Banking StandardsWriten evidence from the Financial Services Authority

1. The Parliamentary Commission on Banking Standards’ scrutiny of the draft Banking Reform Bill provides an important opportunity to debate the major reforms proposed in that Bill and ensure that it is as robust as possible in making the necessary reforms to the banking sector. We welcome the opportunity to submit this Memorandum, which addresses several of the issues raised in the Parliamentary Commission’s Terms of Reference.

2. We strongly support the Government’s objectives as set out in the policy document accompanying the draft Bill (Sound banking: delivering reform). Our submission covers the following areas:

Objectives and general approach.

Delegated powers and accountability.

The ring-fence.

Capital levels.

Executive Summary

A. Objectives and general approach

3. The draft Bill and accompanying secondary legislation should establish clear objectives that set out exactly what the draft Bill intends to achieve and create an accessible regime that is easily understood by all relevant stakeholders including regulators and firms.

4. The draft Bill should clearly set out how the Prudential Regulation Authority’s (PRA) statutory objectives interact and their hierarchy.

5. It should also provide the necessary powers to ensure the appropriate degree of separation between the Ring-Fenced Bank (RFB) group and the rest of the group.

B. Delegated powers and accountability

6. There should be clarity in the draft Bill and accompanying secondary legislation setting out the division of responsibility between HM Treasury (the Treasury) and the regulators. We agree with the Government that legislation should set out which activities are to be undertaken within RFBs, and which are to be prohibited or excluded. These are fundamentally social and economic issues, and are therefore rightly a matter for Government and Parliament. We also agree with the Government that it is for the PRA to ensure the appropriate degree of separation between the RFB and the non-Ring Fenced Bank (NRFB) based upon the objectives set out in legislation.

7. We do not believe it is desirable for the Financial Conduct Authority (FCA) to be given a continuity objective when the only core activity is the acceptance of deposits (and services related to deposit-taking).

8. It would be difficult for the FCA to fulfil this new objective considering its limited regulatory remit over the core services and the relevant RFBs that carry out such services. Giving the FCA an additional objective that encompasses matters and institutions it will have little direct oversight of (except from a conduct perspective), runs the risk of obscuring the FCA’s purpose, remit, and its strategic and operational objectives.

C. The ring-fence

9. The draft Bill and accompanying secondary legislation should give rise to RFBs with a coherent set of assets and liabilities. This should be wide enough to include all of the critical banking services that must be continued in a resolution scenario, and removes incentives for taxpayers to support NRFBs in times of stress. The PRA should be empowered to ensure RFBs meet this public interest test.

D. Capital levels

10. Firms should be required to have sufficient loss-absorbency to enable the authorities to execute their preferred resolution strategy and reduce the risk of public authorities having to provide financial support where a bank is under stress.

11. We agree with the Government that banks should be required to hold sufficient loss-absorbing capacity to ensure that they are more resilient against failure and that, if they do fail, losses can be borne by their shareholders and uninsured unsecured creditors.

12. We consider that loss-absorbing capacity should apply on a whole group basis, with the ability to exempt non-EEA subsidiaries from the loss-absorbency requirement only if certain conditions are met. For example, the group will need to demonstrate to the UK authorities that its UK operations are sufficiently ring-fenced from its overseas entities. They will need to take into account financial, operational and managerial interdependencies, so that the overseas operations can be resolved in a manner that will not pose a risk to financial stability in the EEA.

13. We support the Government in delivering the majority of the Independent Commission on Banking’s (ICB) loss-absorbency proposals through the negotiation of relevant European Directives.

A. Objectives and general approach

Timetable

14. We welcome the Government’s commitment to ensure that all the required legislation is in place by 2015. We agree with the Government that banks should be compliant with the requirements of the legislation by 2019. A shorter timeline could increase the implementation risks associated with such wide-ranging reform.

Objectives of the draft Bill

15. We strongly support the Government’s objectives as set out in the policy document accompanying the draft Bill (Sound banking: delivering reform) to:

make banks better able to absorb losses;

make it easier and less costly to sort out banks that still get into trouble; and

curb incentives for excessive risk-taking.

