Banking StandardsWritten evidence from Davis Polk & Wardwell LLP

1. Introduction

1.1 Davis Polk & Wardwell LLP welcomes the opportunity to make this written response to the Parliamentary Commission on Banking Standards’ pre-legislative scrutiny of the Government’s draft Financial Services (Banking Reform) Bill.

1.2 We are a global law firm headquartered in New York and have long been involved in the policy debates surrounding the appropriate structures for the financial sector and individual institutions as well as the architecture of financial legislation and regulation.

1.3 Our current partners worked on many of the transactions, regulatory interpretations, and court cases involving the Glass-Steagall Act in the 1980s and 1990s and the repeal of certain portions of the Glass-Steagall Act by the Gramm-Leach-Bliley Act of 1999. Since the financial crisis, as part of our representation of many of the UK and US banks that were in difficulty, we have worked extensively on the Dodd-Frank Act and its implementing regulations, with an emphasis on the Volcker Rule; the enhanced capital, liquidity, risk management and other prudential standards designed to reduce the riskiness of the financial system while encouraging a healthy supply of credit, other financial products and services, job creation, and economic output; and the recovery and resolution planning of many US and foreign financial institutions.

1.4 Past partners who have left us their historical files, which we have recently had occasion to consult, advised the major US banks during the creation of the Federal Reserve in 1913 and the enactment in 1933 of the Glass-Steagall Act, the provisions that formed the core of what later became the Federal Deposit Insurance Act, and Section 23A of the Federal Reserve Act.

1.5 We have also recently advised clients on the final report of the UK Independent Commission on Banking (the Vickers Report) and the Government’s white paper response as well as on the final report of the High-level Expert Group on reforming the structure of the EU banking sector (the Liikanen Report).

1.6 In various capacities, we represent or have close contact with virtually all of the largest UK and US banks and bank holding companies and so bring both a historical perspective as well as our recent experience to the issues being considered by the Commission.

1.7 As the Commission will no doubt receive written evidence from many interested parties who are better placed to address many of your questions at a greater level of technical specification for UK law and regulation, we will focus our comments on the relevant lessons from the US experience that should be applicable to your considerations around adopting legislation to implement the Vickers recommendations.

2. Executive Summary

2.1 The retail ring-fence concept, if properly implemented, is a more effective, resilient, and workable structural arrangement than the Volcker Rule or the portions of the Glass-Steagall Act that were repealed and is more consistent with the rest of the Dodd-Frank Act and the portions of the Glass-Steagall Act and related provisions, such as Sections 23A and 23B of the Federal Reserve Act, that remain in effect.

2.2 Any ring-fence model should be implemented with regulatory flexibility. In the process of creating an entirely new system, it is not possible to anticipate all potential interactions and outcomes. Thus, building in flexibility for regulators is a prudent approach, as illustrated by the exclusion of commonly controlled insured banks from the numerical limits in Section 23A of the Federal Reserve Act and the effective use during the 2008 financial crisis of temporary waivers of the numerical limits that are otherwise applicable to transactions between insured banks and their nonbank affiliates.

2.3 The post-financial crisis experience in the US shows that implementing structural change, particularly drawing definitional lines, is much more difficult than anticipated and should be approached with a measure of caution and humility.

2.4 The new corporate governance arrangements that have been proposed for the ring-fenced bank and its wider group should be approached with some degree of regulatory flexibility. It may be instructive to consider the use of bank board committees consisting primarily or solely of independent directors to review and monitor group policies affecting the ring-fenced bank and transactions between the ring-fenced bank and other members of the group.

2.5 Regarding the intra-group restrictions proposed for the ring-fenced bank and its corporate group, a certain amount of regulatory flexibility should be built into the system. As a matter of public policy, rigid numerical limits should only apply to transactions between a ring-fenced bank and its nonbank affiliates; a more flexible standard should apply to transactions among commonly controlled retail banks and wholesale banks. In addition, regulatory authorities should have the discretion to provide a temporary waiver of any otherwise applicable numerical limits during a financial panic when ordinary markets are dysfunctional.

