Banking StandardsWritten evidence from Rt Hon George Osborne MP, Chancellor of the Exchequer

Thank you for your letter of 27 November following my appearance before you to give evidence.

Further to the sixteen page brief from officials that I sent on 12 November with additional information on the likely secondary legislation, please find attached the following:

Annex A addresses the points raised by Andrew Bailey in his letter to you of 21 November and the points you raise with regard to the evidence of Paul Tucker in his appearance before you on 22 November.

Annex B addresses points you raise with regard to written evidence you have received; and

Annex C addresses points you raise with regard to the impact assessment.

I look forward to considering your recommendations.

Annex A


1. The draft Bill should clearly set out how the PRA’s statutory objectives interact and their hierarchy.

The draft Bill currently sets out how the PRA’s objective for ring-fencing and its general objective interact. When the PRA is acting in relation to matters related to ring-fencing, and only then, the PRA is required to act at all times compatibly with its continuity objective. To the extent that this remains unclear, the Government will consider any further specific recommendations from the PCBS.

Paul Tucker, in his evidence before the PCBS, raised the issue of where the “meat” of the ring-fencing regime should be. Mr Tucker agreed with the Government that the meat of the regime should be in secondary legislation, ensuring that the authorities can respond quickly to innovation in the financial sector. The Government has been careful to ensure that the important question of the location of the ring-fence—what constitutes core, excluded and prohibited activities, and what the ring-fence bank can do by way of exceptions to excluded activities– are within the purview of the Treasury and Parliament. This will be covered by clause 4, new sections 142A-F of the draft Bill, and secondary legislation made under those provisions. The PRA will be required to make rules with regard to the height of the ring-fence. The rules will ensure the economic and operational independence of ring-fenced banks from the rest of the group in which they sit. The regulator is best placed to deal with these matters but the outcome and objective will be clearly expressed in legislation.

2. The draft Bill should enable the PRA to have a power to make rules over UK financial holding companies

The question of powers over UK financial holding companies has been discussed at length between the Treasury and the regulatory authorities during the passage of the Financial Services Bill. The Government wants to ensure the regulators have the tools they need to conduct suitably robust supervision of financial holding companies. To that end, the Government has included clauses in the Financial Services Bill that confer on the regulators for the first time substantive powers in relation to the holding companies of authorised persons—specifically a power of direction over holding companies where the direction is considered desirable to advance PRA/FCA objectives. These targeted provisions extend and strengthen the regulatory framework, and strike the right balance between proportionality and delivering effective supervision.

The Government is working with the FSA and Bank of England to consider the merits of further powers over holding companies, both in the context of delivering effective supervision of financial groups and delivering the ICB reforms. The supervision of holding companies is also an important area of international regulatory reform and the Government supports the intention to strengthen holding company supervision through the review of the EU Financial Conglomerates Directive due in 2013.

3. The draft Bill should enable HM Treasury to prohibit non-ring-fenced banks (NRFBs) from owning ring-fenced banks (RFBs) as well as RFBs from owning NRFBs.

The ICB recommended that ring-fenced banks should be prohibited from owning non-ring-fenced banks. The Government has accepted this recommendation, and the draft Banking Reform Bill includes provisions for its implementation. The ICB did not, however, recommend a prohibition on non-ring-fenced banks owning ring-fenced banks.

4. The draft Bill should state that loss absorbency capacity should apply on a group basis, with the ability to exempt non-EEA subsidiaries only once the group has demonstrated that these operations will not pose a risk to UK financial stability

The Government believes that setting an automatic PLAC requirement on a bank’s overseas operations where they do not threaten UK or EEA financial stability if they were to fail would not be appropriate. To do so could create a perception that the UK takes responsibility for providing financial support for these overseas operations, and could dampen incentives for the banks to remove barriers to resolvability. When it comes to bailing out banks, it is the government of the day—on behalf of taxpayers—that pays the price, and is responsible for overall economic well-being of its citizens. It is therefore right that government has a role in ensuring banks hold the right amount of PLAC. It is not unusual for the regulator to consult the Treasury about matters that affect resolution. For example, the regulator needs to consult HMT and the Bank of England on the adequacy of individual firms’ resolution plans.