16. However, we are concerned that the enabling nature of the draft Bill makes it difficult to assess whether or not these objectives will be met. That will, in large part, be dependent on how the delegated powers in the draft Bill are exercised by the Treasury and the PRA. To help ensure that the Government’s objectives are met, we believe there is value in specifying them in the draft Bill to provide clarity on how the Treasury and the PRA should exercise their delegated powers. This would necessarily involve broadening out the matters the Treasury and the PRA would need to consider when using their delegated powers. These are currently narrowly focused on the continuity of the provision of core services in the UK. This by itself does not meet the broader objectives intended by the Government.1

17. Spelling out the objectives of the reforms in the draft Bill in this way would provide clarity for the Treasury and the PRA when exercising their delegated powers. It would have the broader benefits of both providing clarity to firms and regulators over what the draft Bill is intended to achieve and also should help avoid the dilution of the reform objectives over time.

18. One option for articulating these objectives in the draft Bill would be to add a provision similar to that in section 4 of the Banking Act 2009, which requires the authorities to have regard to the special resolution objectives when using or considering the use of particular powers.

19. We would welcome the Committee considering whether such an approach to the architecture of the Bill might deliver an assurance that the objectives of the reforms will be achieved.

PRA statutory objectives

20. We agree with the Government that, in the majority of cases that the PRA will confront, the proposed continuity objective will not create problems of inconsistency with the safety and soundness objective.

21. However, it is not inconceivable to imagine situations where this might not be the case, for instance, in times of stress. It is, therefore important that the draft bill builds on the clarity of purpose and remit that the Financial Services Bill has given to the PRA, and sets out in a clear and transparent manner how the PRA statutory objectives (including those we propose above) are to interact and spells out their hierarchy.

Powers in the draft Bill

22. To ensure that the draft Bill provides enough powers to enable the Government’s proposals on ring-fencing and loss-absorbency to be properly implemented, we consider that the draft Bill should go further in providing for:

powers over financial holding companies incorporated in the UK; and

prohibitions on ownership structures.

Powers over financial holding companies incorporated in the UK

23. In our view it is necessary for the PRA to have a power to make rules over UK-incorporated financial holding companies in order to ensure the proposed reforms can achieve their aims, particularly in ensuring the structural separation of the RFB from the NRFB.

24. To date, when it has been necessary to take action on unregulated holding companies (such as when implementing European Directive requirements on consolidated capital and group supervision), we have been obliged to take action through the regulated subsidiary. This involved requiring the regulated subsidiary to “ensure” that its parent took the necessary action, even though the regulated subsidiary had no power over its parent. This limitation leaves the FSA in a very weak position to enforce group-level requirements.

25. The Financial Services Bill, in proposed section 19, provides a new power of direction over holding companies. It can be exercised only if the acts or omissions of the holding company in question are having, or may have, a material adverse effect on the PRA’s regulation of an authorised firm in the holding company’s group. Furthermore, in deciding whether to give a direction, the PRA must have regard to both the desirability of exercising its powers over the authorised firm rather than the holding company, as well as to the principle of proportionality.

26. As such, the bar to the power’s use is very high, making its proactive use in the absence of a clear and immediate detriment problematic. Additionally, it is not a power to make rules. To effect the same requirement on all RFBs’ holding companies would require a direction in each individual case, each of which would be open to challenge, unlike a rule that would be of general application and cannot be challenged in this way.

27. In this context such a limited power is inadequate to the task of forcing the change to banking groups’ corporate and financial structure necessary to ensure that the Government’s objectives for banking reform are met. In particular, the PRA should have a power to make rules over financial holding companies incorporated in the UK to enable it to:

ensure that the debt instruments necessary to absorb losses are issued by the appropriate entity within the group; and

supervise the RFB and NRFB in the most effective way possible.

