Banking StandardsWritten evidence from Virgin Money

Summary

1. We agree that an enabling Bill, with delegated powers to the Treasury and to the PRA to make the detailed rules, represents a sensible approach, since it will allow flexibility to respond to changing circumstances, to the wish or need to achieve alignment with EC Directives, and to any need to respond to unintended consequences or attempts by some banks to “get round the rules”. However, given the large number of powers that are delegated, we suggest that a date might be set by which the rules should be determined, to remove uncertainty for banks and their customers. To achieve a balance between delegation of powers and accountability to Parliament, we suggest that an initial review of the rules might be carried out after the rules are determined but before they are implemented, that subsequent reviews might be carried out more frequently than every five years, and that the reviews might be carried out by a body that was not involved in setting the rules.

2. We believe that the ICB’s proposals for unsecured debt that can be bailed-in and for depositor preference will reduce future risk to tax-payers and should increase market discipline on banks, and that the proposals for ring-fencing should make resolution easier, although we anticipate that, in conditions that are already stressed, the authorities may for good reasons be reluctant to force banks into the formal process of resolution, required for them to access capital that can be bailed in, if it can be avoided. We agree with the conclusion of the impact assessment that ring-fencing and depositor preference are better than the “do nothing” option, but we regret that the ICB’s reports and the impact assessment do not contain comparative analyses of the costs and benefits associated with alternative options, such as the approach taken in the Dodd Frank Act or recommended in the Liikanen Report, or full separation of retail banking and investment banking, and so it is not possible to give an informed response to the Commission’s question about whether the measures in the draft Bill are the most efficient and effective means of delivering the objectives.

3. We suggest that further consideration should be given to some matters covered in the draft Bill, including whether the continuity objective for the FCA will weaken its competition objective (see the first section of the draft Bill, headed “Objectives of Financial Conduct Authority”), whether the independence of a ring-fenced bank from other members of its group is consistent with subsidiarisation (see section 142H of the draft Bill), whether ring-fenced banks should in some circumstances be allowed to undertake activities that are excluded (see paragraph 2.25 of the policy overview), and whether breaches of the ring-fencing rules should be result in banks being fined but not in individuals being sanctioned (see section 142G of the draft Bill).

4. We do not believe that the measures in the draft Bill will in themselves necessarily lead to a material improvement in banking standards and cultures in banking. The ICB was asked to come up with recommendations to improve financial stability and competition, and Sir John Vickers made it clear that the ICB would not consider matters such as bonuses and governance. We therefore anticipate that the Parliamentary Commission on Banking Standards, seeking to improve banking standards as well as financial stability and competition, and taking account of the further evidence presented to it, may make recommendations which, if accepted, may require some amendments to the draft Bill and/or to the delegated powers in it.

Objectives and general approach

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

5. The draft Bill gives effect to the ICB’s recommendations to improve financial stability through ring-fencing, depositor preference and a framework for implementing PLAC requirements. In addition, paragraph 2.3 in the policy overview confirms that the bail-in tool will be progressed through the proposed RRD, the equity ring-fence buffer through CRD IV and CRR, and the resolution buffer through CRD IV variable Pillar 2 requirements: these all seem to be consistent with the existing approach to banking regulation.

6. The draft Bill does not give effect to the ICB’s recommendations to improve competition, because they will be progressed through alternative means. Paragraph 2.3 confirms that the Government supports the creation of a strong challenger bank from the LBG divestment required by the EC, and that it supports the ICB’s recommendations on PCA switching, with quarterly meetings to hold the industry to account on its September 2013 deadline for the current account redirection service, and on transparency, which the OFT and PRA will implement.

7. Although the ICB’s recommendations to improve competition did not include payments reform, paragraphs 2.66 and 2.67 confirm the Government’s intention to improve competition in payments, note the recent consultation on setting the strategy for UK payments, and state that, although there are no clauses on Payments Council reform in the draft Bill, clauses will be included in the Bill when it is introduced in Parliament early next year.

8. It is not clear whether the measures in the draft Bill represent the most efficient and effective means of delivering the objectives. While we agree with the conclusion of the impact assessment that ring-fencing and depositor preference are better than the “do nothing” option, we regret that the ICB’s reports and the impact assessment do not contain comparative analyses of the costs and benefits associated with alternative options, such as the approach taken in the Dodd Frank Act or recommended in the Liikanen Report, or full separation on retail banking and investment banking.