3. Key Principles and Recommendations

3.1 We would like to highlight three overarching principles that we believe are key considerations in relation to the draft Financial Services (Banking Reform) Bill and, indeed, any major piece of legislation that seeks to make radical changes to the structure of the financial sector. Our responses to certain of the specific questions set out by the Commission build upon these principles.

Principle 1: The retail ring-fence concept, if properly implemented, is superior to the Volcker Rule and the portions of the Glass-Steagall Act that were repealed and is more consistent with the rest of the Dodd-Frank Act and the portions of the Glass-Steagall Act and related provisions that remain in effect.

3.2 We believe that, if appropriately implemented, the retail ring-fence concept is a more effective, resilient, and workable structural arrangement than the Volcker Rule or the portions of the Glass-Steagall Act that were repealed and is more consistent with the rest of the Dodd-Frank Act and the portions of the Glass-Steagall Act and related provisions, such as Sections 23A and 23B of the Federal Reserve Act, that remain in effect.

3.3 The Glass-Steagall Act had two main effects:

(1)it prohibited US insured banks from underwriting, dealing, or market making in corporate debt and equity securities, while preserving their ability to:

(A)underwrite, deal, and market make in US government and agency securities and certain other securities, as well as financial instruments not considered to be securities for purposes of the US banking laws such as loans, collateralized debt obligations, and derivatives;

(B)buy and sell corporate debt and equity securities for bona fide hedging purposes, subject to certain conditions;

(C)act as an agent or riskless principal in securities brokerage transactions; and

(D)buy and sell high-grade corporate debt securities, provided that such buying and selling does not amount to dealing or market making in such securities; and

(2)it prohibited US insured banks from having affiliates that were “engaged principally” in underwriting, dealing, or market making in corporate securities.

The portion of the Glass-Steagall Act that prohibited insured banks (as opposed to securities affiliates) from underwriting, dealing, or market making in corporate debt or equity securities was not repealed by the Gramm-Leach-Bliley Act and remains in effect today. The portion of the Glass-Steagall Act that prohibited insured banks from having certain securities affiliates was repealed by the Gramm-Leach-Bliley Act of 1999.

3.4 Section 23A of the Federal Reserve Act complements the portion of the Glass-Steagall Act that remains in effect. It limited, and continues to limit, the ability of insured banks to enter into certain transactions with their affiliates, including their securities affiliates, to the extent that such transactions expose the banks to what is considered to be an excessive amount of the credit or certain other risks of their affiliates.

3.5 Section 23A is not a flat prohibition on all such risk-taking by US insured banks and never was. Instead, it attempts to limit such risk to a manageable level. It imposes both numerical limits and collateral requirements on exposures to nonbank affiliates. It also imposes a general “safety and soundness” requirement on exposures to all affiliates, including bank affiliates. The numerical limits include a limit on exposures to any single nonbank affiliate equal to 10% of the insured bank’s total capital and a limit on exposures to all nonbank affiliates in the aggregate equal to 20% of total capital. Credit exposures must be fully secured by high-quality collateral.

3.6 Section 23A permits the numerical limits to be waived in emergency situations, and they were temporarily waived during the 2008 financial crisis, subject to certain conditions, including that all such transactions be on market terms and all credit exposures be fully collateralized.

3.7 Section 23A does not (and never did) impose numerical limits or collateral requirements on transactions among insured banks that are commonly controlled at a level of 80% or more. Instead, exposures among such commonly controlled banks are subject only to the more flexible “safety and soundness” requirement. The safety and soundness requirement provides that all intra-group exposures be “consistent with safe and sound banking practices.”

3.8 Section 23B of the Federal Reserve Act was added in 1987 to supplement Section 23A. Section 23B requires that all covered transactions between an insured bank and its affiliates must be on market terms, rather than on terms that represent a discount to market.

3.9 The justification for the prohibition on certain activities of insured banks in the portion of the Glass-Steagall Act still in effect and the limits on their transactions with nonbank affiliates in Sections 23A and 23B of the Federal Reserve Act is that insured banks enjoy a federal subsidy in the form of deposit insurance and general access to the Federal Reserve’s lender-of-last-resort liquidity facilities. The quid pro quo for this federal subsidy are these and other restrictions on activities, which are designed to reduce insured banks’ risk of failure.

