Banking StandardsWritten evidence from Hermes

We welcome the opportunity to comment on the draft Bill.

By way of background, Hermes is a leading asset manager in the City of London. As part of our Equity Ownership Service (Hermes EOS), we also take part in public policy debates on behalf of many clients from around the world. In all, EOS advises clients with regard to assets worth a total of £89 billion invested in companies across global markets. Our clients are significant shareholders in banks and have suffered the consequences of banking failures both directly in terms of the value of those shareholdings and also in their broader investment portfolios; we have therefore taken a particularly close interest in the discussions around the world about how to enhance banking regulation and supervision.

We are strong supporters of the conclusions of the Independent Commission on Banking—a group to which we submitted formal comments twice—and particularly favour its model of ring-fence. We believe that ring-fencing the deposit-taking, retail lending and small business activities of banks would not only have significant benefits in relation to financial stability but would also have advantages in terms of internal capital discipline within banks. Our view is that at present there is a cross-subsidy from explicit and implicit government guarantees across all elements of bank operations; this reduces the perceived cost of capital of the riskiest activities, and increases perceived returns from those activities. Ensuring that a solid ring-fence is in place would remove this cross-subsidy and encourage all the banks to apply an appropriately varied cost of capital across all their activities, removing an inappropriate incentive to take risks which are not warranted.

Subject to the comments below (particularly those in relation to risk management products), we believe that the draft legislation will deliver the Independent Commission on Banking’s intentions and will deliver these important benefits for financial stability and capital discipline within banks.

We respond below to the specific questions which the Commission raises. We also attach our latest think piece on the issue of banking regulation and supervision—Epidemiology—which more fully develops some of our thinking in this area.

Objectives and general approach

1. Does the draft Bill successfully give effect to the objectives set out in paragraph 1.3 of Sound banking: delivering reform and is it the most efficient and effective means of delivering those objectives?

Yes, we believe that the Bill succeeds in delivering the necessary reform—subject to the comments below with respect to risk management products—and does so efficiently and effectively.

2. Do any of the recommendations of the Independent Commission on Banking (ICB), which the draft Bill seeks to implement, need revision as a consequence of developments since the ICB’s report?

No. If anything, more recent events have served to reinforce the good sense evident in the ICB’s proposals.

3. Do the powers in the draft Bill and the Government’s stated intentions for their use give effect to the ICB’s recommendations? Are any deviations justified?

The proposals do give effect to the ICB recommendations. The one key deviation which is proposed—that the Primary Loss Absorbency Capacity (PLAC) requirements should not apply to RWAs held in non-UK and non-EEA operations—is both a pragmatic and proportionate amendment.

4. What should be the timetable for implementation of these measures, and should it be set out more clearly?

Given the number of international developments, both within the European Union and internationally, we believe that there needs to be appropriate flexibility allowed in the timetable. In an ideal world, these changes would be delivered as quickly as possible, but we need to be practical and the final implementation will need to wait for more clarity on the Recovery and Resolution Directive, and perhaps also progress on the Liikanen proposals. However, we believe that there is real value in having certainty and clarity as early as is practical: certainty will build investor and client confidence and trust, helping to revive banking activity. There is also scope for the UK to set the standard for international regulation.

5. The draft Bill proposes continuity objectives on the PRA and FCA. Are these appropriate and compatible with their other objectives?

We believe that these objectives are necessary and appropriate.

Banking standards and competition

6. What will be the impact of the proposed changes in the draft Bill on banking standards in the UK more widely?

We firmly believe that ring-fencing the deposit-taking activities of banks would not only have significant benefits in relation to financial stability but would also have advantages in terms of internal capital discipline within banks. Our view is that at present there is a cross-subsidy from explicit and implicit government guarantees across all elements of bank operations; this reduces the perceived cost of capital of the riskiest activities, and increases perceived returns from those activities. Without appropriate costs of capital being applied the risks of activities are not appropriately priced in, and banks may continue to make mistaken assessments as to the risk/reward trade-off of certain activities. Ensuring that a solid ring-fence is in place would remove this cross-subsidy and encourage all banks to apply an appropriately varied cost of capital across their activities, removing an inappropriate incentive to take risks which are not warranted. Applying an appropriate cost of capital to different banking activities would raise standards across the industry by making more transparent the risks being taken and the genuine risk-adjusted returns being produced. The ring-fence will not deliver this on its own but it should be a catalyst for a more general move to a more disciplined approach.

Ensuring that risky activities face a heightened cost of capital such that performance is understood in a fully risk-adjusted way is necessary for any understanding of performance of both the bank and of its individual staff members. We suspect that significantly less risk would be taken once an appropriate cost of capital is applied to the most risky activities.