Loss-absorbing capacity and unregulated holding companies

28. The draft Bill2 would enable the Treasury to require the PRA to use its powers to require entities in a group that contain a RFB to issue debt instruments to create loss-absorbing capacity. This provision would not create any new power to enforce the Treasury mandate but would have to be fulfilled within the limits of the PRA’s existing powers. In respect of an unregulated holding company, our capacity to force the necessary change would be limited to the proposed power of direction in the Financial Services Bill. We do not consider this to be adequate. To ensure that the debt instruments issued by the holding company create the necessary loss-absorbing capacity, the PRA would, on an on-going basis, need the power to:

impose rules on the holding company as issuing entity as to the terms and amount of the relevant debt instruments;

ensure compliance with those requirements; and

enforce against breaches directly at the holding company level.

29. We note that the IMF has reported on the lack of appropriate regulatory reach that the FSA has over financial holding companies.3 Ring-fencing will make this weakness in the UK regulatory regime even more acute.

30. We have set out below an illustration of how we might use a rule making power over financial holding companies on loss-absorbency requirements. The debt instruments necessary to meet the loss-absorbing capacity requirements of an RFB could be issued externally to the market from its parent entity (i.e., the highest entity within the RFB group). The debt instruments necessary to meet the loss-absorbing capacity requirements of an NRFB could be issued externally to the market from its parent entity (ie, the highest entity within the non-RFB group), with some flexibility for it to be issued higher up in the broader group structure (such as from the ultimate group holding company) if appropriate.

31. A benefit of this approach, in contrast to generating all of the loss-absorbing capacity out of the ultimate holding company, would be to create differentiated wholesale funding costs for the RFBs and the NRFBs in line with their respective risk profiles. This is important for effectively imposing market discipline.

32. The advantage of this structure from a resolution perspective is that the RFB is better firewalled from the NRFB. It also makes separate resolution of the RFB and NRFB less challenging than if the RFB was a subsidiary of the NRFB.

Effective group supervision and unregulated holding companies as a “source of strength”

33. In the scenario outlined above, the financial holding company would act as an effective firewall between the two parts of the group. To achieve this, the PRA may need to exercise appropriate leverage directly over the holding company if, for example, we need to require channelling of group resources towards the RFB to ensure that the PRA’s continuity objective is achieved. We note that in the US, where bank holding companies are regulated by the Federal Reserve, they are required to act as a “source of strength” for depository institutions that they own. Supervisory powers over holding companies would be required if there were a desire that the holding company acts as a “source of strength” to a RFB.

34. The debt issuance strategy described above would not prevent the ultimate holding company from acting as a “source of strength” to the RFB and downstreaming capital to support the RFB when required. An important feature of such a regime would be the flexibility for exercising any future bail-in tool at the appropriate level in the group, not only at the ultimate group holding company level but also at the level of any intermediate holding company. This flexibility would maintain consistency with the structure of the European Commission’s proposed Recovery and Resolution Directive.4

Ownership structures

35. As we have set out, to ensure that that RFB remains sufficiently independent of the NRFB, the legislation should require that banks should have a group structure where the RFB group and the NRFB group are directly owned by a holding company. While we support the delegated powers in the draft Bill that would allow the Treasury or the PRA to prevent RFBs from owning NRFBs, in our view the draft Bill should also give the Treasury or the PRA the delegated power to expressly prohibit NRFBs from owning RFBs.

36. The ownership structure we are proposing (illustrated in paragraph 30) would ensure consistency with the ICB’s independence principle that states that the relationship between the NRFB and the RFB should be on an arms length third-party basis. Allowing an NRFB to own an RFB would permit a parent-subsidiary relation based on control, which would contradict this principle. Business conducted by the RFB can be reasonably isolated from the NRFB through regulation when both companies are subsidiaries of a holding company. However, it is much harder to do in a parent-subsidiary structure where the NRFB owns the RFB.

37. An ownership structure of this type would:

Enable the authorities to deploy different resolution tools to the RFB group and the NRFB should they wish to.

Ensure that the potential for contagion spreading from the NRFB group to the RFB group is reduced with the ultimate holding company acting as a firewall between them.

Help instil market perceptions of credible separation between RFBs and NRFBs.