The Government agrees that the circumstances in which it may be appropriate to exempt non-EEA subsidiaries of a group should be made clear in legislation. However, given that this would require rules as to the way in which loss absorbency capacity is to be calculated in relation to groups, and the technical nature of the provisions necessary, the Government consider that this should best be done in secondary legislation made under the power given to the Treasury in section 142J.

5. The draft Bill should specify that the directors of a ring-fence bank and potentially other appropriate entities in the group should have a statutory objective to ensure the integrity of the ring-fence. This could involve ensuring that the directors have an obligation to protect the ring-fence bank from contagion from the wider financial system. This would include risk arising from the rest of the banking group.

The ICB recommended that the directors of a ring-fenced bank and the group as a whole have a duty to protect the integrity of the ring-fence, and suggested this could be achieved through the Approved Persons regime. The Government agreed with this recommendation in its white paper. The Government believes that imposing a duty on directors through the Approved Persons regime may have advantages over a statutory framework, in particular allowing the regulator to use its powers under section 66 of FSMA to enforce the duty. But the Government will, of course, consider any recommendations on this from the PCBS

Annex B


1. Whether the reference just to services in the UK in the continuity objectives is compatible with EU obligations

The Government considers that the reference in the objectives given to the FCA and to the PRA to the protection of the continuity of the provision of in the United Kingdom of core services is compatible with our EU obligations. Article 9 of the Treaty on European Union requires the Union to observe the equality of its citizens in all its activities. Nothing in the objective given to the regulators in any way detracts from the equality of EU citizens. Requiring the FCA and the PRA to protect the continuity of the core services in the UK rather than in the EEA as a whole reflects the fact that their jurisdiction is necessarily limited to the UK. In this the continuity objective is analogous to the integrity objective given to the FCA (to protect and enhance the integrity of the UK financial system) in the Financial Services Bill (see section 1D of the Financial Services and Markets Act 2000 (FSMA), as amended by the draft Bill), and to the financial stability objective given to the Bank of England in section 2A of the Bank of England Act 1998 (“to contribute to protecting and enhancing the stability of the financial systems of the United Kingdom”).

2. Whether there is an intention to provide exemptions from the prohibition on trading as principal to permit trading on behalf of customers.

The excluded activity as set out in the draft Bill is the regulated activity of trading in investments as principal, as described in Article 14 of the Financial Services and Markets Act 2000. This definition is wider than, for example, proprietary trading, as it includes acting as a trading counterparty on behalf of customers as well as on its own account. However, this exclusion does not on its own prohibit a ring-fenced bank from arranging deals in investments for customers, or from dealing in investments as agent—these are separate regulated activities. The ICB intended that a ring-fenced bank could act as an agent for customers seeking to trade in investments. The Government currently has no intention to designate arranging deals in investments, or acting as an agent on behalf of customers as an excluded activity.

3. Whether there will be a prohibition on the non-ring-fenced bank funding the ring-fenced bank.

The Government believes, as the ICB did, that, in order to achieve the objectives of the ring-fence, ring-fenced banks should have a high degree of legal, operational and economic independence from the rest of the wider corporate groups.

To achieve the necessary degree of economic independence, the Government believes that financial links between ring-fenced banks and other group entities should be managed on a third-party basis, and should be subject to limits on intra-group exposures.

Given the technical nature of the issue, the Government believes that it is appropriate for the details of intra-group exposure limits to be set by the regulator in rules. The draft Bill therefore requires the regulator to make rules “for the purpose of ensuring ... that any ring-fenced body which is a member of a group is able to act independently of other members of the group” (Clause 4 new section 142H(1)(b)). The government requires the regulator to restrict the payments that the ring-fenced body may make to other members of the group, but does not impose a similar requirement on the regulator in relation to payments from the non-ring-fenced body to the ring-fenced body. It will be for the regulator to determine whether such funding may compromise the independence of the ring-fenced body from the rest of the group, and whether therefore restrictions on such funding are necessary. This may not require an absolute prohibition.

