Banking StandardsWritten evidence from Legal & General

Overall Summary:

We welcome the Government’s efforts through The Financial Services (Banking Reform) Bill (hereafter referred to as “The Bill”) to deliver greater stability in the UK retail banking sector and understand the rationale behind the proposals that have been put forward to implement the recommendations of the ICB.

We agree with the Government’s aim of ensuring a vibrant and competitive financial services market for all participants, recognising the distinct nature and contribution that the bank and building society sectors bring to retail banking in the UK.

However, as currently framed, the overall package of proposals could have a significant impact beyond the central policy objective of strengthening the prudential soundness of retail deposit-takers and reducing any perceived implicit Government guarantee with associated costs to taxpayers.

We are concerned that The Bill is an Enabling Act, with the majority of the detailed policy coming later through Secondary Legislation, regulatory rules and/or guidance. This makes it difficult to assess the totality of the proposed measures at this stage. It is important that stakeholders should be given the opportunity to comment on the detailed implementation measures for these proposals. We believe Parliamentary scrutiny of all parts of these proposals, whether through further legislation or regulatory requirements must be a prerequisite. Confirmation from Government that a full process of consultation and scrutiny of all measures will occur would provide important comfort to market participants, including investors in banks.

Some aspects of the proposals could have a negative impact on growth, investment and choice. We strongly welcome the Government’s decision to review its initial stance of prohibiting ring-fenced organisations transacting with insurance companies. However, the broad terms in which the proposals have been expressed suggest that they could significantly reduce the range of counterparties or asset types available to firms for financial management purposes. The resultant concentration of available counterparties could materially increase the risks and costs of funding for retail banks. We are concerned that the Government should take care to avoid placing unnecessary restrictions on activities where it is clear that they are unlikely to give rise to material systemic risks, are intrinsic to the mainstream activities of the ring-fenced entities themselves, and are important for the delivery of broader policy objectives including facilitating saving and prudent management of individual and household finances.

Banks and Building Societies provide millions consumers with essential access to a range of services and product solutions to their financial needs, including their saving, protection and investment needs. Insurers like L&G work in partnership with the proposed ring-fenced institutions to provide consumers with these services. The original Government White Paper was ambiguous as to whether they would continue to allow this. Given there is no material balance sheet exposure to ring-fenced institutions it is our assumption that our partnerships will not be impacted, but we require clarity. Failure to allow this important channel for customers to receive the products and services they need would have a detrimental impact on the UK economy and the ability of individuals to manage their finances, protecting their families and securing their financial futures.

We are disappointed that the Government is looking to provide itself the power to ask the FCA/PRA to levy financial services companies and their customers for UK membership of, or participation in, international organisations without explaining in detail what these costs will be.

Response to Specific Questions

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

1. The Government has stated that the measures will come into force by 2019, with primary and secondary legislation completed by the end of this Parliament in May 2015. We would like to see a more detailed timetable published by the Government, including when they anticipate regulators being asked to create any specific rules or guidance. This is to allow financial services firms to effectively prepare for the proposed changes, and ensure sufficient time to review and comment on draft legislation/regulation to provide effective input to these proposals.

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

2. We agree with the Government’s objective of trying to protect the provision of essential banking services. However, the PRA and FCA Continuity Objectives (sections 1EA and 2BA of The Bill), when combined with the very limited services and activities that ring-fenced institutions can undertake (in effect sections 142A-E of The Bill) is concerning. This is compounded by the fact the secondary legislation has yet to be tabled, making it difficult to establish the true impact that this Bill, or these specific regulatory objectives, will have.

3. As HM Treasury has stated “With a few very important exceptions, the majority of the detail of the policy will be set out in secondary legislation and regulatory rules. For example, the draft Bill introduces the concepts of “core activities” and “excluded activities” but currently only provides for one instance of each type of activity (respectively accepting deposits and dealing in investments as principal).1

4. Without appropriate safeguards in this Bill, or knowing the content of the secondary legislation, there is a risk that these new objectives could create a regulatory environment where ring-fenced institutions have unintended restrictions placed upon them which could impact their ability to undertake activities that are beneficial to the UK. At the extreme, as currently drafted in this Bill, ring-fenced institutions could not provide, for example, mortgages, credit cards, retail savings and investments, protection products etc. Although we do not believe this is the Government’s intention, clarity on this is required given the legislative process being adopted.

5. Additionally, in terms of objectives, we believe that both the FCA and the PRA should be given the same requirement as the FPC to support the wider economic policy of the Government; ie to ensure that regulation delivers its remit within the framework of promoting, for example, jobs and growth.

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?

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?

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?

Combined response to these three questions:

6. We have already set out much of our thinking in answer to question 5 and in our overall summary. Given the very significant changes being proposed, we are concerned that The Bill is an Enabling Act, with the majority of the detailed policy coming later through Secondary Legislation, regulatory rules and/or guidance. This makes it difficult to assess the totality of the proposed measures at this stage. This is compounded by Clause 12 (Transitional provisions and savings) appearing potentially to give Government the power to amend any enactment as a result of or included in this Bill.