3.10 Setting aside the Volcker Rule for a moment, the Dodd-Frank Act is designed to enhance and be entirely consistent with this statutory framework. Its general theme is that, in addition to the special limitations on the activities of insured banks, all financial institutions, regardless of their charter, should be subject to the same limitations and requirements to the extent that they engage in the same activities, with certain exceptions for activities taking place outside the United States.

3.11 Thus, for example, all financial institutions are subject to the same rules and regulations if they engage in swap dealing activities or such a large volume of swap transactions that they are considered major swap participants. It does not matter whether they are chartered as banks, broker-dealers, insurance companies, hedge funds, commodity pool operators, or any other type of financial institution. If they are engaged in the defined activity or the defined volume of activity, they are subject to the same regulations.

3.12 This general theme of the Dodd-Frank Act is subject to an important exception for financial institutions that are deemed by statute or determined by regulators to be “systemically important.” Systemically important financial institutions (SIFIs) are subject to enhanced capital, liquidity, risk-management, and other enhanced prudential standards. However, the Dodd-Frank Act mandates that all SIFIs be subject to the same rules, regardless of their charter, with some flexibility for SIFIs that are less systemically important than others.

3.13 The Dodd-Frank Act generally contemplates that US financial regulators will calibrate the required capital, liquidity, risk-management, and other prudential standards to the relative riskiness of particular activities, regardless of a financial institution’s charter. Thus, riskier activities will require more capital and liquidity and better risk management, regardless of the institution’s charter. Conversely, less risky activities will require less capital and liquidity and less stringent risk management. This framework gives regulators the flexibility to balance the costs and benefits of particular financial regulations—for example, the benefits of a safer financial system against the costs of credit contraction, reduced economic output, and higher unemployment.

3.14 The Volcker Rule was grafted onto the Dodd-Frank Act at the last minute, without sufficient discussion or debate. It is both broader and narrower than the Glass-Steagall Act and is inconsistent with the overall theme of the rest of the Dodd-Frank Act.

3.15 The Volcker Rule is narrower than the Glass-Steagall Act because it does not affect the ability of insured banks to continue having affiliates that are engaged in underwriting, dealing, or market making in corporate securities, except to the extent any such activities amount to short-term “proprietary trading” or investing in hedge funds or private equity funds.

3.16 The Volcker Rule is broader than the Glass-Steagall Act because it flatly prohibits both insured banks and all of their affiliates from engaging in short-term proprietary trading or investing in or having certain relationships with hedge funds or private equity funds. At the same time, it expressly permits insured banks and their affiliates to continue engaging in proprietary trading of US government and agency securities and to continue engaging in otherwise permitted market making and hedging.

3.17 The Volcker Rule is also inconsistent with the general theme of the rest of the Dodd-Frank Act that the activities of all financial institutions should be subject to the same regulation, regardless of their type of charter. Instead, the Volcker Rule applies only to insured banks and their affiliates. It does not apply to other financial institutions unless they are affiliated with an insured bank. These other financial institutions are free to engage in the activities prohibited by the Volcker Rule, regardless of how much systemic risk they impose on the financial system as a result of those activities.

3.18 In addition, the Volcker Rule flatly prohibits some activities—for example, trading in certain highly liquid securities, such as UK and certain other sovereign debt securities or exchange-traded corporate equity securities—even if those activities are safer than certain activities that are permissible under the Volcker Rule. For example, the Volcker Rule does not prohibit banks from making any sort of loans, even though certain types of lending can be far riskier than certain types of short-term proprietary trading. Nor does it impose any restrictions on the ability of insured banks or their affiliates to make long-term investments in any type of securities or other financial instruments, including illiquid securities, mortgage-backed securities, collateralized debt obligations, or credit default swaps, even if such long-term investments are riskier than short-term proprietary trading in such instruments, so long as these long-term investments are not made through a hedge fund or private equity fund and the instruments are not traded with sufficient frequency or intent to amount to short-term proprietary trading.