4. Whether the Part VII transfer process is adequate to achieve separation of activities

The Government considers that the transfer process provided for in Part VII is appropriate to deal with transfers of businesses or parts of a business which are made by a bank to comply with the ring-fencing requirements. However, the Government has noted the comments made by those who have given evidence in relation to the proposed amendments of Part VII, and the Government is exploring with them whether any additional amendments may be necessary to meet their concerns.

5. Whether ring-fenced banks and building societies will be able to offer retail investment products, including structured deposits.

In its June white paper, the Government invited views on how simple retail investment products may be provided by ring-fenced banks in a way that is consistent with the principles of resolution and insulation. The Government received a number of responses on this question from stakeholders, which represented a wide range of views. The Government is also considering appropriate restrictions to place on ring-fenced banks’ own risk management practices and has asked the Parliamentary Commission on Banking Standards to advise on the conditions under which certain risk management products may be provided to customers. These issues will inform the approach taken to retail investment products. Subject to the restrictions on banks’ own risk management practices and the recommendations of the Parliamentary Commission on Banking Standards, the Government believes that there should be circumstances in which the provision of retail investment products would be permissible from within ring-fenced banks and building societies.

6. Whether building societies will face additional restrictions not applied to banks which enjoy a de minimis exemption from the ring-fence.

Building societies will not be subject to the ring-fencing requirements, but they will continue to be subject to the restrictions of the Building Societies Act 1986. The Government has stated its intention to amend the Building Societies Act to bring it into line with ring-fencing. The Government has concluded that, in order to maintain a single, coherent and safe approach for the building societies sector, it will not introduce a de minimis exemption into the Building Societies Act.

7. Whether new section 142F allows the Treasury to make orders which authorise it to make subsequent regulations or give directions without a need for Parliamentary procedure.

Section 142F does, as presently drafted, permit the Treasury to confer powers on itself in any order made under section 142A, 142B, 142D or 142E (though it does not expressly provide that the Treasury may give itself power to make regulations, or to give directions). The power is a subsidiary one, which could only be used in conjunction with the powers given to the Treasury under those sections. It would not enable the Treasury to give itself power to create new excluded activities or core activities, or to provide for exceptions to the core and excluded activities provided for in the face of the Bill without following the Parliamentary procedure provide for in relation to those sections.

8. What the expected timetable and process will be for publication, consultation and compliance with the various orders and rules

The Government intends to introduce this legislation early in the New Year. It will provide principal draft secondary legislation before House of Commons Committee, and publish full draft secondary legislation for consultation later in the year. The Government is committed to completing all primary and secondary legislation before the end of this Parliament in May 2015. The PRA will be empowered to make relevant rules once section 142H of FSMA as amended is brought into force. It will ensure that its rules are completed (including impact assessments and consultation) within sufficient time to ensure that affected banks are able to meet the requirement to have their ring-fence in place no later than the start of 2019.

9. Potential for the prohibition on contracting on non-EEA law to inhibit a range of important bank activities.

The proposed restrictions on operations outside the EEA are intended to ensure that the objectives of ring-fencing are met without impacting on important activities, such as trade finance. The Government’s approach is intended to ensure that ring-fenced banks’ cross-border arrangements do not expose a ring-fenced bank to increased risks, or create barriers in resolution, while at the same time enabling ring-fenced banks fully to support UK firms who wish to export outside the EEA and non-EEA firms who wish to invest in the UK. This will be primarily achieved by restrictions on the location of ring-fenced banks’ branches and subsidiaries. The Government believes that this measure is proportionate and will not unduly affect customers’ access to bank activities. The ICB also recommended that transactions also be subject to the law of an EEA state. The Government recognises the ICB’s concern that banks’ contractual arrangements may give rise to uncertainty as to the authorities’ ability to ensure the continuity of core services in the event of bank failure. However, given the potential for unintended consequences to arise from limiting the governing law of major contracts, the Government is considering alternative approaches to ensuring that ring-fenced banks’ contractual arrangements do not give rise to resolvability concerns.

