Banking StandardsWritten evidence from the Royal Bank of Scotland Group

Summary

The draft Bill remains necessarily broad and general in nature. Therefore it is difficult to assess with precision the extent to which it will deliver the Government’s banking reform objectives. Its general direction, however, appears aligned with the aims the Government has set out.

Because of the draft Bill’s general nature, it remains difficult for banks to plan in detail for implementation of the far-reaching structural changes it will entail. Creating a retail ring-fence will be a complex restructuring involving the potential migration of many retail and corporate customers, and will need to be carried out at the same time as a number of other important change programmes, many of them involving mandatory regulatory programmes. Customer impacts may be amplified if the restructuring is carried out too hurriedly (see response to Q4).

We remain concerned that ring-fencing may unintentionally amplify some of the financial stability problems the Government’s banking reforms are intended to address. For example, ring-fencing could exacerbate the implicit Government guarantee for certain banks (see paragraph 1.4) or increase the risk of financial contagion (see paragraph 18.4).

We support continued efforts to achieve as much harmonisation as possible between the UK’s proposals on loss-absorbency and bail-in and the framework that will be applied more broadly throughout the EU once the European Recovery and Resolution Directive (RRD) has been completed. We welcome the Government’s intention to introduce bail-in and loss absorbency measures through the legislation that will implement an eventual RRD.

It will be important to bear in mind the consequences of the proposed measures for customer services when designing the more detailed secondary legislation and regulations relating to ring-fencing. Of particular concern is the interaction of restrictions on a ring-fenced bank’s geographical activity and on its exposure to financial institutions, which may significantly impair its ability to support UK businesses trading overseas, particularly SMEs, through services such as trade finance and liquidity management.

Responses

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?

1.1 RBS remains supportive of the extensive reform agenda that has been pursued since 2008, most notably through the Basel Committee on Banking Supervision. This agenda includes higher capital ratios, changes in risk weightings, and redefinitions of capital; the addition to the Basel standards for the first time of rigorous global liquidity standards; the application of capital surcharges to systemically important banks; improvements to market clearing infrastructure; enhanced transparency and disclosure; enhanced resolution powers for regulators, including separation and bail-in mechanisms; and enhanced coordination to ensure consistency among international regulators.

1.2 This agenda is well-designed to make banks better able to absorb losses; to make it easier and less costly to sort out banks that still get into trouble; and to curb incentives for excessive risk-taking. Its implementation is already well under way.

1.3 RBS continues to have reservations about the consequences of ring-fencing, as proposed by the UK’s Independent Commission on Banking. We believe it is will tend to weaken banks’ credit ratings, could have negative economic impacts and, if not carefully executed, cause disruption to customers, while bringing at best modest incremental gains in resolvability, over and above the more targeted measures already in train through the Recovery and Resolution Planning Process.

1.4 Of particular concern is the significant risk that ring-fencing will, contrary to the intentions of the ICB or the Government, cement and make more explicit the perceived Government support for the ring-fenced bank. We welcome the Government’s confirmation (paragraph 2.10) that ring-fencing “does not mean that there should be a ‘zero failure’ regime for ring-fenced banks.” This may not, however, be the public perception.

Q2. 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?

2.1 Care will be needed to ensure that UK legislation remains harmonised with any eventual European legislation implementing the ring-fencing proposals outlined recently by the High-level Expert Group on reforming the structure of the EU banking sector (“the Liikanen Group”). Though the two variants of ring-fencing appear compatible in some respects, there could also be some divergences.

Q.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?

3.1 In our view, the draft Bill gives sufficient effect to the ICB’s recommendations,. It provides powers for the Treasury and regulators to define (inter alia) the scope of ring-fenced bodies and the rules to apply to such bodies, and gives preferential creditor status to deposits within scope of the financial services compensation scheme. It also provides powers for the Treasury to require relevant bodies to issue or hold debt instruments.

3.2 Since the draft legislation is framed as an enabling Bill, it is not possible (beyond the high level of generality specified above) to talk of any deviation from the Government’s stated objectives. The extent to which these objectives are met will depend on how secondary legislation and regulatory rule-making is, in practice, defined and implemented. It remains difficult, nevertheless, for banks to plan extensively for the implementation of ring-fencing on the basis of the high-level primary legislative language contained in the draft Bill.

3.3 There remain some significant potential problems: for example, it is not our impression that either the ICB or the Government intended ring-fencing to inhibit the provision of export finance to UK exporting companies, particularly SMEs, whose deposits will be required to be placed inside the ring-fence, yet there remains a significant risk that the restrictions on dealings between a ring-fenced bank and other financial institutions will have this effect.

Q4. What should be the timetable for implementation of these measures, and should it be set out more clearly?

4.1 The structural changes involved in ring-fencing will require a significant implementation effort over a number of years, and will need to be executed alongside a number of other important change programmes, many of them mandatory to meet regulatory requirements. Implementation of the ring-fence will be a complex process involving considerable disruption to customers, for example, potential migration of several million retail customers and tens of thousands of UK corporate customers to new account numbers and sort codes. Legal entities and contractual arrangements will also require significant restructuring. Customer impacts will be amplified if the restructuring is carried out too hurriedly. Some aspects cannot be properly planned until the legislation has taken a clearer shape so the target date of 2019, while potentially achievable, will represent a significant challenge.

4.2 By way of comparison, RBS is currently engaged in the transfer of a substantial part of the business activities of RBS NV, its Dutch affiliate, to RBS plc. While much smaller in scale than the implementation of ring-fencing, this project similarly involves the transfer of assets and liabilities between legal entities, changes to customer arrangements and court and regulatory approvals. Following one year of detailed planning the Group Board approved the full project plan in April 2011, and completion of the transfers is expected at the end of 2013.

4.3 Creating the necessary levels of loss absorbency at each level of the Group may take longer, as this may entail not only migrating existing debt and regulatory capital instruments between legal entities but also potentially issuing the necessary quantities of compliant instruments into a market of as yet uncertain depth.