3.19 The Volcker Rule has proven to be extremely difficult to implement in a way that would not destabilize existing markets or adversely affect the ability of banking entities to manage risk effectively. As a result, the US financial regulatory agencies have been unable to agree upon final implementing regulations despite a statutory deadline of October 2011.

3.20 US regulators have had a particularly difficult time writing regulations that provide a coherent line between short-term proprietary trading, which is expressly prohibited, and market making or hedging, which are expressly permitted. Several governments around the world, including the UK Government, have submitted public comments to the effect that, unless the implementing regulations include a safe harbor for proprietary trading or market making in high-grade sovereign debt securities, the Volcker Rule could disrupt the market in their sovereign debt securities, substantially reducing the liquidity in the market for such securities.

3.21 Numerous other commenters have argued that the lack of robust safe harbors for market making and hedging could destabilize the securities markets generally and have a significant adverse effect on the ability of banking entities to manage risk effectively.

3.22 Proponents of the Volcker Rule typically justify its prohibitions on the ground that US insured banks enjoy the implicit subsidy of deposit insurance and regular access to the Federal Reserve’s lender-of-last-resort liquidity facilities. As a result, they argue that insured banks should not be permitted to engage in short-term proprietary trading or investing or to have certain relationships with hedge funds or private equity funds.

3.23 The problem with this argument is that it only provides a justification for applying the Volcker Rule to insured banks. It does not provide any support for extending the Volcker Rule to an insured bank’s nonbank affiliates. Those affiliates do not enjoy any federal subsidy because they are not permitted to take insured deposits and do not have regular access to the Federal Reserve’s lender-of-last-resort liquidity facilities. Moreover, Sections 23A and 23B of the Federal Reserve Act are specifically designed to prevent insured banks from passing on any material federal subsidy to their nonbank affiliates.

3.24 While the ring-fence concept is not without its shortcomings, we believe that it is a more effective, resilient, and workable structural arrangement than the Volcker Rule or the portions of the Glass-Steagall Act that were repealed and that it is more consistent with the rest of the Dodd-Frank Act and the portions of the Glass-Steagall Act and related provisions, such as Sections 23A and 23B of the Federal Reserve Act, that remain in effect.

3.25 Like the portions of the Glass-Steagall Act that remain in effect, the ring-fence proposal would impose certain activities restrictions on UK retail banks, including a prohibition on proprietary trading, which are designed to reduce their risk of failure. Like Section 23A of the Federal Reserve Act, the UK proposal would also impose limits on the ability of retail banks to enter into certain transactions with their affiliates, although we believe it should be more flexible than proposed for the reasons stated below. Like Section 23B of the Federal Reserve Act, the UK proposal would require all such covered transactions to be on market terms, rather than at a discount to market. The UK proposal would also impose special capital and corporate governance requirements that would further insulate UK retail banks from the risks of their affiliates, although we recommend below that more flexibility be built into such requirements. While the distinction in the UK will be between retail banks and other financial institutions (including wholesale banks), rather than between insured banks and nonbank affiliates, the intent and effect will be similar.

3.26 Unlike the Volcker Rule, the UK proposal would not require the sort of line-drawing between short-term proprietary trading, on the one hand, and market making or hedging, on the other, that has created so many problems for the US regulatory authorities. Like the portion of the Glass-Steagall Act that is still in effect, it would prohibit UK retail banks from engaging in both proprietary trading and market making and provide more regulatory flexibility to distinguish between these activities and permissible hedging. It would not prohibit the wholesale affiliates of a UK retail bank from engaging in proprietary trading, market making, or hedging.

3.27 There is a risk, however, that a ring-fence may be implemented in too strict or rigid a manner or in such a way as to make it difficult to attract capital to the wholesale affiliates. We therefore think that any ring-fence should be implemented following the two principles we suggest below: flexibility and a healthy humility about the difficulty of implementing structural change.

Principle 2: Importance of incorporating flexibility into structural change.