7. What will be the impact of the separation of retail and wholesale banking on the culture prevailing within each?

We believe that the separation will have a positive impact in terms of culture for both parts of the banking industry. Both portions need to reawaken a sense of client service which seems to have gone missing in recent years. One benefit of a readjustment to the costs of capital applied to different businesses may be that a greater discipline is applied in the work that is done and the benefits of that work to clients. We discuss the ways in which the culture of banking has gone awry in the attached paper Epidemiology, and how it needs to be remedied. We hope that a clearer distinction between retail and wholesale banking will assist in this.

By ensuring that the appropriate cost of capital is applied across the business, the separation should also ensure that remuneration more accurately reflects the risk-adjusted returns of the business, rather than being skewed by the effective government subsidy to the retail deposit-taking activities. This change in remuneration approach should have a significantly positive impact on the culture and mindset of the individuals.

8. What will be the impact of the ring-fence on competition, both in retail and investment banking, and in other areas of financial services?

We believe that there is scope for a positive impact on competition in the retail banking sphere as a business which has tended to be seen solely as a source of capital for the broader banking operations will move from being effectively starved of cash to instead having capital for investment in a way which should build a healthier and more robust business.

Delegated powers and accountability

9. The draft Bill grants a large number of delegated powers to the Government. Are the principles under which delegated powers are to be exercised sufficiently clear?

Yes, we believe that the scope of the delegations and the ways in which they are to be exercised are sufficiently clear.

10. Does the scope of the delegated powers in the draft Bill represent an appropriate balance between flexibility for the Government to respond to changing conditions and accountability to Parliament and the public?

Yes, we believe that they strike the appropriate balance.

11. Is there sufficient clarity about the Government’s intended use of delegated powers, both to enable public understanding and to enable affected banks to prepare for the proposed changes?

Yes, we believe that this is sufficiently clear.

12. The draft Bill provides for review of the ring-fencing rules by the PRA every five years. Does the proposed review mechanism provide sufficient accountability?

Yes, we believe that this review process strikes an appropriate balance between a period of certainty for the industry, and its investors, and the need for accountability and rational reassessments.

The ring-fence

13. Is the power to be able to exempt certain categories of deposit-taking firms from having to establish a ring-fenced bank appropriate, and on what basis should the conditions for exemption be set?

We agree that it is appropriate to allow for exemptions from the ring-fence for activities in relation to larger companies and in relation to high net worth individuals (see below under Question 15 for comments about how these two categories are to be defined). However, the exemption as drafted in proposed Clause 142A(2)(b) is left open to Treasury decision-making, subject only to the subclause (3) requirement that it not have adverse consequences for continuity of the provision of core services. We would favour the draft clauses being more explicitly constrained to the circumstances to which the government intends the exemption to apply, such that the intention of parliament is not at risk of being subverted at a later stage.

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?

We believe that this is appropriate, subject to the comments that we make below in response to Question 16.

15. Which categories, if any, of customer should be permitted to deposit with a non ring-fenced bank?

We support the concept of having exemptions for larger companies and high net-worth individuals. We are largely comfortable with the proposed measure of turnover for a company to be deemed large enough to make a judgement as to whether it should be capable of making a judgement as to whether to deal with the bank within the ring-fence or outside it. We are not convinced that the proposed measure for high net-worth individuals is appropriate, and would suggest that the level of free and investable assets should be set significantly above £250,000—£1 million as a bare minimum. We note that the private banking sector regards around £5 million as the minimum scale for a client.

16. The Government is considering whether to allow ring-fenced banks to offer simple derivatives to their customers. Should they be allowed to? If so, what safeguards would be necessary?

We would not welcome there being scope to offer derivatives to customers within the ring-fence. We simply do not believe that these products will be appropriate to the bulk of clients within the ring-fence—a view that is only reinforced by recent events. The scope for larger corporate and individual clients to deal with the bank outside the ring-fence (as discussed in relation to Question 15 above) means that those corporate and individual clients which are likely to have some need for such risk management tools would be able to access them. Banks would need to convince them that the benefits of such tools made it worthwhile to deal with the bank outside the ring-fence.

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?

We are not convinced that there needs to be a separate governance structure for a ring-fenced bank; the structural reform itself delivers the independence which is sought, and active supervision by regulator should reinforce this. It is possible that the boards of banks which encompass both ring-fenced and non-ring-fenced activities may over time decide that they need further governance structures to assist them in their oversight of the different arms of their bank, but we believe that these should be developed over time as boards see the need rather than imposed from the outside.

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?

It is hard to take a firm view on these questions based simply on the discussion and the powers to be given to the PRA. Only once the rules are proposed and promulgated by the regulator will it be possible to take such a view. The intention as articulated in the Treasury paper, in essence that the relationships will be required to be carried out at arm’s length, seems appropriate and to introduce the necessary disciplines, but the rules will be key to understanding whether this will be delivered and be effective.

