Banking StandardsWritten evidence from the Financial Reporting Council

Summary and introduction

1.1 The Financial Reporting Council is an independent regulator responsible for conduct and standards setting in the fields of accounting audit, actuarial practice and corporate governance. As sponsor of both the UK Corporate Governance Code and the Stewardship Code we are charged with promoting high standards of governance across all sectors, including banking. One reason for the introduction of the Stewardship Code was to address the weaknesses in governance that contributed to the banking crisis.

1.2 Our response to the call for evidence makes three- main points:

While we recognise the need for tighter regulation of banks, it is important that this is not done in a way that puts up barriers to the further provision of capital. Making shareholder control rights less powerful and relevant would act as a disincentive to shareholders’ engagement and monitoring and limit their interest in providing additional capital.

Governance arrangements for ring fenced banks need to allow for accountability via the group to the ultimate shareholders. We believe this is best achieved by explicitly allowing the group to appoint the board of the ring-fence bank within the independence requirements and other parameters set out in the rules.

There needs to be more recognition of and debate about the risks to the investibility of banks from the provision of bail-in debt. The Commission is well placed to open discussion on the extent to which widespread use of bail-in debt would change the hierarchy of rights among all holders of bank capital, including its possible impact on control rights and the practicalities of using bail-in debt to remunerate bank executives.

Specific response

2.1 Our approach to banking is guided by the belief that regulation imposed in the wake of the banking crisis should not only make banks safer in systemic terms and therefore less at risk of requiring taxpayer support. It should also make them attractive to those with long term capital to invest. Unless they are able to attract new capital, they will not be able to support economic growth through lending to business.

2.2 Since most banks are now trading below book value, there is a problem with investibility. Ring fencing, which is primarily focused on the first objective, should be designed in a way which alleviates this problem, or at least does not aggravate it.

2.3 The Financial Reporting Council has a responsibility to promote good governance and this response is therefore focused on Question 17 of the call for evidence, which asked whether the governance arrangements will secure the independence of the ring fenced bank, and whether they are compatible with directors’ duties and accountability. Critical to good governance are the procedures for appointing the directors of the ring fenced bank and the need for a clear chain of accountability to the group shareholders who provide its capital.

2.4 The purpose of the ring fence, as we understand it, is to make it easier for the authorities to intervene effectively in times of trouble, to prevent losses in one part of the business contaminating the other, especially that part of the business which would require state support because of its systemic importance, and to be enable a bank to be resolved without affecting depositors and the operation of the payments system.

2.5 It should not be assumed, however, that the ring fenced banks will be intrinsically safer than the remainder of the group. Retail banks are periodically subject to large losses. Indeed property lending, which would be a legitimate activity for a ring fenced bank, was a significant reason for the collapse of Northern Rock, and HBOS.

2.6 In neither of these cases were there large losses from investment banking activities. Were such situation to arise again in a ring fenced bank, it is important that the authorities do have the option to orchestrate a recapitalisation via the market. This will be much harder if investors are being asked to put money into an organisation where they have no effective control rights. A ring fenced bank will also need access to capital in order to support its lending on a continuing basis.

2.7 However, the proposals, as they stand, do not properly recognise this point. The draft bill states that governance arrangements should secure as far as possible the ability of the ring-fenced bank to act independently of other members of the group. However, in its original proposals government envisaged that the ring-fenced bank should treat, and be treated by, other members of the group as a third party. It is to have a separate legal entity and meet capital and liquidity requirements on a standalone basis. Ring fenced banks should therefore have a separate board with a chairman who is independent on appointment. Half the members of the board must be independent, which means they may have no material relationship with the group. No more than one third of the board may be representatives of the rest of the group. There is a strong case, the government has argued, for ring-fenced banks having their own committees, in particular regarding risk and possibly nomination and remuneration.

2.8 We fear the market may be uncomfortable about the extent to which such procedures could divorce shareholders from the business which they would still own. If the board of the ring fenced bank is separate from the group and separately appointed, it cannot be accountable—directly or indirectly—to the shareholders of the group.

2.9 One of the generally accepted lessons from the banking crisis is the importance of shareholder engagement. This approach would move us a step backwards in terms of stewardship if it excludes any possibility of shareholder challenge and influence over the ring fenced bank.

2.10 The final arrangements therefore need to address important questions about the position of the ring-fenced bank within the group and the balance of regulatory powers with shareholder rights. Regulators already have the ability to veto the appointment of unsuitable individuals to board positions and to demand a certain level of capital. It is right that this should continue to apply within the ring fenced structure, but there does also need to be a clear line of accountability to shareholders who will wish to be satisfied that the ring-fenced bank complies with the overall group strategy and risk appetite.

2.11 We consider that the problem could be addressed by making it explicit that the group remains responsible for appointing the directors of the ring–fenced bank subject to both the FSA approval process and achieving the balance of independence laid down in the proposals. There are a number of examples in the financial services sector where similar arrangements already apply and groups have appointed independent directors to subsidiaries. In such cases the group board can be accountable to group shareholders for its stewardship of the subsidiary while still retaining an effective ring-fence.

2.12 The key to independent governance will be the composition of the board and a requirement on board members to act in the interests of the ring-fenced bank and protect the ring fence. These are reasonable duties, but the Companies Act 2006 also states (Section 172) that directors have a duty to promote the success of the company for the benefit of its members as a whole. This responsibility to shareholders cannot be ignored and must exist at least in tandem with duties of directors to support the ring fence. Otherwise the ring fenced bank would be operating in a vacuum, accountable to nobody, except perhaps the regulators.

2.13 Meanwhile Question 32 invites respondents to suggest other matters that the Commission should take into account. The Liikanen Report has proposed a greater use of bail-in debt to bolster bank capital. It has also suggested that it be used to remunerate bank executives. The Commission may wish to consider some governance issues arising from this.

2.14 First, it is expected that holders of bail-in debt will actively monitor and engage, but because they lack control rights, they have no effective power to influence management. Moreover the debt securities they are holding are likely to be substantially less liquid than equity shares, and debt holders therefore lack an orderly exit opportunity. The question therefore arises as to whether consideration should be given to the extension of some control rights to bail-in debt holders in proportion to the residual risk they are being asked to bear. This would be a highly controversial move and the FRC has no firm views on the issue at present. However, we believe this is one example of where more debate is needed on the consequences of using bail-in debt. The Commission is well placed to open up public debate on issues around the structural impact on bank capital, its effect on the hierarchy of capital and any accounting impact that would follow from the different choices that may eventually be taken.

2.15 Second, we note suggestions that the use of bail-in debt might make sense in remuneration because of the incentive it would place on bank executives to avoid reckless risks for short term gain. However, the high coupons attached to this debt might enable them to extract substantial amounts of cash before any crisis struck. As long as there is no active market for bail-in debt, the grants would be very hard to value. There is a risk that some executives would use this to mask excessive reward.

31 October 2012

Prepared 2nd January 2013