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

9. Since the ICB’s report, one set of developments has related to the ongoing eurozone crisis and to reduced forecasts for economic growth. While these developments strengthen the case for ring-fencing, depositor preference and PLAC requirements, to protect tax-payers, there does not seem to be any need to revise the ICB recommendations that are reflected in the draft Bill because of them.

10. Since the ICB’s report, another set of developments has related to LIBOR manipulation and derivatives mis-selling, and to the establishment of the Parliamentary Commission on Banking Standards. It seems unlikely that recommendations made by the Parliamentary Commission will imply the need for any revision to the ICB’s recommendations on depositor preference and PLAC requirements. However, in relation to ring-fencing, it seems possible that the further evidence presented to the Parliamentary Commission, including by Paul Volcker and Erkki Liikanen, might lead it to take a different view from the ICB on the location of the ring-fence and/or on the extent of separation between retail banking and investment banking, to improve banking standards as well as to improve financial stability.

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?

11. Our understanding is that the Government intends to implement in full the recommendations made by the ICB, through either primary legislation or secondary legislation, or through alternative means. We see no intention to water down, or deviate from, the ICB’s recommendations. Paragraphs 2.63 to 2.67 of the policy overview state that, in addition to the ICB’s recommendations, the Bill will cover Payments Council reform and FSCS governance reform.

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

12. We recognise that the deadline of 2019 for full implementation of the ICB’s recommendations to improve financial stability is still some years ahead, but we believe that it is sensible to allow large banks enough time to make the arrangements that will be necessary for ring-fencing, and to align the changes in capital requirements with the implementation of Basel III. Banks already have much higher capital ratios than they did in 2008, and effective recovery and resolution plans should now be in place: it seems undesirable to impose in the short term any additional measures which might limit banks’ ability to lend and to support economic growth.

13. However, it would be helpful to set a much shorter deadline by which the detailed matters which are not specified in the draft Bill, particularly about the location of the ring-fence and the height of the ring-fence, are made clear, at least to the level of detail that the Basel III regulations are already known, to remove uncertainty for banks and their customers.

14. We see no reason to delay the ICB’s recommendations to improve competition. We support the September 2013 deadline for the introduction of the current account redirection service, and believe that a similar deadline should be set for the introduction of measures to improve transparency (including transparency about interest forgone on current accounts), as finalised by the OFT and the PRA.

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

15. We support the intention that there should be continuing provision of essential banking services. However, we are concerned that adding the continuity objective to the objectives of the PRA and of the FCA could have the unintended consequence of tilting the balance further in favour of financial stability at the expense of competition.

16. It is understandable that greater priority was given to financial stability than to competition around the time of the banking crisis of 2008, but we have commented in our submissions to the OFT, Treasury Committee and the ICB on the potential reduction in competition arising from the further consolidation that took place in this period, most notably by allowing the acquisition of HBOS by Lloyds TSB to go ahead despite the OFT’s reservations.

17. There seems to be a possibility that the words in the draft Bill that the FCA’s objective to promote “effective competition in the interests of consumers, but [...] only so far as this is compatible with [...] acting in a way which advances the continuity objective” could have been used to justify the acquisition of HBOS by Lloyds TSB despite the possible lessening in competition about which the OFT expressed reservations, and that it could be used in future in similar circumstance and with similar effects.

18. Since the banking crisis of 2008, various measures have been introduced to support financial stability, including higher minimum equity capital ratios and more conservative bases for calculating RWAs, and the need for banks to have effective recovery and resolution plans. Financial stability will be enhanced further by the implementation of the ICB’s recommendations for ring-fencing, depositor preference and PLAC requirements.

19. The ICB’s objective was to come up with recommendations to improve financial stability, while continuity was a concept used by the ICB to determine which banking services could only be provided by ring-fenced banks: we are not sure that continuity should replace or augment financial stability as the objective. We suggest that consideration should be given to the possible reduction in competition that might arise from the FCA’s duty to promote effective competition being limited by its duty to advance the continuity objective.

Banking Standards and Competition

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

20. It is not clear that the proposed changes in the draft Bill will in themselves have any impact on banking standards in the UK. They were not intended to do so. The objective set for the ICB was to come up with recommendations to improve financial stability and competition, and the ICB took the view that matters such as bonuses and behaviour were not in its remit. At a hearing of the Treasury Committee, on 24 May 2011, Sir John Vickers said, “I think there is a very important set of public policy issues around remuneration, around bonuses and around governance. I think those issues are very relevant to our remit, but I think they are not within our remit and I think there is a danger for us as a Commission of spreading too wide and too thin.”

