during
the implementation phase. In addition, the primary concern of
Government, Parliament, regulators and the affected institutions
should be on getting the new legislation right. The Commission
is not persuaded that immediate introduction of the primary legislation
and its passage through the two Houses on a normal timetable would
best serve this greater interest, given that much of the substance
will reside in secondary legislation which should be available
in draft. The Commission strongly recommends accordingly that,
if the Government proceeds with publication of the Bill before
the February 2013 half-term recess, there be a period of three
sitting months between the second reading of the Bill in the House
of Commons and the commencement of the Committee stage. The Commission
would expect a pause prior to Committee stage of at least two
sitting months even if the Bill is published later than mid-February.
(Paragraph 125)
Objectives in primary legislation
18. 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. (Paragraph 130)
19. 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. (Paragraph 131)
Regulatory judgement
20. 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. (Paragraph 133)
Conditions on the exercise of certain delegated
powers
21. 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:
- do not pose a risk to the continuity objective;
and
- provide a significant economic or financial stability
benefit. (Paragraph 135)
Determining the height of the ring-fence
22. 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. (Paragraph 139)
Scrutiny
23. 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. (Paragraph 146)
24. 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. (Paragraph 149)
25. 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. (Paragraph 151)
26. 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. (Paragraph
152)
Electrifying the ring-fence
27. 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.
(Paragraph 162)
28. 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. (Paragraph 163)
29. 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. (Paragraph 164)
30. 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. (Paragraph 165)
31. 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. (Paragraph 166)
32. 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. (Paragraph 171)
33. 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.
(Paragraph 172)
Derivatives
34. Allowing
ring-fenced banks to sell derivatives other than as an agent creates
additional prudential and conduct risks. There are genuine concerns
that this may lead over time to the sale by ring-fenced banks
of more complex and risky products. The larger and more complex
the derivative book, the more of a threat it could pose. (Paragraph
191)
35. The
effects on consumers of allowing or prohibiting certain derivatives
from being sold by ring-fenced banks as principal are uncertain.
Banks have argued that a prohibition would result in consumer
detriment, but selling derivatives to SMEs has been a highly profitable
activity for them and investigations of mis-selling of interest
rate swaps demonstrate the risk this poses to trust between banks
and their customers; if ring-fenced banks were limited in their
ability to provide these products directly it is plausible that
the wider market would evolve and that other providers would compete
to pick up the business to the benefit of consumers. The control
of the sale of derivatives to prevent mis-selling is a matter
of fundamental importance, to which the Commission will return
in the New Year, but it is far from evident that the use of a
structural solution (preventing ring-fenced banks from acting
as principal) would be the best tool to deal with this issue.
(Paragraph 192)
36. The
sale of derivatives within the ring-fence poses a risk to the
success of the ring-fence. The Commission has concluded that there
is a case in principle for permitting the sale of simple derivatives
within the ring-fence. However, such permission would need to
be subject to conditions. The first is that there are adequate
safeguards to prevent the mis-selling of derivative products within
the ring-fence, a matter to which the Commission will return in
the New Year. The second is that "simple" derivatives
can be defined in a way which is limited and durable, a matter
we consider in the next paragraph. The third is that there are
limits on the proportion of a bank's balance sheet which is allowed
to be taken up by these products. We remain concerned that allowing
these products within the ring-fence may be the thin end of a
wedge which could undermine the ring-fence. (Paragraph 193)
37. In
addition to the elements of a "simple" derivative already
identified by the Treasury, it is essential that there is a requirement
that the size, maturity and basis of simple products should be
limited to hedging the underlying client risk. The definition
of 'simple derivatives' must appear in legislation. The Commission
recommends that the proposed initial definition should be provided
to the Treasury Committee before the Bill has completed its Commons
stages. Whatever definition is chosen in the first instance, the
banks will argue, as certain banks argued to this Commission,
that customers would benefit from broadening the definition. For
this reason, the Commission recommends that the regulator be required
to report annually to Parliament on the extent and nature of the
sale of derivatives within the ring-fence, including the effects
of any changes to secondary legislation proposed by a future Government.
(Paragraph 194)
38. The
Government's proposals to limit the prudential risks arising from
derivatives activity, such as limiting net market exposure to
a small percentage of capital, are important and necessary. However,
this would not limit the absolute volume of derivative activity.
A large derivatives portfolio would still pose an unacceptable
risk to the stability and resolvability of ring-fenced banks,
even if it is supposedly hedged and collateralised. It could also
affect the culture of the bank in an undesirable way. The Commission
recommends accordingly that the Government impose an additional
cap on the gross volume of derivative sales for ring-fenced banks,
and on the total value of derivatives used for hedging. The Commission
would expect consultation to take place before determining how
a gross cap should be measured. (Paragraph 195)
The de minimis exemption
39. A
de minimis exemption from ring-fencing for smaller deposit-taking
institutions represents a sensible compromise between maintaining
financial stability and encouraging new entrants to the banking
industry. Although the level of the threshold is ultimately a
matter of judgement, the Commission recommends that the considerations
to be taken into account by the Chancellor of the Exchequer and
his successors in setting or varying the de minimis exemption
should appear on the face of the Bill. In addition to the factors
that we have recommended in relation to the general power under
proposed section 142A(2)(b) in paragraph 135, there should be
a specific requirement for a decision imposing or revising a de
minimis requirement to have regard to its effect on competition
in retail banking and on new entrants in the market in particular.