4.4 Given the difficulties of separating pension funds and the potentially large costs that could arise from enforced separation at a time when most such funds are in substantial deficit, a longer timescale appears essential for completion of this element. Although the details of bail-in mechanisms are, as we understand it, intended to be included in subsequent legislation implementing the Recovery and Resolution Directive, we note that if bail-in is to be applied in the first instance only to debt instruments that explicitly provide for this, as envisaged in the Government’s White Paper and in the Liikanen report, then it will be difficult by 2019 to establish a sufficiently deep and liquid market to enable issuance in the volumes that are likely to be required.

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

5.1 The continuity objective is framed solely in relation to core services and activities. However, it is conceivable that in the event of a failure of a major group, it may be important to maintain the continuity of certain non-ring-fenced services and activities, if only for a limited period of time, in order to maintain financial stability and thus the safety and soundness of PRA-regulated persons (the PRA’s general objective). For instance, it is quite possible that a resolution authority may wish to maintain the trading operations of a failed bank, until such time as an orderly running-down or sale of a trading book can be effected. Whilst the narrow scope of the continuity objective would not of itself necessarily prevent such action from being taken, a more broadly defined continuity objective that recognises potential risks to financial stability arising from outside the ring-fence and the need to manage these as well, would help regulators meet their wider objectives.

Banking standards and competition

Q6. What will be the impact of the proposed changes in the draft Bill on banking standards in the UK more widely?

6.1 We see three possible adverse consequences of the proposed changes on banking standards:

To the extent that ring-fenced banks are perceived to be safer and to benefit from implicit Government protection, this could give rise to moral hazard and could encourage additional risk-taking behaviours.

By dividing universal banks, ring-fencing could lead to divided resources and increased volatility; this could also affect the ability to sustain customer support in difficult times.

By increasing costs, ring-fencing may also put further pressure on bank profitability; this may also affect behaviours as banks seek to restore profitability levels.

Q7. What will be the impact of the separation of retail and wholesale banking on the culture prevailing within each?

7.1 We do not believe that it can be confidently predicted that separation of retail and wholesale banking will have any measurable impact on culture. Many of the influences on culture within retail banks that have attracted criticism in recent months are derived more from retailing than from investment banking. We would be concerned if the impression were gained that ring-fencing amounted to a panacea for the cultural issues facing the banking industry. We remain concerned that placing a ring-fence between retail and wholesale banking could exacerbate the inaccurate perception that ring-fenced banks will be safe, while non-ring-fenced banks will be less safe. Evidently, the great majority of financial crises in history have been associated to a considerable extent with housing and real estate lending, which would in most cases fall inside the retail ring-fence.

Q8. What will be the impact of the ring-fence on competition, both in retail and investment banking, and in other areas of financial services?

8.1 There is a risk that the perception of Government protection for ring-fenced banks will entrench their competitive position and give them an advantage over smaller competitors or new entrants. While the Government has confirmed that it is not its intention that there should be a “zero failure” regime for ring-fenced banks, it is clear that many of our customers view ring-fenced banks as likely to offer a significantly safer home for their money than any bank not subject to the same regime. This could result in an adverse impact on competition.

8.2 The proposed de minimis exemption from the requirements of ring-fencing is likely to open up competitive opportunities for smaller banks, particularly in customer segments such as wealthier individuals and more sophisticated SMEs, who may be able to obtain a more comprehensive set of products and services from an exempted bank than they would from a ring-fenced bank. It may also lead to the migration of some business lines to the shadow banking sector.

8.3 While these exempted banks would not be subject to the incremental capital buffer proposed for ring-fenced banks, we do not anticipate that this would have any practical effects, as the ratios required of ring-fenced banks are likely to set a market norm which other banks would also be expected to meet.

8.4 UK investment banks will be placed at a competitive disadvantage to other investment banks not subject to the same restrictions, though it is possible that this competitive imbalance may be at least partially redressed by any ring-fencing measures introduced across the European Union as a result of the Liikanen proposals.

Delegated powers and accountability

Q9. 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?

9.1 The stated intention is, of course, for the Bill to be enabling legislation, but it operates at an extremely high level—arguably too high. Whilst some of the principles and parameters under which some of the delegated powers would be exercised are explained in the policy overview section accompanying the draft text of the Bill, these are generally not replicated in the Bill itself. We elaborate on this below.

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?

10.1 We recognise the need for the Government to retain a certain amount of flexibility in order to respond to changing conditions. We would also note the difficulty of taking forward legislation and progressing policy in advance of the landscape at the European level becoming clear. Whilst the European Commission’s High Level Expert Group under the chairmanship of Erkki Liikanen has recently reported on its own ring-fencing recommendations, these remain ambiguous in a number of respects, and the European Commission itself has not yet indicated how it intends to respond to the report.

10.2 Although the policy overview chapter accompanying the Bill is helpful in articulating the basis on which the Bill has been drafted, the key concepts linked to ring-fencing and a PLAC are, in fact, loosely defined in the Bill, with the authorities having been delegated broad powers to craft these concepts. For instance, the Bill does not narrowly define “core services”, “core activities” and other key terms. Similarly, the authorities have broad discretion in s142A (3) to dis-apply ring-fencing to certain institutions; we would welcome greater clarity as to the parameters within which such discretion might be applied. Further clarity would also be welcome in relation to the definition in section s142J (3) of which instruments qualify as loss absorbent, aligning it to the more specific description offered in paragraph 2.57 of the policy overview.

Q11. 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?

11.1 As touched on above, in giving discretion to the authorities to craft secondary legislation and rules, it would have been helpful in our view for the Bill to have provided more specific parameters to help frame the discretion provided for.

11.2 For instance, the exemption in s142A (3) specifies that classes of UK institutions may be exempted from ring-fencing if the Treasury are of the opinion that such an exemption “would not be likely to have a significant adverse effect on the continuity of the provision in the United Kingdom of core services”.