21. To the extent that the proposed changes, including the separation of retail banking and investment banking, have an impact on standards in ring-fenced banks, we believe that it should be positive rather than negative. However, PPI and derivatives mis-selling have, unfortunately, shown that it can not be assumed that retail banks will automatically maintain high standards just because they do not engage in investment banking activities.

22. A possible negative impact of ring-fencing on banking standards is that it could lead to some banks trying to find ways to “get round the rules”. In our submission to the Parliamentary Commission on Banking Standards, we suggested that “manipulation” of regulatory capital requirements should be liable to sanctions, and we suggest that the same should apply to “manipulation” of the ring-fencing rules.

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

23. It is not clear that the separation of retail and wholesale banking, as currently proposed, will have a significant impact on the culture prevailing within each. The measures in the draft Bill are intended to improve financial stability rather than to enhance internal cultures. However, to the extent that the separation has an impact on internal cultures, we think that it should be positive rather than negative.

24. Although it is not clear where the ring-fence boundary will lie, and how much flexibility there will be, our assumption has been that large banks would opt to include a broad range of customer-facing activities for personal and business customers in the ring-fenced bank. In this case, the separation would be between a “retail bank” an “investment bank”, as defined by Sir John Vickers in his speech at the LSE on 22 January 2011, when he introduced the concept of subsidiarisation. As well as supporting financial stability and the continuing provision of essential banking services, this separation would be sensible in terms of cultures, since it would make a separation between activities that are customer-facing and focus on credit risk, and activities that involve trading and focus on market risk.

25. In our submission to the Parliamentary Commission on Banking Standards, we commented on differences between retail banking and investment banking, including that trading activities can easily lead to fundamental conflicts of interest between making profit for the bank (and bonuses for employees) and supporting its customers. Andrew Haldane has recently suggested that a benefit of full structural separation of investment banking and commercial banking is that it would “better ensure that the distinct cultures of retail and investment banking were not cross-contaminated”.

26. Our experience suggests that employees are, in general, more able to identify with homogeneous cultures in distinct subsidiaries than with heterogeneous cultures across large diversified businesses. In this case, the establishment of ring-fenced banks should help to restore a culture in which employees focus on serving their customers, although it may in itself not be sufficient to do so.

27. Outside the ring-fenced bank, separation and transparency may discourage some of the activities which have been described as “casino banking” or as “socially useless activities”, but which have generated large bonuses.

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

28. We believe that the introduction of the ring-fence should enhance competition in retail banking, to some extent, as well as improve financial stability.

29. Our experience is that retail banking has been seen as less interesting than investment banking, within universal banks. Associated with the introduction of the ring-fence, the establishment of a ring-fenced subsidiary with dedicated governance and separate reporting should lead to greater focus on retail banking and on its performance.

30. However, the positive impact on competition in retail banking should not be overstated, given that, in the UK, retail banking is dominated by an effective oligopoly of five large banks which have a greater interest in defending their established positions than in acting as challenger banks. For example, were any one of them to compete by reducing its prices for both new and existing business, the lost income on existing business would almost certainly be greater than the additional income on new business.

Delegated Powers and Accountability

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

31. The draft Bill is clear about what powers are to be delegated to the Treasury, and how they are to be exercised, in matters relating to ring-fencing (exemptions for building societies and other classes of institution, core activities, excluded activities and the imposition of prohibitions) and relating to loss-absorbency requirements and amending legislation relating to groups. The explanatory notes, although not part of the draft Bill, are helpful in confirming what the clauses in the draft Bill mean.

32. In one important area, the draft Bill is not so clear. Paragraph 2.25 of the policy overview states that, “There may be circumstances in which it may be necessary or desirable to permit a ring-fenced bank to undertake an excluded activity. So the draft Bill gives the Treasury power to make secondary legislation providing for exceptions to the excluded activity.” This seems to be a particularly important matter, since it could open up a loophole through with some banks might find ways to “get round the rules”. But the draft Bill, and the explanatory notes, do not give examples of what might be permitted, or what restrictions might be placed on allowing ring-fenced banks to undertake excluded activities.

33. The powers given to the Treasury under Section 142F, including powers to confer powers on themselves or on a regulator, seem sensible, to provide flexibility for future developments which can not be anticipated at the outset. But again, consideration might be given to restrictions on such delegated powers.

