Banking StandardsWritten evidence from Nationwide Building Society

Executive summary

Nationwide is fully supportive of the draft Bill’s objectives—the plan to “carve out” building societies from the ring-fence but then to bring the Building Societies Act into line with these restrictions is a sensible approach.

With regard to firms’ loss absorbency, the Government’s decision to implement a 3% leverage ratio, rather than the ICB-proposed 4.06%, will avoid significant unintended consequences. Should this be reviewed, the leverage ratio must reflect material differences in institutions’ risk profiles and in particular a separate class for building societies should be created. A lack of clarity also remains as to the definition of an institution’s Primary Loss Absorbing Capacity.

Depositor preference should be applied to all retail depositors—not just those with balances below £85,000—to provide a clearer and more powerful message to savers.

With increasing attention on the culture and standards within the banking sector, we believe that building societies may be able to provide valuable examples of how a greater focus on customer need can be achieved successfully.

Overarching comments

1. We recognise the need, following the financial crisis and in anticipation of any future crises, for significant reform of the banking sector to ensure greater financial stability. The reform package proposed by the ICB represents an important step towards this goal.

2. We have consistently emphasised the importance of effective challengers, particularly those in the mutual sector, being able to provide consumers with a competitive alternative to the listed banks. Reforms should, therefore, be guided by the following:

They should be ambitious in delivering the Coalition Agreement commitment to “foster diversity in financial services, promote mutuals and create a more competitive banking industry”.

They should not dilute the ability of existing and future challenger brands to compete effectively with the big banks, and they should not discriminate against or disproportionately impact lower risk business models.

Building societies and ring-fenced banks should remain distinct—but the Government should ensure consistency, as far as is appropriate, between the permitted activities of the two.

3. In this context:

We are supportive of the draft Bill’s objectives and general approach. It represents an important step forward in improving the resilience of the UK’s financial system and Nationwide fully supports its core objectives. We broadly welcome the Government’s plans for implementing the recommendations of the ICB. Although the draft Bill itself is light on detail, we believe that this is necessary to ensure the legislation can be future-proofed. Where the ICB’s recommendations are not to be implemented fully, we believe that the Government’s decisions have been appropriate.

With regard to the ring-fence, we support the proposed “carve out” for building societies and a review of the Building Societies Act to create a level playing field with the banks. Given the existing restrictions contained within the Building Societies Act, this is a sensible decision to avoid overlap and confusion, with the draft Bill providing a power to amend the Act to fully reflect the ring-fencing restrictions. It will be essential that these amendments are carried out simultaneously with the introduction of the ring-fence into legislation.

On capital levels, the adoption of a 3% leverage ratio, consistent with Basel III, will avoid significant unintended consequences. We support the principle of a backstop capital measure, along the lines of a leverage ratio. However, the ICB-proposed level of 4.06% would become the primary driver of our regulatory capital requirements. In this situation, the only response available to us would be to shrink our balance sheet and restrict mortgage lending, or perversely, to increase our risk taking.

However, should the Commission wish to revisit this decision, we would urge strongly that the leverage ratio is calibrated based on institutions’ risk profiles. Building societies, in general, have materially different risk profiles as a result of the restrictions within which they operate (section 9A of the Building Societies Act and statutory lending and funding limits) compared with unrestricted banks, and should therefore face a relatively lower minimum. This could be achieved by the creation of different classes of institutions, characterised by their risk profiles, and with corresponding leverage ratios.

We welcome depositor preference, but believe this should be applied to all retail depositors, not just those below the FSCS limit. We are doubtful that this would have a material impact on the cost of wholesale funding and believe that the consumer message is much more powerful and comprehensible without qualification. In any case, we support the Government’s intention (as set out in its recent Green Paper, The future of building societies) to use the Butterfill Act to ensure that building society depositors rank at least pari passu with unsecured creditors and create parity with bank depositors in this regard.

With regard to the resolvability of institutions, uncertainty remains as to eligibility of debt instruments to form part of an institution’s Primary Loss Absorbing Capacity (PLAC) and it will be important that the bail-in tool recognises different business models.