11.3 Such an approach will make it difficult for oversight and challenge to be applied to the exercise of such discretion by the Treasury—ie whether such delegated powers have properly been applied. This is particularly significant given that the use of such delegated powers in many cases could significantly impact the ability of individual institutions to compete in the market.

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?

12.1 While we are conscious of the danger of increasing and extending market uncertainty about the franchise value of ring-fenced banks, on balance we consider it appropriate to establish a mechanism for reviewing the effects of ring-fencing and other associated reforms, which are far-reaching and will have significant impacts on the business and operating models of affected institutions.

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?

13.1 We acknowledge that the additional costs ring-fencing would entail for banks with only small amounts of mandated deposits could be disproportionately heavy, and might in some cases not be justified by the limited increase in resolvability that ring-fencing would bring for a bank of this size.

13.2 Nevertheless, if the intention of ring-fencing is to improve the possibility of resolving firms without taxpayer support, then it would appear that this ought also to apply to firms with less than £25 billion of insured deposits. We note that Northern Rock, at the end of 2006, had £22.6 billion of retail deposits, yet the Government of the day took the view that it was necessary to take Northern Rock into temporary public ownership.

13.3 In principle, our view is that ring-fencing should be applied to ensure that all firms authorised to accept deposits in the UK operate on a level playing field. RBS is concerned that this principle will be undermined if there is a £25 billion threshold of mandated deposits below which firms will not be subject to the ring-fencing requirements, and so will be able to offer a more extensive and flexible product offering, by utilising prohibited services, than would be available to firms that are required to comply with the ring-fence principles. This same concern as to prejudicing equal treatment extends to the Government’s proposal to exempt non-EEA headquartered firms from the ring-fencing requirements. If firms below a certain size are to be exempted from the requirements of ring-fencing, we, therefore, suggest consideration should be given to a lower threshold than that proposed by the Government.

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?

14.1 The draft Bill appears to give the Government ample scope to define both the baseline core activities and any additional activities that might subsequently be considered core (see above para10.2). It should be noted that transferring activities of this kind from one legal entity to another may entail significant execution difficulties and disruption to customers, so adjustments to the perimeter of core activities should not be undertaken lightly.

Q15. Which categories, if any, of customer should be permitted to deposit with a non ring-fenced bank?

15.1 From the customer’s point of view, it is important that the ring-fencing regulations balance the competing priorities. On the one hand, it is clearly necessary to protect the interests of those customers who are not well-placed to cope with a disruption of supply, and who would be likely to benefit from the perceived security afforded by the ring-fence. On the other, those clients with more complex financial requirements should not be unduly restricted in their freedom to be served within a single bank, if they should so choose. This will have implications in particular for two categories of customer: wealthy individuals and more complex SMEs.

15.2 Wealthy individuals

Whilst an opt-out mechanism provides a means of balancing these interests, it is important that the criteria be clear and certain, in order to reduce the risk of retrospective challenge. We agree with the White Paper’s view (paragraph 2.17) that the client needs to actively choose to place his or her deposits outside the ring-fence. We also support a sophistication test along the lines proposed in paragraph 2.17, and agree that a financial threshold based on free and investable assets with a single bank will be much easier for banks to apply than a definition based on total client assets, so reducing the risk of accidental non-compliance. The calibration of the opt-out threshold is more problematic. At the upper end of the band proposed in the White Paper (£750,000), 11% of our Wealth division’s UK clients would potentially be eligible to opt out of the ring-fenced bank. At the lower end (£250,000) an additional 15% of UK clients would be eligible, capturing many professionals after 10–20 years of career in middle management. In more buoyant economic conditions, some clients lacking the appropriate sophistication might be attracted to non-ring-fenced banks. Since the White Paper favours an exemption from ring-fencing requirements for banks with less than £25 billion of insured deposits, covering a very large portion of institutions competing in the high net worth market, it is particularly important that the opt-out mechanism provides a workable means for the very few banks that will be affected by ring-fencing to continue to provide an appropriate level of service to more sophisticated clients, to avoid competitive distortions. Ensuring full compliance with all opt-out requirements for the larger client segment would be likely to create additional operational complexity and costs.

15.3 SMEs

Some customers categorised as SMEs by virtue of their turnover have an operating model that demands access to a complex product suite. Typically, these customers are found within the Professional/Financial Institution/Real Estate Sectors, who in RBS’s case make up 18% of the SME portfolio segment. The cost of accessing such products (via a non-ring-fenced provider) may increase for these customers were their deposits to be mandated within the ring-fence. We are also wary of imposing restrictions on customer choice without compelling reasons. This suggests either a low turnover threshold for defining core SME deposits, or alternatively a mechanism permitting a small number of customers defined as SMEs to opt for service from a non-ring-fenced bank.

15.4 We are mindful of the practical difficulties in implementing “opt-out” provisions. At a minimum, tight processes and controls would need to be in place, including, but not restricted to, mechanisms to ensure that opt-outs were only possible at customer instigation; controls to ensure that no incentives, direct or indirect, were in place to influence opt-in/opt-out decisions. Legal rigour would also be needed to ensure that the option was exercised solely in the customer’s own interests. Nevertheless, we consider that an opt-out mechanism would be a necessity if the turnover threshold were set at the higher £25.9 million level discussed in the Government’s White Paper on Banking Reform, to protect the interests of customers with more complex financial requirements whose access to appropriate services would otherwise be harmed. In some instances these customers could retain access to a broader set of services through agency arrangements, but they would be likely to suffer some cost impact.

15.5 An alternative would be to set the turnover threshold at £6.5 million, which we understand was broadly supported by respondents to the White Paper. This would maximise access to products for customers with complex needs. It would not provide the mandated protection to the majority of customers who would be unaffected by issues around access to more complex products. However, as the White Paper notes (2.11) firms above the threshold could of course choose to place deposits in ring-fenced banks if they wished. We also anticipate that, as a matter of practical customer segmentation, we would in any case continue to serve many customers with turnovers in excess of £6.5 million from within the ring-fenced bank, just as today there are a number of customers with turnover greater than £25.9 million who we would, nevertheless, currently serve within our Business and Commercial Banking business as their financial needs tend to be more straightforward.