3.28 In the process of creating an entirely new system, it is not possible to anticipate all potential interactions and outcomes; thus, contrary to Chairman Volcker’s recent testimony, we believe that building in regulatory flexibility is a prudent approach.

3.29 Although promising, the concept of the ring-fenced bank is entirely new in the UK and the EU and is untested in practice. Its implementation also comes at a time when other major elements of financial regulation in the UK, EU, and US are being materially changed and are in flux.

3.30 Moreover, the shift to the ring-fenced bank will occur mid-stream, amid the full and regular functioning of global capital markets. In contrast, major US banks had already stopped securities underwriting when the Glass-Steagall Act was first implemented in the depths of the Great Depression. Similarly, the structural foundation for the partial repeal of the Glass-Steagall Act by the Gramm-Leach-Bliley Act of 1999 was established slowly and well in advance. In the current situation, however, there will be no such luxury of a pause in the marketplace or the benefit of a gradual, ongoing development of such a structural shift.

3.31 We believe the importance of regulatory flexibility is well illustrated by the US experience during the last financial crisis with temporary waivers of the numerical limits in Section 23A of the Federal Reserve Act that would otherwise have applied to transactions between insured banks and their nonbank affiliates. We discuss this example of flexibility in further detail in response to Question 18.

3.32 Although there are rightful concerns about regulatory and cognitive capture, creating a new structural framework without significant regulatory flexibility is equally unwise, especially given all of the possible unintended consequences. We therefore recommend that as much flexibility as possible be given to the Treasury, the Prudential Regulation Authority, and the Financial Conduct Authority, with a recognition that “[t]here are known knowns … We also know there are known unknowns … But there are also unknown unknowns” (Rumsfeld). Flexibility is an indispensable tool for dealing with the “unknown unknowns” of the ring-fence model or any other significant change in the structure of financial institutions and their regulation.

Principle 3: Recognition of the difficulty of implementing structural change.

3.33 The post-financial crisis experience in the US shows that implementing structural change, particularly drawing definitional lines, is much more difficult than anticipated and should be approached with a measure of caution and humility.

3.34 By now it is well-known that the implementation of many of the changes mandated by the Dodd-Frank Act is taking far longer than anticipated. Out of a total of 237 Dodd-Frank rulemaking requirement deadlines that had passed as of October 1, 2012, regulators had missed 149 deadlines, or approximately 63%, according to Davis Polk’s October 2012 Dodd-Frank Progress Report.

3.35 Ascribing these delays and difficulties only to regulatory advocacy by the banking sector or other stakeholders is not credible. Nor is it appropriate to blame the regulators for taking more time than the legislature initially contemplated once it became clear that implementation was more difficult than envisioned.

3.36 Major structural change in the banking sector is extremely challenging and getting it wrong can disrupt economic recovery.

3.37 It is not a surprise, for example, that the Volcker Rule and its proposed regulations are running far behind schedule. Notwithstanding the simplicity that Chairman Volcker has ascribed to his rule, it has proven very difficult to draw lines around the concepts of short-term proprietary trading and market making in order to distinguish prohibited from permitted transactions as required by the Volcker Rule’s transaction-focused approach.

4. Question 14: Is the range of core and excluded activities defined in the draft Bill appropriate and sufficiently broad? Are the Government’s stated intentions for using powers to define further core and excluded activities appropriate?

4.1 Please see our core principles outlined above, in which we suggest that built-in regulatory flexibility is appropriate, especially in light of the fact that implementing structural change takes far longer than anticipated. We believe it is appropriate to begin with retail deposits as the sole core activity, but regulatory flexibility may be needed over time.

5. Question 17: Are the proposed corporate governance arrangements between the ring-fenced bank and the wider group sufficient to ensure the independence of the ring-fenced bank? Are these arrangements compatible with directors’ duties and principles of accountability?

5.1 Based on the US experience, we believe it would be wise to approach these new corporate governance arrangements with some degree of regulatory flexibility. We do not believe that establishing separate, independent boards at the holding company, the ring-fenced bank, and the non-ring-fenced bank will be conducive to effective management of what will remain integrated groups from both a financial reporting and a market perspective. It may be better to consider alternatives, such as including some independent board members, rather than a majority, on the ring-fenced bank’s board of directors.