34. Section 142H gives powers to make ring-fencing rules, including for “requiring the disclosure to the appropriate regulator of information relating to transactions between the ring-fenced body and other members of the group”. We suggest that it would be helpful, in supporting the independence of the ring-fenced bank, if wider powers were given for rules to be made for the minimum regulatory and financial disclosures to be made by ring-fenced banks, to their regulator and in public disclosures. We think that requirements for comprehensive public disclosures would encourage the ring-fenced bank to think of itself as an independent subsidiary rather than a division.

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

35. We agree that an enabling Bill, with delegated powers to the Treasury and to the PRA to make the detailed rules, represents a sensible approach, since it will allow flexibility to respond to changing circumstances, to the wish or need to achieve alignment with EC Directives, and to any need to respond to unintended consequences or attempts by some banks to “get round the rules”.

36. However, given the large number of powers that are delegated, we suggest that, to achieve a balance between delegation of powers and accountability to Parliament, an initial review of the rules might be carried out after the rules are determined but before they are implemented, and that subsequent reviews might be carried out more frequently than every five years.

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

37. An important issue for customers of banks, and for banks themselves, is that many important details are not clear at this stage. For example, for smaller banks which might qualify for the de minimis exemption, it is important to know exactly how the de minimis threshold will be determined and at what level it will be set. For retail banks, it is important to know exactly where the location of the ring-fence will lie, so that they can decide whether or not to continue any existing activities that will be outside the ring-fence. For universal banks that will have activities inside the ring-fence and outside the ring-fence, it is important to know where the ring-fence will lie, so that they can explain the ring-fencing rules to their personal and business customers.

38. We therefore suggest that a deadline should be set for the details to be determined, and, possibly, reviewed and reported on through the Treasury to Parliament, so that banks and their customers can understand the implications for them, and make appropriate arrangements.

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

39. We support the concept of a periodic review of the ring-fencing rules, with a report to the Treasury and through it to Parliament.

40. While we have no objection to the reviews being carried out by the PRA, there is a case for the reviews to be carried out by a body other than a body that was involved in setting the rules. If not by the PRA, the reviews could be carried out either by the Treasury Committee and/or by an independent body with appropriate credentials.

41. Given the extent of the detailed matters that are delegated in the draft Bill, we suggest that there could be merit in an initial review after the rules are determined but before they are implemented, to confirm both that the rules are appropriate and that the review process is effective. Also, we suggest that the periodic reviews should be carried out more frequently than every five years, at least initially, so that any shortcomings in the rules, or unintended consequences of them, or attempts by banks to “get round the rules” can come to light and be addressed more quickly.

The ring-fence

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

42. We support the proposed exemptions for certain deposit takers.

43. In our submissions to the OFT, Treasury Committee and ICB, we have expressed concern about limited competition in retail banking, caused partly by its domination by an effective oligopoly of five large banks, leading to high concentration and limited diversity. The view has been put forward that the large banks should be broken up to create new challenger banks. Although we think that this would in theory be good for competition, we are not sure that this is practical, given the difficulties experienced by RBS in separating the branches which it had agreed to sell to Santander, and by Lloyds in finding a buyer for its divestment. We therefore believe that it is important to reduce barriers to entry and expansion.

44. In this context, a de minimis exemption from ring-fenced requirements, as proposed in the Banking Reform White Paper, seems sensible—provided that the exemption does not inhibit the ability of smaller banks that are not ring-fenced to secure funding at competitive rates. Given that retail deposits form the only product that will certainly be among the products that can only be provided by ring-fenced banks, we believe that it is appropriate for the de minimis threshold to be set in terms of retail deposits. We note the proposal in the White Paper that the threshold should be set at £25 billion of retail deposits. As an indication of scale, the retail deposits of Virgin Money (including those of the acquired business Northern Rock) were £16.7 billion at 31 December 2011.

45. We agree with the proposal that building societies should be exempted from the ring-fence requirements, and dealt with by amendments to the Building Societies Act. Building societies offer important sources of diversity and competition in retail banking. It seems desirable that building societies should maintain their distinct identity under the Building Societies Act.

14. Is the range of core and excluded activities defined in the draft Bill appropriate and sufficiently broad? Are the Government’s stated intentions for using powers to define further core and excluded activities appropriate?