4. We also recognise the increasing attention on professional standards and the culture within the banking industry. Given the forthcoming establishment of the Financial Conduct Authority, Prudential Regulatory Authority and the Financial Policy Committee, we believe that these organisations should be given time to mature in their oversight of the sector before further regulatory bodies are considered.

5. Ensuring that meeting customer needs is at the heart of institutions will, however, be important to addressing concerns here. Building societies, including Nationwide, can provide valuable examples of how this can be successfully achieved. Our mutual ownership drives a business culture with a natural customer focus, supported by governance structures. For instance:

Our corporate ethos, which ensures our internal values set prioritises meeting members’ needs, is built into our performance management processes. It ensures we calibrate how we position our reward, performance, other employee policies and demonstrate the behaviours required to demonstrate how we “Treat Customers Fairly”.

Customer satisfaction measures have consistently been a key component of our bonus structure for all staff (branch and back office) and we incentivise employees to increase our independent customer service score lead over our competitors.

We have embedded formal customer advocates within the Society. We have a dedicated Customer Experience division to challenge the design and execution of our products and services, including sales and customer communications.

We look to reward customer loyalty and encourage long term relationships through avoiding “brand new customers only” products and instead providing exclusive offers to those that have the deepest relationships with us.

And we aim to be as transparent and simple with our terms and conditions as possible, and through initiatives such as our Savings Promises and Savings Watch we believe we currently lead the market. There is more the industry can do to enhance transparency and ensure the level of product complexity is appropriate for the customer. Opportunity also exists to make some basic simplifications to existing product areas. For example, an equalisation of the cash and stocks & shares ISA limits would provide consumers with a simplified, fairer offer, building on the popular ISA blueprint. The current arrangements over-complicate the existing ISA proposition, especially for groups such as first time buyers and older people who can benefit from the simplicity and flexibility of cash ISA holdings.

We constantly aim to improve our Board’s engagement with our customers to allow for direct access and accountability. For example, in addition to our AGM (at which around eight million of our members are entitled to vote on issues such as executive remuneration), we hold member “talk backs” around the country, hosted by the Chairman, Chief Executive or other Executive Directors, and run online focus groups. This enables direct feedback from and discussions with members, as well as an opportunity to grow personal relationships. We have held well over one hundred such events since 1997.

6. Ultimately, the single biggest force for change will be a greater number and diversity of firms able to compete effectively with the big banks and incentivise a longer-term focus on the customer across the sector. The building society sector has the potential to provide this greater challenge. Nationwide will be doing more, growing our share of current accounts and entering the SME market. But to maximise the impact we can have, we need a level playing field. We would urge the Commission to consider these points as it takes forward its wider work.

Responses to specific questions raised by the Parliamentary Commission

Objectives and general approach

Q1: 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?

The draft Bill sets out a legislative framework for implementation of the ICB’s recommendations. As the draft Bill is very high level, we will take a keen interest in the secondary legislation which will follow. The advantage of primary umbrella legislation is that it will allow flexibility across a highly diversified and complex industry as well as future proofing constraints on business activity so as not to stifle appropriate industry innovation. Building societies already operate under a similar statutory framework.

Q5. The draft Bill proposes continuity objectives on the PRA and FCA. Are these appropriate and compatible with their other objectives?

Yes.

Delegated powers and accountability

Q10. 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. Section 6 in the draft Bill provides sufficient flexibility to amend the Building Societies Act and related secondary legislation to ensure there is appropriate consistency between building societies and ring-fenced banks.

Q12. 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?

This seems sensible in order to future-proof the overarching primary legislation framework. However, it will be important that there is consistency and an equivalent commitment for building societies so that its legislative framework is reviewed and any changes are similarly and simultaneously carried across.

The ring-fence

Q13. 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 do not believe that a de minimis threshold should apply such that institutions with a minimum level of deposits could avoid the ring-fence restrictions. This would defeat the overriding objective of implementing ring-fence legislation which, at a practical level, would be difficult to monitor and would create confusion for the public.

