Banking StandardsWritten evidence from ICAEW


1. We are writing to provide evidence to the Parliamentary Commission on Banking Standards, on the Draft Financial Services (Banking Reform) Bill. ICAEW would be pleased to provide oral evidence on any aspect of its submission.

Executive Summary

2. Key points:

Banking reform is not just about structural change. Ethics and culture must change for banking to become more stable and focused on the long-term.

Ring-fencing may reduce the impact of financial instability. But it will not necessarily make banking safer.

The proposed ring-fence will not protect the deposits of institutions including charities, hospitals and schools should their bank go bust. The proposal to prefer insured retail deposits in the event of a bank insolvency will make their position worse than it is now.

Ring-fenced banks will still be able to make the risky loans we saw in the lead up to the crisis.

The reforms won’t necessarily protect taxpayers from future bail outs of complex, international banking operations.

The EU Liikanen proposals for structural reform would come closer to achieving the government’s goals than the Vickers proposals.

3. Key recommendations:

The Commission should challenge the banking sector to develop an effective model of professional standards (see paragraph 10).

Make it clear in the legislation that all secondary legislation will be consulted on (paragraph 12).

The ring-fence should be reviewed at the same time as the Bank of England’s financial stability strategy (every three years) (paragraph 15).

The definition of “core activities” included in the ring-fence needs to be broadened to include banking for institutions including charities, hospitals, schools and mid-sized companies above the SME threshold (paragraph 18).

Our Response to the Commission’s Questions

Objectives and general approach

4. The three main objectives of the draft Bill are welcomed, and the proposed ring-fence might reduce the impact of financial instability. But we have serious concerns around the proposed approach including:

The ring-fencing proposals include prioritising retail deposits over those from organisations including charities, schools, universities and local authorities. If a bank goes bust, retail deposits will be returned before others, meaning the deposits from socially vital institutions including those listed above might not be returned at all if their bank goes bust. This damaging position for socially vital institutions is being proposed despite the fact that retail deposits are already protected under the FSCS compensation scheme (see depositor preference section for more details, paragraph 27)

The proposals will not prevent the kinds of risky loans that caused the recent crisis, such as sub-prime residential property loans.

Taxpayers money is still at risk of being used in bail-outs.

Ring-fenced banks will have higher costs. These will be passed on to the customer (individuals, SMEs, charities etc).

5. The proposals are also different to the two other banking structure reforms being proposed: Liikanen in the EU and Volcker in the US. Three different banking structures in an increasingly global market place will add to costs, and may create scope to get around the spirit of the reforms.

Banking standards

6. Confidence in the financial services sector has been severely damaged. And trust is going to take a decade to restore. The proposals in the draft Bill do not directly address the culture or ethics of banking. No amount of legislation around banking structure can change the culture and ethics of the sector. So it is crucial that whilst structural reforms are introduced, the debate around how to encourage better culture and ethics remains a high priority.

7. ICAEW has a long history of developing and upholding professional standards, and the BBA has recently called for a professional body for banking which mirrors that of the Institute of Chartered Accountants. We are about to launch a new integrity training programme for those who work in the “back office” finance function of banks. This programme focuses on embedding ethics and integrity into banks by training their finance professionals (those at the heart of control and risk of banks’ balance sheets) to lead their colleagues in a more ethical approach to banking.

8. Recommendation: The Commission should challenge the banking sector to develop an effective model of professional standards that supports and encourages personal and organisational integrity, is underpinned by effective monitoring and enforcement mechanisms and that can be seen to promote confidence. A sound and effective regulatory system will always be required, and should complement such a model. If the banks took professional standards seriously (and could demonstrate that they did), government or independent regulation might become closer to a backstop, rather than a primary means of maintaining confidence in the financial system. However, it may take a generation to achieve this objective of having professional standards in banking that inspire confidence.

Delegated powers and accountability

9. The draft Bill outlines a number of delegated powers split between HM Treasury and the PRA. It is not clear in the Bill how sufficient accountability for use of these powers to Parliament and the public will be put in place. Given that the proposed legislation relies heavily on delegated legislation even with regard to key features such as the location of the ring-fence, and given the nature of its role in economic and financial stability, more accountability for the delegated powers is required.

10. Recommendation: Despite HM Treasury setting out on page 53 of “Sound banking: delivering reform” that they will consult on all secondary legislation, this is not evident in the draft Bill itself. To be accountable and transparent, this should be integrated into the final clauses of the Bill.

11. Recommendation: The Treasury Committee should review with the PRA and Bank of England how the delegated powers are being used and what impact they are having. The review should be carried out annually in the first few years of the new structure.

12. The proposal for the PRA to review the ring-fence rules every five years does not deliver sufficient accountability. The Bank of England has to review its financial stability strategy every three years. Given the ring-fence is being put in place to help promote financial stability, these two reviews should take place at the same time so that the UK’s financial stability strategy (controlled by the Bank of England) and the new ring-fencing structure are consistent and compatible.

13. Recommendation: The ring-fence rules should be reviewed at the same time as the Bank of England’s financial stability strategy, every three years. The review should include formal consultation with the public, and be assessed by the Treasury Committee.

The ring-fence

14. We acknowledge that ring-fencing might reduce the impact of financial instability by making it easier to identify and separate some aspects of UK banking business which are essential to the functioning of the wider UK economy. It may also increase the policy options available to the authorities should a non-ring fenced part of a banking group require resolution. However, we do have a number of concerns around the approach taken to ring fencing.

15. The “core activities” defined in the draft Bill are too narrow and do not include deposits from socially vital institutions including charities, schools and hospitals, and also mid-sized businesses. Where these institutions deposit inside the ring-fence they will be subordinated to insured retail and SME deposits, and so will have little protection if their bank goes bust.