46. It seems uncontroversial that retail deposits should be inside the ring-fence, and that proprietary trading should be outside the ring-fence. However, these reflect the ends of a spectrum, and it may be difficult to make rules with definitions which indicate whether some other banking activities are core or excluded, or permitted. As a result, the rules could become complicated, as has happened in framing the Dodd Frank Act, despite the apparent simplicity of the Volcker Rule. Voluminous and complex rules could, as in prudential regulation, reinforce a “tick-box compliance” mindset which the Government and the FSA are trying to change to a more judgemental approach, and could lead to some banks finding ways to “get round the rules”.

47. The ICB set out a framework for categories of activities that must be inside the ring-fence or must be outside the ring-fence, or that can be either inside or outside, and it seems reasonable for the draft Bill to give delegated powers to the Treasury to finalise the definition of each category. However, it would be helpful to have, within a reasonable period, determination of the details, to remove uncertainty for banks and their customers.

48. Paragraph 2.25 of the policy overview states that, “There may be circumstances in which it may be necessary or desirable to permit a ring-fenced bank to undertake an excluded activity.” While this sounds sensibly pragmatic, it may be difficult to define such circumstances in a way that avoids the possibility of creating a significant loophole. Experience suggests that loopholes, once opened, can be used in unexpected ways, and can become larger over time.

49. Clause 142G comments on the sanctions that will be applied to ring-fenced banks that carry on excluded activities or contravene prohibitions. The explanatory note states that, “Under subsection (1) a ring-fenced body which has done this is treated as having contravened a requirement imposed on that body by the regulator under FSMA. It will in consequence be liable to the disciplinary measures and penalties which the regulators may impose under Part 14 of FSMA. However, under subsection (2), the ring-fenced body will not have committed a criminal offence solely by reason of the contravention, and transactions entered into contrary to a prohibition remain valid.”

50. This raises an important issue, in the context of recent cases where some bankers have been deemed to have exercised poor judgement but not to have broken any laws, and in the context of improving banking standards, as to whether corporate fines are having an adequately positive impact on behaviour, or whether individuals should be liable to professional and criminal sanctions, through processes that are fair and transparent.

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

51. We support the proposal that high net worth individuals and large companies should if they wish be allowed to place deposits with a bank that is not ring-fenced.

52. However, definitions of the levels of thresholds, in terms of income or assets, are not easy, as is indicated in the summary of responses to the Banking Reform White Paper, where it is reported that different banks have different views on the appropriate levels of the thresholds. This is likely to reflect the fact that different banks segment their personal and business customers in different ways.

53. For business customers, paragraph 2.20 of the policy overview suggests a threshold of £6.5 million annual turnover, which seems reasonable. Turnover figures have the advantage of being readily available for business customers, and, according to the summary of responses, the level of £6.5 million is preferred to the £25.9 million figure which is used in some analyses. For high net worth customers, the suggested threshold of £250,000 free and investable assets, suggested in paragraph 2.21, does seem quite low, as some respondents have observed, and it is not clear how banks will know the free and investable assets of such customers.

54. We support the proposal that the thresholds should be determined in secondary legislation, after further consultation. We suggest that consideration should also be given as to how, and how often, the thresholds will be updated.

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

55. We agree with the proposal that ring-fenced banks should be allowed to offer simple derivatives to their customers. Many customers use derivatives in a responsible manner to reduce foreign exchange and other risks in their businesses, and will find it convenient to get a broad risk management service from their ring-fenced bank, as they get from their bank at present.

56. However, if the distribution of derivatives to their customers by ring-fenced banks is allowed, we suggest that it should be subject to restrictions such as the following:

The derivatives should be distributed on an agency or brokerage basis. Ring-fenced banks should not be allowed to engage in proprietary trading of derivatives (or of other securities).

The distribution of derivatives should be subject to a code of conduct, with sanctions for breaching the code, to limit the risk of mis-selling derivatives.

The derivatives should be limited to simple derivatives that are centrally cleared.

57. The definition of “simple” derivatives may not be easy. Clearly CDOs are complex, while interest rate swaps are simple. In determining the category of derivatives to be permitted, we suggest that consideration be given to Article 132 of the Solvency II Directive. This article says that insurance companies “shall only invest in assets whose risks the undertaking concerned can properly identify, measure, monitor, manage, control and report”.

58. We support the proposal, in paragraph 2.26 of the policy overview, that ring-fenced banks should be allowed to use derivatives to manage their liquidity, interest rate and credit risks.

17. Are the proposed corporate governance arrangements between the ring-fenced bank and the wider group sufficient to ensure the independence of the ring-fenced bank? Are these arrangements compatible with directors’ duties and principles of accountability?