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

The Bill will in effect place a significant burden on the supervisory authorities to supervise the banks vigorously and effectively. As set out in our attached paper Epidemiology we regard the regulatory failure ahead of the financial crisis as largely a supervisory failure rather than a regulatory failure as such—in essence, a failure to question and challenge at appropriate times—and we hope and expect that the regulatory authorities will place their focus, and focus their energies, on supervision going forwards. Only if this is done effectively will the structural reforms have their full required impacts.

20. How effective will the provisions on corporate governance for ring-fenced banks be in promoting a wider improvement of standards? Should other measures also be considered?

We favour bank boards being enabled and empowered to develop governance processes and approaches which seem to them best suited to delivering the appropriate effective and independent oversight of ring-fenced entities. Inevitably, the supervisory authorities will seek to debate and have input on any conclusions which boards reach on these matters.

Depositor preference

21. Is the proposal to prefer insured deposits in the event of a bank insolvency justified? Is there a case for broadening the scope of deposits which benefit from this protection?

Yes, we believe that the proposed preferred treatment of insured deposits makes sense and we also believe that it should not be extended beyond the proposed level. The Treasury’s paper considers the various extensions which have been proposed and we believe that it reaches the appropriate conclusions.

Capital levels

22. Does the draft Bill adequately implement the ICB’s recommendations on loss absorbency requirements?

Yes, we believe it does so appropriately.

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?

We believe that the proposed route ensures that the detailed rule-making sits at the appropriate level, particularly in light of the uncertainties introduced by the state of negotiations on the Recovery and Resolution Directive.

24. Is the Government’s stated intention for the design of loss-absorbency requirements workable? Will it provide a sufficiently well-capitalised banking system? In particular, how justified is the intention to allow an exemption for assets held in overseas operations?

Yes, we believe it is workable and appropriate. The exemption allowing the Primary Loss Absorbency Capacity (PLAC) requirements not to apply to RWAs held in non-UK and non-EEA operations is both pragmatic and proportionate, and we accept the case made by the Treasury for this deviation from the ICB proposals.

25. Is the Government justified in its decision not to implement the ICB recommendation for a higher leverage ratio than is required by Basel III?

Again we believe that this is a reasonable pragmatic approach, provided that the efforts of the supervisory authorities are appropriately focused on challenging and questioning bank staff and boards on their decision-making and risk management such that the minimum ratios are seen as a foundation on which to build, not a target about which there can be no discussion as long as they are met.

Resolvability

26. Will the UK authorities have the necessary tools and powers (as a result of this legislation and other initiatives) to be able to resolve a large failing ring-fenced or non-ring-fenced bank, while maintaining financial stability and minimising the risk to public funds?

Yes, we believe that the range of new tools and powers is appropriate and sufficient. The challenge will be for supervisors to use those tools and powers effectively and appropriately.

27. What is your assessment of the Government’s preferred design of “bail-in” powers needed to improve bank resolution? How likely is it that the Recovery and Resolution Directive will deliver effective bail-in powers?

We do not feel able to comment on these questions at this stage of debate on the Recovery and Resolution Directive.

Impact assessment

28. Is the impact assessment of the costs and benefits credible and balanced?

29. Might there be any other unintended consequences which have not been considered?

We accept and support the impact assessment.

International issues

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

On the face of it, there will inevitably be some drag on international competitiveness—though the pragmatic approach on the Primary Loss Absorbency Capacity in relation to overseas RWAs mitigates the worst of this impact. We believe that this reduction in competitiveness is justified in the circumstances, and will over time be mitigated by regulatory change elsewhere in the world.

On the other hand, we note that at a time when trust is at a premium in the banking sector, and there is an effective buyers’ strike on bank capital, there is scope for these proposals to have a significant positive impact on the way in which UK banks are perceived and the confidence that investors can have in them. A number of large investment institutions have minimised their exposure to the banking sector, but might be tempted to return to providing capital to banks which look more like utility providers of retail and small company banking services, in other words, to banks within the ring-fence. The certainty and confidence which may be built through prompt delivery of these proposals may thus in some ways provide a competitive advantage to UK banks.

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?

The developing nature of international rules is one reason why we believe there needs to be some flexibility in the timing of the implementation of these proposals and the flexible way in which they are implemented, though we would argue that the proposals should not be delayed excessively as there is scope to lead global regulatory reform. We agree with the Liikanen committee that the UK proposals are largely consistent with their proposals, though they approach the ring-fence from the opposite direction. As set out in our paper Epidemiology we believe that the UK proposals are to be preferred to the Liikanen proposals.

Other

32. What other matters should the Commission take into account?

We have nothing further to add.

31 October 2012

Prepared 2nd January 2013