38. In its October 2012 report, the Liikanen High-level Expert Group on reforming the structure of the EU banking sector set out its view on ownership structures. It recommended that banking groups should be structured so that holding companies own the trading entities and other bank entities. The report stated that trading entities (NRFBs) should neither own or be owned by an entity carrying out other banking activities5 and should fund themselves independently from deposit banks (RFBs). The OECD has also previously expressed its view, in a different context, that holding companies should directly own commercial banks and investment banks.6

B. Delegated powers and accountability

Division of responsibility between the Treasury and the regulators

39. We agree with the Government that legislation should set out which activities are to be undertaken within RFBs, and which are to be prohibited or excluded. These are fundamentally social and economic issues, and are therefore rightly a matter for Government and Parliament. We also agree that it is for the PRA to ensure the appropriate degree of separation between the RFB group and the rest of the group according to the policy set out by the Government.

40. The architecture of the draft Bill goes some way to demarcating the roles of the Treasury and the regulators. However, there are still some gaps where the PRA is potentially exposed to situations of making rules for social purposes without being given sufficient legislative mandate to do so. For example, the draft Bill requires the PRA to make a class of rules known as “ring-fencing rules” and specifies certain matters in relation to which rules must be made. We are content with the lists of matters on which the legislation will require the PRA to make such rules, as the draft Bill would provide the PRA with the necessary authority. However, should the PRA choose to make ring-fencing rules that are not mandated in the draft Bill, it could potentially be seen to be acting beyond its remit.7

41. In our view the draft Bill should provide “parameters” within which the PRA is given a statutory mandate to make rules to enforce the appropriate degree of separation between the RFB and the NRFB in the event that it needs to exercise its rule-making powers in ways not specified in the draft Bill. Examples of this could arise if the regulator determined that it would need to:

set parental/intragroup funding limits (to avoid concentration risk and reputational risk from the perceived contagion between the RFBs and other group entities); or

restrict the issuance of loss-absorbing instruments to other group companies by the RFB (to avoid concentration risk).

42. The objectives we have proposed in paragraphs 16–18 of this memo would supply such “parameters”. Alternatively, or in addition, the draft Bill could be amended to impose an obligation on the Treasury to set, by order, appropriate limitations with which the PRA must comply when making rules not specified in the draft Bill. It is our view that the requirement on the PRA to act compatibly with its continuity objective would not provide the necessary mandate to make such rules.

FCA statutory objective

43. We do not believe it is desirable for the Financial Conduct Authority (FCA) to be given a continuity objective when the only core activity is the acceptance of deposits (and services related to deposit-taking).

44. It is not clear to us how the FCA could act in such a way that could jeopardise the continuity of core services. We also believe it would be difficult for the FCA to fulfil this new objective considering its limited regulatory remit over the core services and the relevant RFBs that carry out such services. Giving the FCA an additional objective that encompasses matters and institutions it will have little direct oversight of (except from a conduct perspective) runs the risk of obscuring the FCA’s purpose, remit, and its strategic and operational objectives.

45. The Government proposes to extend the power of direction of the PRA over FCA actions8 to cover FCA actions that could threaten the continuity of core services. It therefore seems unnecessary for the FCA to also be given a continuity objective.

46. We believe that, instead of giving the FCA the continuity objective from 2019, more workable alternatives are:

legislating for the objective at a later date should the Treasury subsequently seek to use the power to increase the range of core activities to encompass activities and firms that are directly regulated by the FCA; or

dealing with the FCA’s role (if any) through the co-operation mechanisms/agreements between the PRA and FCA.

C. Ring-fence

Activities to be included in RFBs

47. We agree that deposit-taking should be classified as a “core activity” that should be undertaken in an RFB and that the Treasury should be given powers to make secondary legislation creating additional core activities. This approach allows the Government to respond flexibly to changes in the banking system.