15.6 We recommend that, for companies forming part of a group of companies, any assessment of the requirement to bank with a ring-fenced bank should take place at group level.

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?

16.1 We agree both that the provision of certain derivatives to third parties should be exempt from the general prohibition on trading in derivatives, and that with appropriate safeguards the ring-fenced banks should be permitted to sell retail investment products.

16.2 There is a clear benefit to any client (particularly smaller clients) to be able to source all banking product from one provider. A split banking proposition under the proposed model (loan from the ring-fenced bank, hedge from the non-ring-fenced bank) would result in additional costs for the client given that the non-ring-fenced bank will require collateral to cover the risk in the derivative contract.

16.3 Retail mortgage customers currently have access to products that enable them to manage interest rate/currency risk. The final definition should allow retail clients the same range of currency/interest rate risk management options they currently have. Corporate customers served by the ring-fenced bank should also have access to interest rate and currency risk management products.

16.4 We propose a model where the ring-fenced bank would act as principal in the derivative transaction, while backing out the market risk, through a fully-collateralised ISDA arrangement, to a non-ring-fenced entity. The ring-fenced bank would receive client trade revenues and retain the full credit risk, while the non-ring-fenced bank would receive revenues from the hedge trade, while retaining the market risk. This is in line with commentary in the White Paper and draft Bill; it would also make it easier and less costly to sort out banks that still get into trouble as any market risk exposure is fully collateralised, making it readily transferable to a third party. Doing this on a portfolio basis is a lot simpler than to novate thousands of individual contracts to a new third party.

Exposure Safeguards

16.5 In practice, it is extremely difficult to define “standardised” or “simple” derivative products. In particular, the proposal in 2.41 of the White Paper to use the accounting fair value hierarchy to define the restriction does not appear appropriate, since this could exclude innovative products of material benefit to clients.

16.6 A robust approach would be to define the product restriction in terms of the net market risk and credit counterparty risk remaining in the ring-fenced bank.

16.7 The ring-fenced bank could provide derivatives (and, in particular, structured retail deposits) wherever the ring-fenced bank is able to:

16.7.1Mitigate entirely the resultant market risk by laying off the risk on a back-to-back basis with the non-ring-fenced bank;

16.7.2Ensure the contract with the non-ring-fenced bank is covered by standard documentation (Credit Support Annex and ISDA); and

16.7.3Mitigate any counterparty credit risk through full collateralisation of the net derivative position with the non-ring-fenced bank with daily margin calls.

16.8 The resilience and resolvability of the ring-fenced bank would, therefore, be maintained and ring-fenced banks could deliver products demanded by their clients. If the non-ring-fenced bank were to fail in an idiosyncratic event, the collateralised portfolio of hedges could be readily sold in the market in a reasonable timeframe given the number of competitors and scale of competition

16.9 These restrictions could be supported by a materiality threshold on how much of the ring-fenced bank’s business could be taken up by these client-originated products—for example, a cap on the proportion of the ring-fenced bank’s revenues or gross balance sheet devoted to such products. This would address concerns about the impact of providing these products on the resilience and resolvability of a ring-fenced bank in a more general market crisis.

Conduct Safeguards

16.10 The assessment of the suitability of any product for a particular client is overseen by the FCA under Conduct of Business regulation. Therefore, there should be no need for further restrictions on the type of client to whom products can be sold.

16.11 In the model we have proposed, the client transacts directly with the institution it is used to, through the relationship manager it knows. The relationship manager is best placed to understand the client’s needs, suitability of products and can introduce to professionally qualified product specialists where appropriate.

Q17. 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?

17.1 The draft Bill states that Ring Fencing Rules must make provision about the corporate governance of the ring-fenced body with a view to securing as far as practicable its ability to act independently of other members of the group. The ICB recommends that independence is protected through rules requiring at least half the board of the ring-fenced bank, excluding the Chair, to be independent of the non-ring fenced Bank. A board member should not have had a material business relationship with the ring-fenced bank, or the rest of the group within the previous three years. In addition it is proposed that no more than one-third of the members of the ring-fenced bank’s board should be representatives of the rest of the group (either as board members of the wider group or executives).

17.2 RBS fully understands the requirement to protect the independence of the ring-fenced bank. However, we believe it is also important to reflect appropriately the ring-fenced bank’s obligations to its shareholder within an integrated group structure.

17.3 We consider that companies should retain the flexibility to determine their own corporate structures provided that operational separability and resolvability can be maintained.

17.4 As to whether these arrangements are compatible with directors’ duties and principles of accountability, structural considerations and the cross-membership between ring-fenced and parent boards highlight the requirement to consider and clarify the legal responsibilities of each board in order to minimise conflicts arising as a result of directors’ duties to each company and their respective shareholders. We believe ring-fencing rules must give practical clarification of responsibilities in this regard. RBS believes that decisions relating to the strategic direction of the group must lie with the board of the parent company as it is ultimately, and solely, responsible to external shareholders for the performance of the entire group, including the ring-fenced entity. Day-to-day decision making within the confines of implementing the strategic plan should be the responsibility of the ring-fenced bank.

Q18. 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?

18.1 We agree with the RRD proposals to allow intra-group support arrangements, but with specific approvals for agreements concluded in times of disruption. As alluded to in the White Paper, this should also be aligned with developments of the BCBS Large Exposures Group, ensuring that UK banks are not placed at a competitive disadvantage.

18.2 It is important that a group has flexibility to re-balance funding across the group to manage business cycles. Restrictions should not create an incentive to perversely take on additional risk to utilise available funding. They should also not pressurise groups to re-organise business so that assets are aligned with funding already raised. This disrupts customers and places banks at a competitive disadvantage.