10. Whether customers which are exempted from depositing with the ring-fenced bank will be able to access the full range of services from the non-ring-fenced bank.

The Government proposes that the deposits of large organisations (ie organisations that are not SMEs) and high-net-worth individuals should not be considered “core”. This will allow such organisations and individuals to place deposits with non-ring-fenced banks if they so choose—though there will be no requirement for large organisations or HNWIs to do so.

Each individual non-ring-fenced bank will decide what services it will offer to its customers (including depositors), according to its own commercial strategy. Depositors with non-ring-fenced banks will be able to access such services as those banks choose to offer.

11. Whether prohibitions on dealing with other financial firms will restrict relationships and distribution of products which do not involve risk and exposure.

The Government proposes to prohibit ring-fenced banks from having exposures to other financial institutions, in order to insulate ring-fenced banks against shocks arising elsewhere in the financial system and to prevent arbitrage of the ring-fence via exposures to institutions that carry on excluded activities. The Government intends to deliver this prohibition using the power granted by Clause 4 new section 142E(1)(a) of the draft Bill.

The Government does not propose to prohibit relationships that do not result in ring-fenced banks having any exposure to other financial institutions. For example, the Government does not propose to prohibit ring-fenced banks from selling products, such as insurance policies, to their customers acting as an agent for a third party.

12. Whether intra-group exposure limits are intended to be more restrictive than exposure limits with third parties.

The draft Bill requires the regulator to make ring-fencing rules regarding the terms on which ring-fenced banks enter into contracts with other members of their group, and to restrict payments from the ring-fenced bank to other members of the group, for the purposes of ensuring that the ring-fenced bank is not harmed by acts or omission of other members of its group, and is able to act independently of the rest of its group. The precise rules on intra-group large exposure limits will be a matter, therefore, for the regulator. However, in the Government’s white paper, the Government expressed support for the principles that were set out in the ICB’s original recommendations with respect to intra-group large exposure limits.

13. How legal liability will be allocated between the ring-fenced and non-ring-fenced banks for any activity conducted before the split (e.g on mis-selling or LIBOR manipulation).

Liability for any activity conducted before a banking group is split into a ring-fenced bank and a non-ring-fenced bank will remain with the legal entity which was responsible for the activity in question before the split. So if mis-selling was conducted by X bank limited before the ring-fencing was conducted, X bank limited will remain liable for that activity, whether or not it becomes a ring-fenced bank after the split.

Banks will have some flexibility about how they implement the ring-fence. It is therefore possible that in implementing ring-fencing a banking group will create new companies, but this would not mean that liabilities for activities such as mis-selling would be transferred to the new entities. If by contrast implementation of the ring-fence led to the dissolution of a company, that company’s liabilities would be cancelled. In that case a creditor or other third party may be able to restore the company in order to bring a claim against it. However, we would not expect implementation of the ring-fence to involve the dissolution of any company. Legal liability for past action is therefore unlikely to be affected by the introduction of ring-fencing.

A bank’s approach to implementing the ring-fence will almost certainly require sanction by court order under Part VII of FSMA, and under the amendments proposed in the draft Bill, any application for approval of a part 7 transfer must be approved by the PRA. The regulator is unlikely to approve any scheme involving the dissolution of a company within a banking group if that would affect any liabilities for mis-selling.

Annex C


1. Please provide a copy of the Regulatory Policy Committee’s scrutiny of the Impact Assessment.

The Impact Assessment published alongside the draft Banking Reform Bill was not submitted to the Regulatory Policy Committee (RPC) for scrutiny. This was agreed by the Reducing Regulation Committee (RRC) in order to minimise delays in implementation of the ICB’s recommendations and thus mitigate risks of instability as a result of market uncertainty. An Impact Assessment to be published alongside the Banking Reform Bill on its introduction to Parliament has been submitted to the RPC for scrutiny.