7. There is also some ambiguity about the Government’s intended use of some of the powers as a result of them using enabling legislation with the detail in secondary legislation. As an example, the Government is using the Bill to provide HM Treasury with the power to direct the FCA/PRA to levy financial services companies and their customers for UK membership of, or participation in, international organisations. However, the Government has stated that “The detail of the organisations which are relevant to this power, and the detail of what expenses can be recovered, will be set out in secondary legislation”.2

8. Given that the Government is asking for customers of financial services firms to bear these costs, we do not think it is appropriate for financial services firms and their customers to be asked to fund public policy without full explanation of the anticipated costs. In the interest of transparency, the Government should publish its estimates to help all stakeholders, including Parliament, understand the full implications of these provisions.

Q11. 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?

9. We agree that it is important for there to be a regular review of these proposals. However we note that negative unintended consequences of poor primary or secondary legislation in terms of reduced investment in ring-fenced banks or reduced provision of financial products for individual savers, would be felt quickly, and could be difficult or impossible to correct after five years. We would reiterate therefore the importance of proper accountability, consultation and detailed scrutiny ahead of the process being implemented. Specifically on the five-yearly review, and given the broad nature of the proposed amendments, which also create requirements on the FCA and the Bank of England, we think that the Government should lead the review of the impact of ring-fencing rules with input from the regulatory bodies. We also suggest this report should also have to be laid before Parliament, including the Treasury Select Committee, to ensure effective scrutiny of the new laws.

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?

10. Only those activities which impact on the Government’s central aim of making deposit-takers more resilient to financial shocks should be considered when determining whether or not an activity should be prohibited. We are concerned that the proposals could unnecessarily prohibit or restrict the following:

The ability of ring-fenced institutions to sell and/or distribute retail investment and savings products.

The ability for Insurers and ring-fenced institutions to work in partnership to provide important retail products to consumers.

Consumers’ access to advice, especially in the post- Retail Distribution Review (RDR) marketplace.

The delivery of the Government’s Simple Financial Products initiative.

11. As we have already outlined in previous answers, our primary concern stems from the lack of reassurance provided by this Bill at present, owing to much of the detail being expected only to become known through secondary legislation.

12. As background, the manufacturing and distribution partnerships that we enter into with ring-fenced institutions will have no material adverse impact on their resolvability. These partnerships may involve one or more of: the co-manufacture of retail products; the provision of advisers employed by us to provide advice and guidance to the bank or building societies’ customers; or the distribution of our products through their own customer-facing staff. These arrangements allow banks and building society partners to leverage our expertise in the savings, investment and protection markets to provide a strong proposition to retail customers. Indeed, it can reduce consumers risk exposure through diversification.

13. If it were the Government’s intention to prohibit such activity (which we assume cannot be the case) it would have a substantial impact on the profitability and invisibility of the institutions Government are seeking to reform; it would remove employment from the economy and by reducing consumers’ access to financial products would make them more vulnerable to the variety of financial shocks and challenges that they will face during their lives.

14. The bancassurance model is a key route to market for millions of customers across the UK to access financial services products and advice to meet their savings and protection needs. Last year, 23% of our customers came to us via the 20 partnerships we have with banks and building societies. Across the market, almost one in 10 UK customers used this channel to meet their financial needs. We believe this route will become increasingly important following implementation of the Retail Distribution Review (RDR) next year which will reform the advice market.

15. Furthermore, as the Sergeant Review of Simple Financial Products (to which we provided support) has highlighted, bancassurers are viewed as potentially key distributors of simple financial products, as they represent a key “shop-window” for consumers—particularly first-time consumers—seeking access to products or advice on their core financial needs. Should the Government create any prohibition in the area of protection and saving, we believe the success and coherence of the Government’s strategy in this area could be significantly undermined.

16. We understand the Government’s desire to take a more precautionary approach in identifying the activities that ring-fenced institutions should be allowed to engage in; but given there is no downside risk involved in many of those that would be captured in the restrictions initially proposed, we strongly believe this Bill needs to consider these issue again in more detail in order to give a clearer, more risk-focused indication of the intent of the legislation.

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?

17. Our response to Q14 is also pertinent to this question. We are pleased that the Government has developed its thinking since it published its White Paper. We had been very concerned the Government may have been concerned about retail structured deposits. Given the change in language adopted by the Government in its “Sound banking: delivering reform” paper, it would appear they have accurately recognised that structured deposits have the same risk profile as any other form of fixed term deposit account offered by a retail deposit taker.

18. However, we remain concerned that the Government has not sufficiently articulated what it means when it asks in “Sound banking: delivering reform”, “whether ring-fence banks should be able to offer simple derivatives to their customers”. As a result it is difficult to assess the impact of their intentions. Until we are able to understand this, it is also difficult to set out what safeguards would be necessary.

19. We would be extremely concerned if the Government wanted to prohibit ring-fenced institutions from offering products which used derivatives for efficient portfolio management and the financial management of risks. To do so would preclude consumers from accessing a substantial range of important products. For example, a fixed rate mortgage, a fixed rate deposit account, a stakeholder pension, multiple types of investment based product. As it would run directly counter to policy objectives as we understand them, we are assuming that it is not the Government’s intention to prohibit such products.