However, as touched on above, we believe that it is entirely appropriate for building societies to be “carved out”.

Through this decision, the Government has recognised the particular position of building societies and the fact that they already operate within a legislative framework—the Building Societies Act—that seeks to achieve similar aims. Having to comply with both the Act and the ring-fence rules would be unnecessarily burdensome and confusing. We therefore welcome the decision to “carve out” building societies from the ring-fence rules, but to revise the Act as appropriate to reflect the restrictions to be placed on ring-fenced banks.

This approach will help create a more level playing field between building societies and banks, where the aim should be to ensure both face the same restrictions on activities, whilst maintaining the distinctiveness of building societies (primarily achieved through the retention of the Act’s funding and lending limits).

We have argued strongly that further reforms are necessary to the Building Societies Act—beyond those to reflect the ring-fence restrictions—to remove inappropriate barriers to competition with the banks. We want to work constructively with HM Treasury, following their welcome intentions set out in the consultation paper, The future of building societies, to review the Act more fully and ensure building societies are not at a competitive disadvantage.

Q14. 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?

The draft definitions are very high level and therefore sufficiently broad. The proposed definition of core activities is more specific in that it clearly captures deposit-taking only. The reference to “core services” associated with core activity requires consideration as this was not anticipated in consultations leading up to the draft Bill. The excluded activities definition would capture a multitude of activity and transactions as well as those more traditionally associated with investment banking, so the secondary legislation which caters for permitted ancillary activity should be closely monitored. We are keen to ensure that none of the existing risk management activity allowed under building societies legislation is inadvertently excluded. Building societies have successfully used a range of risk management techniques underneath a statutory framework without jeopardising retail savings.

Q16. 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?

Building societies currently have this ability which we would not want to see removed, in order that we are able to compete with ring-fenced banks. The statutory restrictions as regards purpose for entering such derivatives have ensured that retails savings are not put at risk. The manner in which derivatives are sold will continue to be subject to regulation and will no doubt build on the lessons learnt from the FSA’s recent investigation into mis-selling by the main high street banks.

Depositor preference

Q21. 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?

We fully support a move to depositor preference, ensuring retail depositors are nearer the head of the queue at insolvency. The potential burden on the rest of the industry through the FSCS charge may also be reduced and retail investors should derive confidence from their preferred position, thus supporting stability in this key funding market.

However, Nationwide has consistently argued that all retail deposits in all ring-fenced institutions should carry creditor priority, not just those up to the FSCS limit. We are doubtful that this would have a material impact on the cost of wholesale funding and believe that the consumer message is much more powerful and comprehensible without qualification.

In any event, we welcome the Government’s intention (as set out in its “Future of building societies” paper) to use the Butterfill Act to ensure building society depositors rank pari passu with unsecured creditors, creating parity with bank depositors in this regard.

Capital levels

Q23. 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?

In the exercise of this power, it will be vital that higher loss absorbency requirements are applied to firms in a transparent and risk-based manner to avoid unintended consequences, as discussed below with regard to the leverage ratio.

There also remains a lack of clarity as to whether and by what magnitude the Bank of England’s Financial Policy Committee (FPC) will be able to amend capital and other measures as part of its macro-prudential toolkit. We would urge the FPC to ensure that macroprudential tools are:

Used in a proportionate manner.

Transparent in how and why they are to be used or in what triggers their use.

Harmonised and sympathetic to international standards in a way that does not damage the competitiveness of the UK’s financial service sector.

Used in a way which avoids unintended consequences. For example, while we are not necessarily seeking special exemption on the use of the tools, the leverage ratio has the potential to have a differential impact on low risk business models such as building societies.

Q25. Is the Government justified in its decision not to implement the ICB recommendation for a higher leverage ratio than is required by Basel III?

The ICB originally recommended a higher leverage ratio of up to 4.06% for large institutions. Such a move would have had significant unintended consequences for institutions such as Nationwide and its members.