16. Recommendation: The definition of “core activities” needs to be broadened to include deposits from the institutions listed above.

17. Ring-fenced banks as proposed would not necessarily be particularly safe as they will still be able to make the kinds of loans that caused the crisis, such as sub-prime residential property loans. These loans could “go bad” even though they are within the ring-fence—for example, if a large company in a town closes, and many employees lose their jobs and so can’t pay their mortgages.

18. Recommendation: Bank regulators should create an over-arching requirement and set of principles setting out how ring-fenced banks have a duty of care to operate prudently and safeguard depositors.

19. Ring-fenced banking will be expensive for banks and that cost will almost certainly be passed on to the customer, whether individuals or SMEs. This could hit bank lending levels and further harm economic growth.

20. Recommendation: Either be honest about the fact that a more stable banking system is a pricier banking system; broaden non-bank finance options like peer-to-peer equity finance; and/or move much faster to bring new entrants into the market to drive prices down.

21. Despite the proposals curtailing the “perceived implicit guarantee enjoyed by banks and financial firms”, there is no guarantee that taxpayers will not be called upon to bail out a bank which remains outside of the ring-fence, especially if it is large, complex and operating internationally. There might be insufficient liabilities which could be “bailed in” or the consequences of imposing losses through bail-in could be judged to pose an unacceptably high risk to confidence and financial stability. It is certainly possible to imagine scenarios in which the taxpayer should not bail out a bank in serious trouble, the impact on global capital flows could be as economically catastrophic as the collapse of Lehmans, creating another credit squeeze.

22. Recommendation: Ensure regulators hold banks’ feet to the fire to strengthen their processes, particularly risk management, and speed up efforts to implement cross-border bank resolution regimes.

23. Recommendation: We agree with the government that ring-fenced banks will need to be able to use derivatives in order to offer certain products to customers (e.g. fixed rate mortgages). But the regulator (PRA) should be clear with ring-fenced banks about what types of derivatives this does, and does not include, e.g. those which help in providing day-to-day service to customers and can be easily risk managed.

24. The proposals are likely to be compatible with sound corporate governance. A common difficulty with governance in financial institutions is a lack of alignment between the structures of legal entities and of management. However, the draft Bill removes that potential conflict because it makes clear that the boards of ring-fenced banks will have considerable independence and a clear responsibility to maintain the integrity of the ring fence. Such arrangements would not prevent the parent group from making strategic decisions relating to matters such as the broad size, product range, marketing approach and funding strategy of a ring-fenced bank which it owned.

Depositor preference

25. The proposal to prefer insured deposits in the event of a bank insolvency is not justified. There is a strong case for broadening the scope of the deposits which benefit from the protection scheme.

26. The Financial Services Compensation Scheme protects individual deposits up to £85,000. So the proposals do not affect the position of most individuals. Rather, insured-depositor preference protects those who stand behind the FSCS scheme—the banks and, in some scenarios, HM Treasury.

27. The price of protecting the banks and, possibly, the taxpayer would be borne by institutions such as larger charities, hospitals, schools, local authorities, universities and lawyer/accountants’ client money accounts (which often temporarily hold, for example, clients’ deposits on house purchases), as well as mid-sized companies. They will not be able to use ring-fenced banks with confidence.

28. These institutions would probably be better protected by banking with non-ring fenced banks—but that undermines the idea that ring-fenced banks would cover all (or most) banking that’s essential to the UK.

29. Recommendation: There are three ways this could be solved. Firstly, extend the FSCS coverage to all “end-user” of the banking system. Secondly, extend depositor preference to all end-users. Or, drop the “depositor preference” proposal altogether.


30. It is not clear from the proposals that a large failing bank (especially a non-ring-fenced bank which was complex and operating internationally) could generally be resolved by the authorities without taxpayer involvement, at least in the form of public guarantees. The challenges here include differences in resolution and insolvency regimes across borders, the difficulties of managing and un-winding large trading books, and the need to maintain confidence and hence financial stability.

31. While it is desirable that banks should be subject to market discipline, and expectations of public sector bail-outs should be minimized, it is important that preventing the use of public funds in bank resolution is not elevated into an ideology. In some cases, public support will be the least-bad option. As noted in paragraph 23, catastrophic credit squeezes are a risk, as is the spread of contagion if the public fears that their bank is about to fail.

32. The government’s proposals around “bail-in” powers will be expensive for borrowing banks, because providers of funding will demand a premium for the risk that debt will be transferred into shares, exposing them to capital losses and the fact that interest would no longer be payable. These costs will almost certainly be passed on to customers, increasing the costs of banking.

Impact assessment

33. It is not clear why the net benefit figure of the reforms to the UK economy (£68 billion) quoted in the White Paper has almost doubled to £118 billion in the draft Bill. The content of the two papers is similar This illustrates the difficulty on putting a benefit figure on financial stability reforms, and suggests that we should not consider any figure quoted around the net benefit to financial stability to be wholly accurate.

International issues

34. The three proposed structures for banking reform show no consensus on what needs to be done to deliver a more financially stable global banking system:

The Volcker rule prevents banks in the US from engaging in proprietary trading.

Liikanen proposes that banks’ trading business should be placed in separate subsidiaries, suggesting the greatest risks lie in trading, despite most banking crises stemming from mis-judgements about traditional lending.

35. We believe Liikanen’s proposals would come closer to achieving the government’s aims than the draft legislation. In very broad terms, Liikanen would separate commercial and investment banking, and unlike the draft legislation seems to cover “essential banking”.

29 October 2012

Prepared 2nd January 2013