18. How appropriate are the proposed restrictions on exposures and operational dependencies between the ring-fenced bank and the rest of the group? Will these result in a sufficient degree of independence and resilience?

59. The draft Bill’s requirements that a ring-fenced bank acts independently of other members of its group and that it operates on an arms-length basis with other members of its group, and the limitations on the ring-fenced bank’s shares or voting powers in other companies and on payments to other members of its group, address key issues which should support the independence of the ring-fenced bank, as far as a fully-owned subsidiary can be independent of its parent, especially when the parent has to answer to external shareholders on its behalf.

60. However, we are not sure that the independence of the ring-fenced banking subsidiary is in practice really possible. As implied by the question about directors’ duties and responsibilities, the board of a fully-owned subsidiary normally reports to its parent group board as its shareholder, and responds to the views of its parent group board.

61. Also, we are not sure that the independence of the ring-fenced banking subsidiary was really intended. The draft Bill’s requirements ensure that the ring-fenced bank could easily be separated and continue to operate, and is protected from problems in other parts of its group. Independence sounds more consistent with full separation of retail banking and investment banking than with subsidiarisation.

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

62. While it would be helpful to get more detailed information within a reasonable period about the matters which are delegated in the draft Bill to the Treasury (for the location of the ring-fence) and to the PRA (for the height of the ring-fence), we believe that the degree of regulatory discretion proposed in the draft Bill will support effective monitoring and policing, because it will allow flexibility to respond to any attempts by banks to “get round the rules”.

63. We are optimistic that the recommendations of the Parliamentary Commission on Banking Standards will lead to a significant improvement in banking standards. However, banks have a track record of “getting round the rules”. For example:

The Basel Committee has found evidence of banks moving assets from their trading book to their banking book, or vice versa, to achieve less onerous capital requirements.

Over the last year, the Bank of England has commented on “RWA optimisation” by some banks, to reduce their regulatory capital requirements.

In this case, the possibility exists that ring-fencing, while improving financial stability, and enhancing competition in retail banking to some extent, might result in some banks finding ways to “get round the rules”, particularly if the rules are or become extensive and complex. The flexibility allowed by the degree of regulatory discretion in the draft Bill would enable the Treasury and the PRA to address any such outcomes, while adhering to the principles set out in the draft Bill.

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

64. It is not clear that the governance arrangements for ring-fenced banks will in themselves necessarily lead to a wider improvement in banking standards, and we believe that other measures should be considered. Other measures to improve banking standards might include the professionalisation of banking, with training and CPD, a professional code of conduct and sanctions for breaches of the code, some regulatory parameters for bonuses and total remuneration (at least in ring-fenced banks), supported by shareholder oversight, and requirements for disclosure of information about bonus schemes and bonus payments. It might also be sensible to ask the OFT and the FCA to examine cross-subsidies between, and within, retail banking products, including current accounts, since they can lead to mis-selling, as with PPI. These and related measures to improve banking standards were discussed in our submission to the Parliamentary Commission.

Depositor Preference

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

65. We support the concept of depositor preference. This will reduce risk to tax-payers, and, along with unsecured debt that can be bailed in, should enhance market discipline on banks.

66. We believe that depositor preference should be limited to insured deposits, whose owners have no incentive to apply market discipline.

67. Assuming that depositor preference is introduced, and that it is limited to insured deposits, we consider it important that:

there is a clear rule that consumers can understand. This supports the proposed link with the limit on insured deposits, and suggests that the scope of depositor preference should not be extended to other categories of deposits.

the implications of depositor preference are explained clearly to retail depositors, to avoid the possible perception, based on what happened in the banking crisis of 2008, that all retail deposits are implicitly guaranteed by the Government, if not by the FSCS, and to allow retail depositors to make appropriate arrangements to mitigate potential losses on non-insured deposits, if they wish to do so. One straightforward way to achieve this would be to encourage banks to offer clearly-labelled accounts, one type for insured deposits, with a limit of £85,000, and another type for deposits that are not insured, with no limit.

Capital Levels

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

23. The draft Bill gives the Government power to direct the way in which the regulators can implement loss-absorbency requirements. How appropriate and well-designed is this power?

68. Paragraphs 2.54 to 2.58 in the policy overview confirms that the Government intends to implement the ICB’s recommendations that:

there should be a PLAC, and that it should be set at 17% of RWAs.

long-term unsecured debt should be capable of being bailed in, in the event of resolution.

