Banking Standards Joint Committee Contents

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)


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)


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)


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)


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)


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)

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Prepared 21 December 2012