The Commission also recommends that the regulator be required
to report annually to Parliament on developments affecting the
appropriateness of the level of the de minimis requirement. (Paragraph
200)
The large deposit exemption
40. The
exemption for large deposits makes sense. It is right that holders
of large deposits should be required to make an informed decision
to hold their deposits in a non-retail bank. (Paragraph 203)
Geographical restrictions
41. The
Commission is broadly content with the Government's approach to
meeting the ICB's objective of effective geographic limits on
the business of ring-fenced banks. In pursuing this primary consideration,
however, consideration needs to be given to the effects of the
solution devised on UK banks' ability to support trade. It is
essential that full consideration is given to the repercussions
of the measures proposed. For this reason, the Commission recommends
that the Treasury undertakes a full separate consultation exercise
on the draft secondary legislation to give effect to geographical
restrictions and publish its findings two weeks prior to the House
of Commons report stage. The Commission also considers it essential
that, when the relevant secondary legislation comes into force,
the Treasury monitors and reports to Parliament on its assessment
of the trade-off between the direct intended effects of the limits
and the capacity of the banks to support trade. (Paragraph 209)
Retail and SME lending
42. The
Commission considers that it is right in the first instance not
to require banking groups with a ring-fenced entity to carry out
all lending for SME and retail customers within that entity. This
is a provisional conclusion, which should be subject to review
in the light of experience. There is a possibility that banking
groups will conduct their most profitable lending from outside
the ring-fence, where capital requirements will be lower and there
will be fewer restrictions on dividend payments, leaving less
profitable lending within the ring-fence. This could reduce the
commercial strength of the ring-fenced entity. It could also reduce
the transparency of the operation of the ring-fence. The Commission
recommended earlier that the regulator should monitor and publish
a statement on how the ring-fencing rules have been implemented
by the industry, with specific consideration being given to which
services are provided inside and outside the ring-fence. The Commission
has concluded that the development of retail and SME lending outside
the ring-fence is a matter for the regulator to monitor as part
of its work on this statement. (Paragraph 215)
Independence and governance of the ring-fenced
bank
43. There
is likely to be a tension between the integrity of the ring-fence
and the duties that directors of ring-fenced banks will owe to
the parent company and through them to shareholders. This tension
will be present regardless of the whether directors of the ring-fenced
bank are employed elsewhere in the group. It is not possible under
current company law to create a subsidiary which is entirely independent.
The Commission recommends that the Government insert within FSMA
a legal duty on boards of directors to preserve the integrity
of the ring-fence. (Paragraph 222)
44. The
Commission further recommends that the Government set out, in
its response to this Report, a full account of how directors would
be expected to manage the relationship between such a duty and
their duties to the shareholders. The Commission considers that
an element of conflict between the duties may be unavoidable,
and that this will constitute a permanent challenge for any structural
solution which falls short of full structural separation. (Paragraph
223)
45. In
the previous chapter, the Commission recommended that the core
minimum requirements for a ring-fence of adequate height should
be set out in secondary legislation subject to affirmative resolution
procedure, and not be the subject of regulatory discretion. The
Commission welcomes the Chancellor of the Exchequer's clear position
on the key elements that should be included to ensure the proper
independence of a ring-fenced bank. The Commission recommends
accordingly that the initial secondary legislation made under
proposed section 142H of FSMA (as envisaged in our recommendation
in paragraph 139) should give the regulator a duty of ensuring
operational independence for the ring-fenced bank in respect of
governance, risk management, treasury management, human resourcing,
capital and liquidity. (Paragraph 224)
Relationship between the ring-fenced bank and
the holding company
46. The
Commission found that the arguments for prohibiting a non-ring-fenced
bank from directly owning a ring-fenced bank are persuasive. This
is a clear and straightforward way to strengthen the ring-fence,
and is far better done at the outset. The Commission recommends
accordingly that the regulator be given the power to require a
sibling structure between a ring-fenced and non-ring-fenced bank,
with a holding company. The Commission would expect this power
to be exercised. (Paragraph 228)
Liabilities
47. The
Commission finds it disconcerting that the Treasury should raise
the possibility that the establishment of the ring-fence might
lead to the dissolution of a company and the cancellation of its
liabilities. The onus should not be on the regulator to prohibit
the dissolution of a company. Nor should the onus be on creditors
of a company to make a court application to restore the company
in order to meet obligations. The Commission recommends accordingly
that the regulator be required to set rules to ensure that the
creation of ring-fenced and non-ring-fenced entities is not used
as an opportunity to shift liabilities or potential liabilities
in an artificial way. (Paragraph 230)
Bail-in
48. 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.
(Paragraph 236)
49. 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. (Paragraph 242)
50. 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.
(Paragraph 245)
PLAC
51. 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.
(Paragraph 258)
52. 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. (Paragraph 262)
53. 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. (Paragraph
263)
Depositor preference
54. 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. (Paragraph
279)
Leverage ratios
55. 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. (Paragraph 294)
56. 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. (Paragraph 295)
57. 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. (Paragraph 296)
Fees to meet Treasury expenditure
58. The
Commission accepts the principle that those creating the risks
that need to be regulated should bear the costs of regulation,
including costs of cooperating with international authorities.
If provisions based on Clause 9 are included in the Bill, the
Commission considers it essential that the Clause be amended to
limit the levy to recovery of subscriptions rather than unspecified
expenses, so that the provision cannot be used by a future Government
to recover part of the Treasury's running costs, such as the salaries
of civil servants involved in this work. (Paragraph 300)
| 