However, neither section 142J nor the corresponding paragraph in the explanatory notes mention the terms primary loss-absorbing capacity or bail-in.

69. We understand the intention that the draft Bill should not be too prescriptive, and that it should delegate powers, in this case to the Treasury, to set PLAC requirements.

70. However, contrary to what might have been expected, unsecured debt holders did not suffer losses in the banking crisis of 2008, because injections of equity capital were made before banks failed—although, had such injections not been made, the equity capital of the relevant banks would not have been sufficient to absorb the losses that arose. Even in more recent banking problems, such as Bankia, equity holders have lost much of their capital, and injections of equity capital have been made, but unsecured debt holders have not suffered losses.

71. It seems that unsecured debt holders are reluctant to accept that they will suffer losses in such situations in future, even though it is expected to be part of European recovery and resolution plans. So we suggest that there is a case for the draft Bill making explicit mention of primary-loss absorbing capacity requirements, including, as well as equity capital, some category of unsecured debt that can be bailed-in. Also, given the relative losses suffered by equity investors, debt holders and tax-payers in banks that were failing, and given the likely and understandable reluctance of the authorities to force banks into resolution in conditions that are already stressed, there is a case for the draft Bill making it clear that a failing bank can not receive an injection of equity capital from tax-payers unless or until the relevant debt has been bailed in.

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

72. We support the ICB’s recommendation that there should be a PLAC, including some unsecured debt that can be bailed-in as well as equity capital. And, on the basis of the losses suffered by banks over the years around the banking crisis of 2008, we believe that the level of 17% of RWAs that was recommended by the ICB seems adequate.

73. With hindsight, it is clear that banks’ minimum equity capital ratios were too low ahead of the banking crisis of 2008. Looking to the future, while it is very undesirable that tax-payers should have to make further equity capital injections in banks, it is also undesirable that banks’ minimum equity capital ratios should be set at a level that overly restricts banks’ ability to lend and to support economic growth. Minimum equity capital ratios are already much higher under the Basel requirements, and the bases prescribed for calculating RWAs are now more conservative. The availability of unsecured debt that can be bailed in will provide access to additional equity capital if it is required, but will enable banks to hold levels of equity capital that are not excessive.

74. We support the proposed exemption from PLAC requirements for some assets held in overseas operations. We accept that the extension of PLAC requirements to non-EEA operations might cause some banks with large non-EEA operations to reconsider their domicile, and we think that the proposed exemption is sensible and reasonable, provided that the ring-fencing arrangements are such that losses on non-EEA operations cannot deplete the PLAC of ring-fenced banks in the UK.

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

75. The Basel III regulations propose a minimum leverage ratio of 3% for all banks. There is merit in consistency with this in the UK, to avoid introducing a difference which could lead to regulatory arbitrage between areas. However, there was also merit in the ICB’s recommendation that minimum leverage ratios should be higher for large banks, in a manner that is consistent with the higher capital ratios that will be required for large banks. Different approaches to setting capital and leverage ratios could lead to a new sort of regulatory arbitrage, between the two ratios.

76. The Swedish Financial Markets Committee suggested that the introduction of a leverage ratio might have the unintended consequence of restricting the growth of the banks with the lowest risk, and might have the undesirable consequence of encouraging them to engage in greater volumes of securitisation. The potentially perverse impact of a minimum leverage ratio on banks with low-risk assets such as prime mortgages was recognised by the ICB, and in paragraph 3.21 of the Government response to the Independent Commission on Banking. We are concerned that the imposition of a single minimum capital ratio for all banks might have unintended and undesirable consequences for retail banks such as Virgin Money which have low-risk assets such as prime mortgages.

77. The ability to make sound judgments about this matter is constrained by lack of publicly-available information about banks’ leverage ratios. UK banks have not normally disclosed their leverage ratios. And, if they had, they might have been subject to “leverage ratio optimisation” along the lines of the “RWA optimisation” about which the Bank of England has expressed concern.

78. We therefore agree with the Bank of England’s proposal that UK banks should disclose their leverage ratios from a date earlier than that required under the Basel regulations. We suggest that the draft Bill should give delegated power to the PRA, with input from the FPC, to determine the minimum leverage ratio, and that, within such power, the option should be left open to set different minimum leverage ratios for different categories of banks rather than to set a uniform minimum leverage ratio for all banks.