48. However, the degree of flexibility that the draft Bill allows in the design of the ring-fence in terms of activities that can be undertaken either in RFBs or NRFBs, risks ending up with banking structures that do not go far enough in achieving the stated objectives of the policy. For example, a very narrow RFB does not put in place an adequate foundation to achieve the policy aim of making banks more resolvable because a number of critical economic functions (such as retail and SME lending) may remain in the NRFB, creating unwanted incentives for the authorities to support NRFBs in times of stress.

49. The PRA should be empowered to ensure RFBs meet this public interest test, being accountable through the objectives that Parliament considers appropriate for the draft Bill to contain.

50. As such, we favour broader RFBs that are viable not only in resolution, but also commercially. For market discipline to work it is important that the market sees them as viable balance sheets in their own right. This will ensure that funding costs more accurately reflect different risks on each side of the ring-fence.

51. We are not advocating making retail and SME lending a “core activity” as that may result in an undesirable restriction of credit provision by non-banks.9 However, to address the concern that RFBs may become too narrow and not meet the policy objective of making banks more resolvable, we propose that where banking groups contain RFBs, they should conduct all of their UK retail and SME lending from those RFBs.

Activities to be excluded from RFBs

52. We agree that, at a minimum, trading in investments as principal should be an excluded activity. The draft Bill provides for other regulated activities to be excluded from RFBs if the Treasury believes they pose a risk to the continuity of the provision in the UK of core services. We believe that any regulated activity should be excluded from RFBs if, in the judgement of the PRA, it:

makes it significantly harder or more costly to resolve the RFB; or

in any other way threatens the objectives of the ring-fence.

53. We also note that the draft Bill gives the Treasury the power to make exemptions to excluded activities, so that they can be performed by RFBs where doing so does not threaten the provision of core services. We would not support any exemptions from excluded activities that do not meet the criteria set out above. In addition, we consider that where exemptions are proposed, the conditions attached to them need to be clearly spelt out in legislation.

54. Any hedging exemption, for example, will require consideration of limits around product type, client type, and size of activity. It is essential that any exemption is crafted with certainty to enable the PRA to effectively supervise it. Without clarity, there is a significant risk that supervising the exemption could become unachievable or extremely resource intensive. Similarly, if the exemptions become too complex to supervise then the objectives of ring-fencing may be undermined.

D. Capital levels

Group Primary Loss-Absorbing Capacity (PLAC) requirement for UK-headquartered groups

55. We agree with the Government that, in order to reduce the implicit guarantee for systemic banks, it is essential to increase the loss-absorbing capacity of these banks to mitigate the risks of potential losses. Ensuring that creditors can be bailed-in to bear losses in both RFBs and NRFBs should help impose greater market discipline on the banking sector and ensure that risktaking is not excessive.10 ^.

56. We note that the draft Bill gives the Government the power to direct the way in which the PRA can implement loss-absorbency requirements. We consider that loss-absorbing capacity should apply on a whole group basis, with the ability to exempt non-EEA subsidiaries from the loss-absorbency requirement only if the following conditions are met:

the group has demonstrated to the UK authorities that the UK bank(s) is sufficiently ring-fenced from the overseas entities, taking into account financial, operational and managerial interdependencies, so that these operations will not pose a risk to financial stability in the EEA;

the UK authorities (in conjunction with relevant overseas authorities) have determined that a regional break-up is feasible for the group and have in place plans to resolve the entities in their respective jurisdictions; and

the group would need to make the strategy public (in the annual report and in disclosures to clients, for example) in order that creditors understood that they were exposed to the firm with which they are dealing and had no recourse to other entities in the group.

57. We would be concerned if banks’ non-EEA operations were exempted from group loss-absorbency requirements unless it was demonstrated that they pose a risk to EEA financial stability. Firms are best placed to make this case and it is up to them to demonstrate their resolvability globally if they want a group loss-absorbing capacity exemption. The default position should therefore be that systemic banks need to hold group loss-absorbing capacity until they can satisfy the conditions outlined above. Where the preferred group resolution strategy involves a top-down approach whereby the UK bails-in loss-absorbing capacity issued by the UK holding company (ultimate parent company) and downstreams capital as required to recapitalise domestic and overseas subsidiaries, no group PLAC carve out should be available.

31 October 2012