18.3 The Government should also consider how seasonal trends, which are likely to be similar for ring-fenced banks, will be accommodated within market flows. A process under which balances simply flow between the ring-fenced segment and the non-ring-fenced segment via third parties may not provide a material improvement in the effective independence of these two segments, certainly if compared to a collateralised intra-group funding model.

18.4 We believe that exposures between the ring-fence and the rest of a group should, at a minimum, be treated the same as on a third party basis as proposed by the Government. However, we believe that this limit should be higher than for third parties, to provide groups with the ability to manage the seasonality of its group business. Unduly restricting intragroup exposures would tend to exacerbate the systemic risk the ICB’s proposals were intended to address, by increasing intergroup linkages and so raising the risk of contagion.

18.5 It is important that exposures are measured on a “net of collateral” basis as would be the case for third party Large Exposures. Collateral should also be of sufficient quantity and quality and should at least include assets that the ring-fenced bank is permitted to hold. Eligibility of collateral should also be reasonably broad so that banks are able to maintain adequate collateral availability for discount window facilities. The proposal to measure exposures gross of collateral contemplated by both the ICB and the Government, appears perverse, as it would intragroup exposures on a more restrictive footing than those between groups.

18.6 Governance requirements for a ring-fenced bank provide strong measures to protect the independence and resilience of the ring-fenced bank. These should safeguard management of credit risk as well as any incentive to mis-state the value of collateral for internal transactions.

18.6 The Government has previously stated (White Paper paragraph 2.59) that banks should be free to organise their operational structures as they choose, so long as they remain consistent with separability of the ring-fenced bank and have regard to the need to continue the provision of its services. We are keen to see early clarification of a number of elements related to operational structures, including the basis on which an operational subsidiary of the ring-fenced bank might be approved, and whether it is intended that a ring-fenced bank would be prohibited from owning a non-banking operational subsidiary outside the European Economic Area.

Q19. Will it be possible to effectively monitor and police the ring-fence, given the degree of regulatory discretion the draft Bill proposes?

19.1 The draft Bill proposes very wide discretion for the assumption of regulatory powers. However, given that the parameters for the nature of the ring-fence are as yet insufficiently clear, it is difficult at this stage to determine with certainty how easy it will be to police effectively.

Q20. 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?

20.1 In addition to the comments made in response to Q17 we believe that a degree of commonality of membership between the board of the ring-fenced and the board/s of the holding company/non ring-fenced entity is essential. This commonality will promote consistency and coherence, promote the interests of the ring-fenced bank with the main group, avoid conflicts and reduce duplication. However, the ICB requirement to have both a majority of independent directors on the ring-fenced board and also to ensure that two thirds of the board have no connection with the rest of the group raises practical and operational concerns. It is fundamental that there is strategic coherence in the manner in which the ring-fenced and non-ring-fenced banks operate, and this can only be achieved where there is a reasonable degree of cross-membership between the decision-making entities within the group.

20.2 Under current proposals, to have even a limited degree of common membership across both boards could lead to unwieldy boards, with a large number of new independent members. For example, it would not be unreasonable to have three individuals on the ring-fenced board who were also representative of the wider group/non-ring-fenced board. Applying the requirements as set out in the White Paper, this would result in a ring-fenced board of at least ten, comprising an independent chairman and five entirely new independent members. The remaining member (potentially an executive of the ring-fenced bank) would also be unable to represent the rest of the group. While prima facie this may not appear unduly onerous, the requirement increases proportionately with each “dual-hatted” member.

20.3 Furthermore, current board directors could not make up the independent membership (even if they no longer represented the non-ring-fenced bank), given they have held a material business relationship with the wider group in the preceding three years. Practically, sourcing and recruiting the appropriate number of new independent directors who possess the correct skill set is likely to prove difficult. Restrictions on the available talent pool, the need to consider diversity targets and/or the need to limit boards to a manageable size is likely to serve to limit common board membership and the number of individuals on the parent board who are representing the interests of the ring-fenced bank.

20.4 Provided responsibilities are clear, and conflicts policies are understood, RBS believes that policies implemented should support a level of common membership that allows, practically and operationally, the successful adoption of dual board governance. In order to maintain continuity it is important that flexibility in arrangements, in particular the ability to consider existing holding company directors for positions on the ring-fenced board, is supported through transition and implementation.

20.5 Subject to the above, RBS believes that together with appropriate regulatory oversight, these measures will promote separability, will improve standards and will provide protection to the ring-fenced entity.

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?

21.1 The proposal to prefer insured deposits in the event of a bank insolvency is in our view of questionable benefit. We are concerned that the UK proposal on depositor preference may be a) inconsistent with EU policy and b) incorrectly positioned as helping depositors, when it would in fact only benefit deposit guarantee schemes. Depositor protection comes from the Financial Services Compensation Scheme (FSCS) and not through any preference on liquidation. Preferring insured depositors results in the FSCS being preferred, as the depositor loss that it covers would only materialise after other senior creditors have absorbed losses first. This makes it a remote possibility that the FSCS would be used and alters the previously pari passu status it shared with other senior creditors in the creditor hierarchy. The preservation of the creditor hierarchy is an important principle agreed by the industry.

21.2 If the principle of depositor preference is retained, it should ideally be limited to as narrow a scope as possible. Broadening the scope further increases the pool of preferential creditors, decreasing the rights of other creditors and, therefore, making the UK banks less able to conduct business.

21.3 It is important that preferred status is limited as far as possible, to ensure that sufficient eligible liabilities are available to absorb losses through bail-in, while preserving as far as possible that no creditor should be worse off than in liquidation.

21.4 Rather than granting the FSCS this preferred status, or enabling the FSCS to assume the preferred status of the depositors it is insuring, deposit guarantee schemes should, as in the EU RRD proposal, be included in a bail-in regime as a senior unsecured creditor, similar to their status in liquidation. This would ensure that the pool of eligible bail-in liabilities is as broad as possible to absorb potential losses. It would also ensure that all banks are able to meet any bail-in requirements set by regulators, and would be in the best interests not only of other creditors but also of the FSCS itself, since the purpose of a bail-in is to preserve more value than would remain for all creditors in the event of a disorderly and protracted liquidation.