5.2 In the post-financial crisis US, supervisors have engaged in informal efforts to strengthen the quality of board members at the largest bank holding companies and banks. At the subsidiary bank level, there are specific regulatory requirements for independent directors to be represented on a bank’s audit committee. Depending on the size of the bank, the audit committee may be required to consist solely of independent directors or to have a majority of independent directors. It is not generally the case, however, for the full boards of bank holding companies or banks to have a majority of independent directors. Moreover, it is neither a requirement nor customary business practice for nonbank affiliates, such as broker-dealers, to have independent board members.

5.3 If a ring-fenced bank is part of a larger banking or financial group, we do not think it is realistic for the board of directors of that bank to be fully independent of the parent company of the group. In the US, the regulatory expectations for the board of directors of a bank that is part of a larger banking or financial group include, as part of fulfilling the board’s duty of loyalty to the bank, the protection of the bank in its dealings with the rest of the group. To that end, a bank’s board must review bank holding company policies that affect the bank to ensure they are appropriate for the bank and must carefully monitor transactions between the bank and its nonbanking affiliates, including the payment of dividends to the parent company, extensions of credit, and purchases of assets. Discharging these obligations may be facilitated by providing for a bank board committee, such as the audit committee or a risk committee, of which independent directors are either the only members or a majority of the members, to be primarily responsible for reviewing and monitoring such transactions and policies.

5.4 An alternative to requiring full independence of a bank subsidiary board is to require directors of an insured bank to take into consideration the interests of stakeholders other than shareholders in discharging their duties. This is, in fact, the approach generally taken with respect to the duties of the directors of insured banks in the United States. For most US companies incorporated under Delaware law, directors’ duties focus on the best interests of the corporation and its shareholders. However, it has long been the position of the Office of the Comptroller of the Currency, which is the federal chartering authority and primary federal banking supervisor for national banks (which include the largest US banks), that the directors of an insured bank owe duties not only to the bank and its shareholders, but to a range of other stakeholders, including insured depositors. Similarly, the banking law of New York state, under which many major state-chartered banks are chartered, specifically provides that bank directors may take into account various constituencies and factors, including the bank’s customers, its creditors, and its ability to continue to provide services to the communities in which it does business.

6. Question 18: How appropriate are the proposed restrictions on exposures and operational dependencies between the ring-fenced bank and the rest of the group? Will these result in a sufficient degree of independence and resilience?

6.1 Once a country moves to a system that separates a protected banking entity—i.e., the insured bank in the US and the ring-fenced bank in the UK—from its affiliates and limits the powers and activities of each on the policy basis that the protected entity needs to be separated and insulated from activities deemed to be riskier and appropriate only for the affiliate, it is a necessary corollary that there must be a system of principles and rules governing the relationships among the affiliates.

6.2 In the US, we view the core purpose of such rules as designed to protect the insured bank from being exposed to an excessive amount of the credit and other risks of its affiliates, especially its nonbank affiliates, and to prevent insured banks from passing on any material federal subsidy to their nonbank affiliates.

6.3 The proposed UK intra-group restrictions are also focused on the goal of protecting the ring-fenced retail bank from being exposed to an excessive amount of the credit and other risks of its wholesale bank and nonbank affiliates.

6.4 Although the UK intra-group numerical limits of 25% of a ring-fenced bank’s total capital appear to be somewhat less restrictive than the numerical limits in Section 23A of the Federal Reserve Act, we believe that they could turn out to be unduly restrictive under certain circumstances unless they are limited to transactions between a ring-fenced bank and its nonbank affiliates and some flexibility is built in for waivers during financial panics when ordinary markets are dysfunctional.

6.5 As noted above, the numerical limits in Section 23A have never applied to transactions among FDIC-insured banks that are commonly controlled at an 80% or more level, even if one of the insured bank affiliates engages in riskier activities than the others, such as riskier lending activities or underwriting, dealing, or market making in financial instruments not considered to be securities for purposes of the US banking laws, including loans, collateralized debt obligations, or derivatives. Instead, transactions between such commonly controlled insured banks are subject only to a more flexible safety and soundness requirement. This more flexible approach for transactions between commonly controlled insured banks has worked well since 1933, including during the financial crisis of 2008.