With a balance sheet comprising predominantly low risk, prime UK residential mortgage assets, a leverage ratio at this level would become the primary driver of Nationwide’s regulatory capital requirements, rather than a backstop measure, as intended. The only response available would be to restrict mortgage lending or, perversely, to increase our risk taking. 

Should the decision to implement a blanket 3% leverage ratio be revisited, we believe that the leverage ratio should be recalibrated based on institutions’ risk profile, with building societies in general facing a lower minimum relative to other institutions.

We agree with the principle of a “backstop” capital measure along the lines of a leverage ratio. However, it should be recognised that a business model constrained by prohibited activities, as set out in the Building Societies Act (section 9A), and with a balance sheet governed by funding and lending limits will behave differently to one that is unrestricted (i.e. a bank).

This difference, and more precisely the underlying risk characteristics, needs to be recognised in the leverage ratio to avoid an inconsistent capital backstop. The key issue therefore is to determine the extent to which a retail ring-fenced bank and a building society have different risk profiles. In the event that the profiles are materially different, then two different leverage ratios should apply.

We believe that this could be achieved by creating different classes of institutions, characterised by their risk profiles, and with corresponding leverage ratios. For building societies, we would anticipate it being no more than 3%, otherwise it will become a primary measure.

Resolvability

Q26. 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?

The tools and powers included within the European Recovery and Resolution Directive and UK Recovery and Resolution Plans Consultation Paper, along with the changes proposed in Rapporteur Hokmark’s report issued on 16 October, should enable UK authorities to resolve a large financial institution.

These tools and powers, which now include sale of business, bridge banks, asset separation, bail-in and temporary public ownership, will aid in maintaining financial stability and minimising the risk to public funds. However, the addition of temporary public ownership to the toolkit does mean that public funds may continue be put at risk in the event of future failings. The proposed amendments in the Hokmark report will need to be carefully assessed to understand the reasons behind the inclusion and how the proposals would work in practice. It is vital to ensure that the proposals do not destabilise the existing initiatives and key attributes of a successful recovery and resolution plan as set out by the Financial Stability Board.

Given the significant inter-linkages between these proposals and other regulatory initiatives, both domestically and at European level, there is a significant danger of a piecemeal rather than holistic approach developing. One of the key challenges will be to ensure that each of the initiatives are aligned to avoid significant future impacts to the UK financial sector.

Q27. 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?

Significant further clarity regarding the PLAC proposals is required before we are able to assess their full impact.

As discussed above, should a piecemeal approach develop, this will leave investors and issuers with potential areas of uncertainty due to overlaps or gaps in the overall framework. We fear that this may translate into increased pricing and/or inability to access markets with undesirable knock-on effects into the wider economy.

For example, the European Recovery and Resolution Directive provides detail on provisions dealing with point of non-viability (PONV) in the context of bail-in and resolution. However, PONV is also relevant to the definitions of capital in the Capital Requirements Directive and Regulation. Legislators need to ensure the various pieces of proposed legislation are properly linked to provide clarity to issuers and investors about the requirement for issuing compliant capital and the timescales for the introduction of the particular requirements.

We strongly encourage the authorities to try to introduce solutions in a co-ordinated fashion or, to the extent that this is not possible, to clearly signal where the gaps are, which initiative will close them and over what timescale.

Furthermore, the bail-in tool, as currently articulated, is not particularly nuanced to take account of different business models. As an example, Nationwide and the building society sector draw the majority of their funding from their retail deposit base with very little reliance, relative to the banks, on wholesale markets. Accordingly, the impact of bail-in will be more concentrated on investors in mutuals than in plcs, resulting in a higher write-down per investor. Further consideration should therefore be given to depositor preference for all retail depositors, which would create a situation where all senior unsecured debt-holders were effectively “bailed-in” on insolvency without needing to tackle the complex and potentially destabilising topic of formal bail-in of senior unsecured creditors.

31 October 2012

Prepared 2nd January 2013