21.5 “Rather than a Deposit Insurer having to wait to discover its losses until the end of the process of a potentially destructive realisation of the bank’s assets, it would hear up front how much it had lost. Its losses should be smaller that way. And it might gain a stake in a surviving business, which it could sell once conditions had calmed.”1

Capital levels

Q22. Does the draft Bill adequately implement the ICB’s recommendations on loss absorbency requirements?

22.1 We believe that bail-in is best achieved through statutory application to as wide a range of bank liabilities as possible, though with clarity around the hierarchy within which bail-in would apply. We believe that the best way of achieving an appropriate loss absorbency regime will be through alignment with CRD IV/CRR and the RRD, rather than setting out a standard minimum loss absorbency requirement.

22.2 We support the Government’s acknowledgement of loss-absorbing capital in the Basel III accords, for implementation across the EU through the CRD IV/CRR. We also support the Government’s recognition of the RRD proposals on requirements for banks to hold “minimum eligible liabilities”.

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?

23.1 Our view is that the most appropriate means of achieving an effective loss absorbency regime is through alignment with CRD IV/CRR and the RRD, rather than setting out a standard minimum loss absorbency requirement.

23.2 We believe it is important that the Government works through the RRD process to achieve a harmonised loss absorbency regime across at least the major economies, ensuring consistency and enforceability.

Q24. 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?

24.1 We support the introduction of a loss absorbency regime, but believe that some aspects of the design would be more effective if aligned with CRD IV/CRR and RRD proposals.

24.2 We believe that, in the unlikely event that capital requirements are insufficient to absorb losses, a regime that is sufficiently broad will be capable of providing a well-capitalised banking system.

24.3 We agree with the Government’s proposal to allow an exemption for overseas operations that pose no likely threat to UK or EEA financial stability. We believe this exemption should be based on the relevant regulator’s assessment of a group’s resolvability and its loss absorbency requirements.

24.4 We support the RRD proposal for loss absorbency requirements to be set by the individual bank’s regulator. The regulator will be able to consider the minimum eligible liability requirement after taking into account the risk profile of the individual bank and its loss absorbing capital held through CRD IV/CRR. A standard minimum across the industry can result in perverse fund-raising purely to achieve minimum eligible loss absorbency requirements.

24.5 We support the Government’s view that categories for loss absorbency should include regulatory capital, subordinated debt and senior unsecured debt and believe that the pool of senior unsecured creditors should be made as broad as possible to ensure that there is more than enough debt available to absorb losses.

24.6 We do not support an exclusion of liabilities based on “term remaining”. This will lead to confusion on which debt is included when loss absorbency is triggered. We believe that an exemption based on “original maturity” would provide clarity at the time of initiating the liability, on which liabilities will be included in the loss absorbency regime.

24.7 While we feel that a term maturity exclusion may not be necessary, as a result of the liquidity regime having been greatly strengthened and of the increased costs that longer term senior creditors would demand for bearing a greater risk of loss, we feel that on balance, excluding liabilities with an original maturity greater than six to twelve months may reduce a run on any bank in times of stress and thereby limit contagion.

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?

25.1 We agree with the Government’s decision not to increase the leverage ratio beyond the Basel III level to maintain consistency with international standards.

25.2 We note that the Basel Committee, in its initial recommendation of a backstop Tier 1 leverage ratio, was far from certain that this figure was correctly calibrated. Therefore, it proposed an observation period to 2017, to allow more precise calibration through the cycle. It would be premature to conclude that a higher ratio is required. The Basel Committee observed that, while the data it had examined “provide a sense of recent historical trends that is useful background for calibration, they do not lead directly to suggested regulatory requirements.”

25.3 We also note that neither the original Basel Committee data nor, as far as we can determine, the ICB analysis supporting its recommendation of a higher leverage ratio, matched the definitions ultimately adopted by the Basel Committee, which includes, in addition to total assets, undrawn exposures. It is puzzling that the ICB should be so certain, to two decimal places, of the appropriate ratio, while ignoring this substantial change to the denominator.

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?

26.1 We are of the view that UK authorities will have the necessary tools and powers to carry out resolution while maintaining financial stability and minimising risk to public funds. These add to the powers already introduced under the SRR for sale of assets and a bridge bank.

26.2 In particular we would point to the proposals under CRD IV/CRR to provide capital and liquidity strength and resilience, as well as loss absorbency capability.

26.3 We would also point to a well-designed loss absorbency regime that provides for broad loss absorbency and recapitalisation to avoid risk to public funds. If this regime is not defined through requirements to issue specific instruments then it is even more likely to be established.

26.4 A “retail” ring-fence may also add to resolvability and financial stability by aligning activities supporting depositor business and essential services. However, care should be taken to ensure that this alignment does not negate the benefits that a group offers, enabling support across the group as proposed by the RRD to manage peaks and troughs in business activity.

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?

27.1 We support the Government’s intention to deliver a bail-in regime through the transposition of the EU RRD, resulting in a broadly consistent design of bail-in tool across different jurisdictions, particularly the EU, US and Asia.

27.2 We believe that the design of the bail-in environment should take into consideration aspects commented on in Qs22–24 above, so that there is broad bail-in eligibility that provides maximum loss absorbency and recapitalisation.

27.3 We believe that good progress has been made through industry working groups to propose a workable bail-in regime, which if adopted by the RRD may deliver effective bail-in powers. Key here is for the authorities of the different jurisdictions to agree on a harmonised legal framework.

Impact assessment

Q28. Is the impact assessment of the costs and benefits credible and balanced?

28.1 Like the ICB’s cost/benefit analysis before it, the impact assessment tends to apply a narrower and more selective filter for the estimated costs than for the putative benefits.