6.6 We believe that such a flexible standard is more appropriate for controlling the exposures of ring-fenced retail banks to the credit or other risks of wholesale bank affiliates. Under such a standard, numerical limits would be permitted but not required. Instead, the main tools for limiting the exposures of ring-fenced retail banks to their wholesale bank affiliates would be appropriate collateral requirements as well as requirements that transactions be made on market terms, rather than at a discount to the market.

6.7 We also believe that UK regulatory authorities should have the flexibility to waive any numerical limits when appropriate, including during financial panics when ordinary markets are dysfunctional. During the 2008 financial crisis, for example, when the broker-dealer affiliates of the largest US insured banks suffered a run on their short-term repo financing and otherwise encountered severe liquidity difficulties, the Federal Reserve granted temporary waivers to the numerical limits in Section 23A, allowing insured banks to make fully secured liquidity available to their affiliated broker-dealers on market terms in excess of the normal intra-group numerical limits. These liquidity facilities were repaid without losses.

6.8 Although the Dodd-Frank Act imposed additional conditions on such exemptions (i.e., they can no longer be granted unilaterally by the Federal Reserve, but must be found by multiple regulators to be “in the public interest” and consistent with the purposes of Section 23A and are subject to veto by the FDIC), it nonetheless retained an explicit process for waiving the limits in certain circumstances. The UK proposal, on the other hand, does not explicitly provide for any sort of safety valve mechanism to temporarily lift the intra-group numerical restrictions when the financial system is in distress.

6.9 Our strong recommendation is that a waiver authority, which should involve an appropriate process and safety backstops, is necessary and should be set out in any subsequent legislation.

6.10 We believe that the waiver mechanism also should permit other members of the corporate group outside the ring-fence to provide assistance to the ring-fenced bank in a period of stress. If the ring-fenced entity finds itself in trouble and the parent company or an affiliate has the capacity to provide assistance, as a matter of public policy, the “independence” requirements of the ring-fence model should not preclude those entities outside the ring-fence from offering assistance to the struggling ring-fenced bank.

7. Question 19: Will it be possible to effectively monitor and police the ring-fence, given the degree of regulatory discretion the draft Bill proposes?

7.1 Please see our comments on flexibility above.

8. Question 23: The draft Bill gives the Government power to direct the way in which the regulators can implement loss-absorbency requirements. How appropriate and well-designed is this power?

8.1 Please see our comments on flexibility above.

9. Question 30: What will be the impact of the proposals on the international competitiveness of UK banks?

9.1 To maintain the competitiveness of UK-based banks and the City, the ring-fence model must be structured and implemented with as much flexibility and attention to international coordination and harmonization as possible.

10. Question 31: Are the proposals consistent with existing and forthcoming international and EU regulatory initiatives, for example the recent Liikanen Report? To what extent are they likely to be superseded or generate conflicts?

10.1 The UK proposal, the Liikanen proposal, and the Volcker Rule (both in its statutory form and under proposed regulations) all aim to achieve the same general policy goals: changing the culture of banking, separating higher-risk activities from an insured bank, and aiming to avoid taxpayer funding of the banking sector in the next financial crisis.

10.2 Agreement on goals, however, has not led to agreement on the architecture of financial regulation to achieve these goals. We urge the Commission not to be swayed by reports in the media or the diplomatic statements of some policymakers who say that the retail ring-fence proposals are overwhelmingly similar to the Volcker Rule or a return to the Glass-Steagall Act.

10.3 As we have discussed above, there are major differences among the retail ring-fence models and the Volcker Rule that exist at a fundamental level and not merely in the sense that “the devil is in the details.” The outlier, however, is the Volcker Rule, which, as explained above, sits uneasily within the Dodd-Frank Act’s larger framework and will coexist even more uneasily with the retail ring-fence models.

31 October 2012

Prepared 2nd January 2013