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

79. We think that the powers and tools will be adequate, as a result of a combination of the measures that have already been taken to improve financial stability, since the banking crisis of 2008, and the measures in the draft Bill:

The possibility of bank failures has already been reduced by requirements for much higher minimum equity capital ratios and capital buffers, and for more conservative bases for the calculation of RWAs.

Further protection to tax-payers will be given by the ability of the authorities to bail-in long term unsecured debt in the event of resolution.

The ability of the authorities to resolve failing banks has been enhanced by the Special Resolution Regime and the requirement that banks have effective plans for recovery and resolution.

Practical aspects of resolution will be easier as a result of ring-fencing and the separation of retail banking and investment banking.

80. As a result of these developments, the failure of a large ring-fenced bank is less likely, but, should such an event occur, it seems that the UK authorities will have adequate tools and powers to resolve it, and to continue the provision of vital banking services, while maintaining financial stability and minimising the risk to public funds.

81. For a large failing non-ring-fenced bank, the best answer might be to allow it to fail, through the resolution process, with systemic risk reduced by the developments listed above. However, it remains to be seen whether the authorities, in the UK or elsewhere, will be willing to allow such an outcome, in what would probably be severely stressed conditions, given what followed the failure of Lehman Brothers in 2008.

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

82. We support the concept that long-term unsecured debt should be capable of being bailed-in, because it will enable banks to access additional equity capital if required to do so in a crisis, when the issuance of new equity capital would be difficult, but it will not require banks to hold so much equity capital as to restrict their ability to lend and to support economic growth.

83. To protect the buyers of the unsecured debt that can be bailed-in, and to limit the increase in the rate paid to holders of the unsecured debt because of the possibility that it might be bailed-in, it seems likely that the terms of the debt will have to specify that bail-in will only be possible in the event of resolution.

84. However, this means that the authorities will have to put the bank into resolution for it to be able to access the additional equity capital. In such a situation, where conditions are likely to be already stressed, the authorities, in the UK or elsewhere, may for good reasons be reluctant to force a potentially failing bank into resolution, and the possibility exists that they might instead put pressure on holders of the unsecured debt to accept a voluntary bail-in or write-down, as happened to holders of Greek government debt. A voluntary approach may in some circumstances be better than the formal process of resolution, but, to protect tax-payers, we suggest that a failing bank should not be able to receive an injection of equity capital from tax-payers unless or until the relevant debt has been bailed in.

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

85. When the ICB’s proposals were first mooted, and were expected to include subsidiarisation and ring-fencing and a capital surcharge for large ring-fenced banks, there appeared to be some concern that, although they would improve financial stability, they might reduce the ability of UK banks to compete effectively with their international peers. However, parallel developments in the UK and Europe, discussed at hearings of the Parliamentary Commission with Paul Volcker and Erkki Liikanen, confirm that the US and Europe have similar objectives, even if they are seeking to achieve them in different ways and at different speeds.

86. Also, responding to a question about whether less stringently regulated financial centres would benefit, Paul Volcker observed that London and New York were the only two markets with capability, size and knowledge. This suggests that it would not currently be easy for banks to move activities to other areas, although of course things may change in future.

31. Are the proposals consistent with existing and forthcoming international and EU regulatory initiatives, for example the recent Liikanen Report? To what extent are they likely to be superseded or generate conflicts?

87. There is a case for focusing on what is appropriate for the UK, even if it leads to some conflict, because of the importance of banking to the UK and the importance of London as a leading financial centre. There is also a case for consistency with the approach being taken internationally, in which context it is reassuring that paragraph 2.4 of the policy overview states that, “These [the recommendations of the High-Level Expert Group chaired by Erkki Liikanen] include strong support for a bail-in tool and a requirement for the structural separation of banks’ trading activities from retail deposit-taking. [...] The Group’s proposal for ring-fencing of trading activities from deposit-taking has many similarities with the recommendations of the ICB, and the Group has noted that the Government’s plans for ring-fencing of UK banks are compatible with the Liikanen recommendations.”

88. We suggest that the delegated powers in the draft Bill should be sufficiently widely drawn to allow for the possible requirement or wish to achieve greater alignment with the approach being taken in Europe, or in the US, and to allow for the possibility that the Parliamentary Commission, in seeking to improve banking standards as well as financial stability and competition, and taking account of the further evidence presented to it, including by Paul Volcker and Erkki Liikanen, might take a different view from the ICB on the location of the ring-fence and/on the extent of separation between retail banking and investment banking.

2 November 2012

Prepared 2nd January 2013