28.2 The estimates of costs, although open to discussion on some points, are itemised. The estimates of benefits, on the other hand, are dependent on a broad hypothesis relating to the growth impact of financial crises and the frequency of such crises. The impact assessment’s analysis draws heavily on the ICB own cost/benefit analysis, which in turn draws heavily on analysis conducted by the Basel Committee on Banking Supervision.

28.3 Such analyses tend to estimate the cost of financial crises on the basis of an extrapolation of pre-crisis growth trends, without adjustment for the unsustainable credit booms that generally precede them; and to attribute the entirety of the output gap to the financial crisis. We note that the International Monetary Fund’s latest estimates now acknowledge that actual output in 2007, a period the Government has itself described as characterised by unsustainable levels of leverage, debt and credit growth, was in fact 3.6% above sustainable potential output. This means that the gap between forecast potential output and pre-crisis trend potential output is smaller (because the starting point is lower; it also means that the economy benefited for a while from above trend growth, which is not factored into the impact analysis.

28.4 The benefits of reducing the probability and impact of financial crises have been claimed many times over by official impact analyses. The BCBS analysis2, on which both ICB and the Government Impact Analysis draw, estimated that increasing the ratio of Tangible Common Equity to Risk-Weighted Assets from 6% to 10%, combined with improved liquidity ratios (meeting the Net Stable Funding Requirement) that fall far short of the improvement in fact achieved by UK banks, would reduce the probability of systemic banking crises from 4.8% (close to the 4.5% figure used by ICB and the Government as a central baseline) to 1.2%. The only portion of this 75% reduction in probability that could properly be attributed to the ICB’s recommendations would be the marginal increment in capital ratios from the 9.5% CT1 ratio that will apply to systemically important banks to the 10% CT1 ratio proposed for ring-fenced banks. There is no obvious basis for positing that ring-fencing measures would reduce the probability of crises. Yet the Impact Assessment assumes that existing reforms will only have delivered a 30% reduction in the probability of financial crises and suggests that the measures in the draft Bill might deliver a further 10% reduction.

28.5 Put another way, the Impact Assessment calculates that to produce an incremental benefit to GDP of 0.1% (the upper end of the estimated range of GDP costs) would require the measures in the draft Bill to reduce the probability of future crises by 2.6%. The BCBS study suggests that the same reduction might more easily be achieved by an increase of approximately half a percentage point in capital ratios, without the disruption to customers ring-fencing will entail.

Q29. Might there be any other unintended consequences which have not been considered?

We have a number of concerns relating to the consequences of ring-fencing for certain customers. There is, for example, a real danger that a section of mid-market clients find that they no longer have access to a range of essential products, or have access only at a much increased price. For example:

29.1 If the ring-fenced bank were to be prohibited from selling basic risk management products, these would only be available from the non-ring-fenced bank or from international banks in the UK that operate below the ring-fencing threshold.

29.1.1Such non-ring-fenced banks/international banks mostly focus on the large corporate/financial institution market. They do not have the infrastructure (sales force, credit processes) or risk appetite to service a broad corporate client base across UK.

29.1.2Clients that fall outside their target demographic are likely to find no provider of risk management products, or at best no effective competition in the market for these services

29.1.3Clients who are able to access risk management products are likely to be obliged to fully collateralise exposures, given the non-ring-fenced bank will have limited risk appetite for mid-market credit exposures.

29.1.4This will significantly increase the cost and complexity of risk management for UK corporates.

29.2 Retail investors currently have access to a range of investment options, including capital guaranteed, equity-linked deposit products (structured investor products).

29.2.1Should the ring-fenced bank be restricted to selling only “standard” term deposit products, then such capital-guaranteed deposit products would no longer be available to UK retail investors.

29.2.2There is a danger that such investors would turn to either offshore providers or other higher-risk investments to find alternative investment solutions.

29.3 Larger corporate clients may be obliged to operate a “split banking” arrangement with the ring-fenced bank providing domestic clearing and the non-ring-fenced bank providing access to capital markets and risk management solutions.

29.3.1The high ring-fence proposal will limit the ability of the ring-fenced bank and the non-ring-fenced bank to work in tandem to support client needs.

29.3.2Clients are likely, therefore, to be obliged to separately collateralise exposures to each entity, as their banks will be unable to rely on intra-group limit structures to “share” pools of collateral.

29.3.3Each bank is likely to price services in isolation—potentially driving up cost of funding for corporates.

29.4 We remain concerned that the interaction of restrictions on a ring-fenced bank’s geographical activity and exposure to financial institutions may significantly impair its ability to support UK businesses trading overseas, particularly SMEs, who will only be permitted to place their deposits with ring-fenced banks but may not be able to access trade services from the ring-fenced banks. We urge the Parliamentary commission to give the most careful consideration to ways of ensuring that ring-fenced banks will be able to provide trade finance and liquidity management services to exporters and other businesses trading outside the UK.

International issues

Q30. What will be the impact of the proposals on the international competitiveness of UK banks?

30.1 Given the Government’s intention to allow for a de minimis exemption for any bank with less than £25 billion of insured deposits, the impact of the proposals is likely to be limited to a small handful of larger UK banks. There is likely to be some detrimental impact on the international competitiveness of this small number of affected UK banks.

30.2 The ICB did not deny that the impact on UK banks’ competitiveness would be negative but took the view (Final Report 5.82) that the question of competitiveness should be construed not in relation to UK banks but more broadly in the context of the wider City financial industry, arguing that:

“The historical record does not suggest there is any strong link between the success of UK banks in wholesale/investment banking and the success of the City.”

30.3 The Commission may take a different view of the consequences for competitiveness, employment and the wider UK economy of differentially handicapping UK-based banks in relation to their foreign competitors.

30.4 Absent a harmonized bail-in regime across key jurisdictions (certainly including Europe and the US) there may also be significant variance between different banks’ funding costs, depending on how the bail-in tool is embedded in the statutory regime in each jurisdiction and on regulatory guidance on how the tool would potentially be used.