20. We therefore suggest that further detailed work is undertaken to understand the precise concerns the Government has and to provide detailed input to inform what might or might not be included within this definition as part of any detailed secondary legislation. Given the Government’s intended legislative approach this would not in anyway undermine this Bill, and would in fact add to the credibility of the overall approach by removing ambiguity.

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. We agree with the Government’s view not to extend depositor preference beyond insured deposits to other categories such as non-EEA deposits, bank pension funds, local authorities or charities. We think it is important to provide reassurance to customers that their deposits are protected up to the FSCS limit. However we agree with the Government that the case has not been adequately made for widening the scope further. This is especially so given that the more senior unsecured creditors that are created alongside FSCS deposits, the less attractive the ring-fenced bank becomes to other investors (creditors).

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?

22. We recognise that the Government is likely to be much better placed to understand and influence the potential changes to the EU banking sector and we therefore welcome the update they provided alongside this Bill. However, it is clear that the EU legislative process often means that the initial proposals are modified, sometimes substantially, prior to being enacted. As a result, we think it is almost unavoidable for there to be overlap, under-lap and conflicts between the UK and EU initiatives in this area.

23. We believe that the UK Government will need to remain fully engaged with the EU banking developments, and should proactively look to ensure that it mitigates the cost and risks associated with any potential conflict given the substantial costs associated with both the UK and EU proposals.

Additional Points Not Covered In The Above Questions

Prohibited Institutions

24. We set out in our overall summary that we strongly welcome the Government’s decision to review its initial stance of prohibiting ring-fenced organisations transacting with insurance companies. However, we are concerned that even though the Government has not reached a view on this, it is continuing with this legislation that could enable them to enforce such a prohibition, only proposing to act at the secondary legislation stage.

25. Focusing specifically on insurance companies, it is worth noting that during the credit crisis, no UK listed insurer required government assistance or failed to meet obligations to policyholders. Indeed they were liquidity providers to the market and hence contributed to stability.

26. Even the largest insurance companies, so long as they are conducting insurance business, are moreover not “systemic” in the same way as banks. Insurance companies, when they fail, do so via a period of more protracted run-off as products are more illiquid and policyholders cannot therefore participate in a “run on the company” of the sort seen for example at Northern Rock. The exception is where insurance companies conduct non-insurance business (eg AIG). Shadow banking, or certain types of riskier non-insurance business conducted by insurers could in our view be justifiably prohibited.

27. It should moreover be noted that a well-established prudential regime, administered by the FSA, already exists for insurance companies, and is likely to be strengthened further by Solvency II. These arrangements, which have worked well, are designed specifically to protect retail customers. It would seem odd that the White Paper effectively proposes that, while consumers’ exposures to insurance companies are adequately covered by these rules, insurers are effectively deemed too risky for the ring-fenced banks.

28. More broadly, we had originally proposed to the Government an alternative, more risk based approach. The June 2012 White Paper had originally said: “The Government proposes that the type of institution that ring-fenced banks should be restricted in their dealings with should include:

non-ring-fenced banks, or banks that engage in otherwise prohibited activities;

investment firms;

funds and fund management companies; and

insurance companies.”

29. We believe this approach is inconsistent with the White Paper’s description (paragraph 2.32) of the characteristics of “risky” institutions. A much more appropriate approach would be to focus on the types of transaction conducted between ring fenced banks and other financial institutions—and particularly the exposures these create for the ring fenced entities—rather than the descriptions of the institutions concerned.

30. We are also concerned that the definitions of funds should not inadvertently capture entities such as pension funds, which could generally be characterised as low-risk institutions (and are limited by the nature of their own regulation as to how and why they can make investments and incur economic/market exposures) and, in the case of DB schemes at least, need to be able to access a range of counterparties in order to transact derivatives for legitimate, risk-hedging activities relating to their long-term (liability-driven) investment strategies. Furthermore, any application of a prohibition or restriction to “fund management companies” should take account of the nature of investment management activity in the UK whereby investment managers are usually acting as agent for underlying investors. Under any approach which does choose to focus on the institution with whom the ring-fenced bank transacts, it should be ensured that the principal underlying client, and not the manager firm is assessed.

31. A more appropriate approach would therefore be to permit or prevent types of transaction between ring-fenced and other financial institutions based on the degree of risk involved to the ring fenced bank, rather than imposing a blanket rule based on type of institution. Under this approach, only those transactions or relationships creating a genuine risk exposure for the ring-fenced bank would be forbidden. Where no such exposure is created, no restrictions should apply.

32. There is more scope to tackle this issue via quantitative limits, which vary according to the level of balance sheet exposure for the ring fenced bank, the credit rating of the counterparty and the transaction type. Where no exposure is created (eg distribution arrangements via ring fenced banks) there should be no restriction.

2 November 2012

1 HM Treasury, Sound Banking: delivering reform, October 2012; paragraph 2.5, page 6.

2 HM Treasury, Sound Banking: delivering reform, October 2012; paragraph 2.62, page 16.

Prepared 2nd January 2013