Q31. 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?

31.1 While the Liikanen Report states that its own recommendations are compatible with the proposals in the draft Bill, it should be emphasised that they start from a different philosophical perspective. Whereas the Vickers proposals are based on the concept of ring-fencing those core activities that governments wish to protect, Liikanen takes the opposite perspective, recommending the ring-fencing of those trading activities it wishes to quarantine. The Liikanen recommendations are still at a very early stage of elaboration, and could emerge in somewhat different form once the European Commission has got to grips with some of the more detailed practicalities of implementation with which the UK Government has been engaged since the ICB published its final report. There is, therefore, a risk of conflicts emerging between the UK measures and any subsequent EU legislation giving shape to the Liikanen recommendations.

31.2 As an example, Liikanen gives no consideration to geographical scope. This might, therefore, potentially mean that a UK bank’s US or Asian deposit-taking branch or subsidiary would be prohibited from Vickers retail ring-fence, because it was outside the European Economic Area, and also prohibited from the Liikanen trading ring-fence, because of its deposit funding.

Other

Q32. What other matters should the Commission take into account?

We would draw attention to the following points:

32.1 Primary Loss Absorbing Capital (PLAC)

32.1.1The Policy Overview (paras 2.54 to 2.60) sets out the detail of the Government’s proposals in relation to PLAC, which include defining the categories of PLAC as being regulatory capital, subordinated debt and senior unsecured debt with at least twelve months’ term remaining and which the resolution authorities are confident can be bailed-in. However, S142J of the draft Bill does not reflect the important detail set out in the Policy Overview as the Bill refers only to the Treasury being able to order a “relevant body” to issue any debt instrument or to hold debt instruments of a particular kind. The Government has taken the decision to specify “senior unsecured debt with at least twelve months’ term remaining” as being eligible to count toward PLAC if the resolution authorities are confident that the debt can be bailed in. However, the EC RDD proposal is only to exclude from bail-in unsecured debt with a maturity of less than one month?

32.2 Liikanen

32.2.1The Policy Overview (para 2.4) notes that Liikanen Group’s proposal for ring-fencing of trading activities from deposit-taking has many similarities with the recommendations of the ICB, and that the Government’s plans for ring-fencing of UK banks are compatible with the Liikanen recommendations.

32.3 Core Activities

32.3.1S142(B)(2) states that the “regulated activity of accepting deposits (whether carried on in the United Kingdom or elsewhere ) is a core activity unless it is carried on in circumstances specified by order made by the Treasury.” This does not mirror paragraph 2.15 of the Policy Overview which specifically states that the Government believes that accepting deposits from individuals and SMEs should be a “core activity”. We would argue that the primary legislation could make it clear that the “core activity” will cover accepting deposits from individuals and SMEs, subject to the exemptions and threshold limits to be introduced for HNWIs and SMEs.

32.4 S5 Banking business transfer schemes

32.4.1S5 of the draft Bill introduces a new type of transfer scheme with the specific purpose of avoiding a ring-fencing contravention. Is the intention of this additional scheme to permit both (i) an institution that is licensed to accept deposits to transfer business to an entity outside of the ring-fence where the transferring business does not include any deposits; and (ii) an institution not authorised to accept deposits to transfer parts of its banking business to a deposit taking and/or non-deposit taking institution? This drafting may require amplification, more particularly as the transitional mechanisms put in place by the legislation will be of critical importance to minimizing the substantial organisational and customer impacts that transferring large numbers of customers between legal entities would otherwise entail.

32.5 Risk management/hedging

32.5.1Whilst the Policy Overview acknowledges that the process of accepting deposits and extending loans is inherently risky and that the ring-fenced banks will need to be allowed to manage this risk by means of hedging, derivatives and so on, the detail of what the ring-fenced banks will be allowed to undertake has still to be decided upon by the Government. In setting out the conditions for risk management the Government is requested to give thought to the practical implications of any restrictions that it is looking to impose as, for example, the proposal for derivatives contracts to be allowed only if they are centrally cleared (paper 2.27) is not likely to be a workable option until CCPs have had time to embed across the majority of institutions.

32.6 S410A Fees to meet certain expenses of the Treasury

32.6.1Further detail is requested from the Government on S410A and the wide power that it affords to HMT to introduce regulations that will allow each of PRA, FCA and the BoE to require payment of fees for “relevant expenses” (stated to include expenses of a capital nature) incurred in relation to activities around financial stability or financial services.

32.6.2An indication of the level of fees anticipated and the time at which fees will be imposed should be provided to avoid market concerns on what could potentially prove to be a new and substantial bank levy.

32.7 Pensions

32.7.1UK banks carry substantial pension liabilities, and in the current economic climate their defined pension funds have substantial deficits. Whilst we accept that to ensure an effective ring-fence, banks will need to separate the liabilities of their pension funds between those that relate to the ring-fenced bank and those that sit outside, it is important that this is managed over a long time period and without imposing further cash or capital requirements on banks at a time when that capital could be better used to generate economic growth in the economy.

32.7.2In achieving the pension fund split it may well be that the banks will trigger the payment of debts under Section 75 of the Pensions Act. We believe that an exemption from Section 75 debts should be legislated for as part of separation.

32.7.3It may also be that the separation of a bank’s pension liabilities can be effected by segregation of the pension fund’s liabilities into two separate sections, rather than through complete separation of the pension fund. Segregation would allow the combined bank to benefit from a single governance structure and economies of scale. Therefore, we suggest that segregation is a permitted option as well as full separation.

32.7.4In the current economic climate it is important to give banks sufficient time to achieve the separation or segregation of the pension liabilities. However, while we can understand why 2025 is proposed, we would support a later date for required separation. Even given a longer time period to separate pension schemes, banks still may not reach the point of fully funding their pension funds by this time if current economic conditions remain for a sustained period. We would, therefore, suggest that flexibility is given to allow the Government of the day to postpone the final date if difficult economic conditions prevail.

31 October 2012