2. Why is the net benefit of the Draft Bill measures (£117.6 billion) assessed to be significantly higher than the net benefit of the complete package of the ICB reforms (£68.2 billion) when the Draft Bill excludes measures such as bail-in?

See answer to Question 5 below.

3. What are the differences between the policy measures included in the IA of the Draft Bill and policy measures included in the IA of the Banking Reform white paper?

The policy measures included in the white paper IA are detailed in paragraphs 6–12. The draft Bill IA has fewer policy measures than included in the white paper. The excluded measures are a bail-in tool, and loss-absorbency measures (including higher capital requirements for ring-fenced banks, and requirements to maintain a minimum of level of loss-absorbing debt) that the Government expects to be delivered by other legislative means, such as through EU law. Paragraphs 6–12 in the white paper and paragraphs 6–9 in the draft Bill IA give detail of measures included in each of the IAs. Where necessary for the purposes of impact analysis, assumptions have been made as to the loss-absorbency requirements that will apply—these assumptions are described in Annex A of the draft Bill IA.

4. Have any of the benefits or costs of the policy measures been revised since the IA of the Banking Reform white paper was carried out?

The estimates of the costs to GDP are calculated from the impact that the measures have on the private costs to banks. The estimate of the private costs to banks was calculated using scenario modelling data provided by the affected banks themselves and after scrutiny of the data. The modelling for the private costs is detailed in paragraphs 27–32 of the draft Bill IA.

The balance sheet scenario modelling was not revised between the publication of the white paper and the draft Bill. The policy assumptions underlying the post-ring-fence balance sheet scenario remained the same for the draft Bill as for the white paper.

The scenario modelling undertaken by the banks was intended to capture the impact of the policy measures in the long-run “steady state”. Both the baseline scenario and post-ICB implementation scenarios were modelled as “steady state” future scenarios, in order both to ensure that impact of regulatory changes such as Basel III that are not yet in full force were captured in the baseline, and to reduce the sensitivity of the scenario modelling to short-run changes in the market environment.

5. Please provide a reconciliation between the net benefit calculated for the Draft Bill and the net benefit calculated for the complete package of the ICB reforms in the IA that accompanied the Banking Reform white paper.

The present value costs and benefits used to calculate the net present benefit figures in the Banking Reform White paper and draft Banking Reform Bill IAs are set out in the table below:

PV Cost to GDP

PV Benefit to GDP

Net Present Benefit to GDP

White paper IA




Draft Bill IA




Note that the costs and benefits being compared are those to GDP. This is appropriate because although implementation of the measures in the draft Bill (and White paper) would have a first-round cost to UK banks, the benefits that would result (from improved financial stability) will be to the economy as a whole. Hence the appropriate cost to compare to this GDP benefit is the second-round cost to GDP.

As the table above shows, the present value cost estimate for the White paper IA was higher than that in the draft Bill IA. For the White paper, the present value cost was calculated from a central estimate annual cost to GDP of £770 million. This annual cost estimate was produced using the NiGEM model as described in the IA. For the draft Bill, the annual GDP cost estimate was lower—£720 million—reflecting the exclusion from the cost calculation of measures such as bail-in that were not included in the draft Bill. Hence the present value GDP cost given in the draft Bill IA was lower than that in the White paper IA.

On the benefits side, the present value figure for the draft Bill IA was higher than that in the White paper IA as a result of a change in method. In both IAs, the Government discussed the uncertainties involved in estimating the costs of financial stability, and argued that it was only possible to convey the scale of the potential benefits of greater stability through illustrative calculations. Using assumptions made by the ICB as a starting point, the White paper IA presented an illustrative calculation showing that if “baseline” regulatory reforms reduced the costs to GDP of financial instability by 30%, and if implementing the measures in the White paper further reduced the probability of future financial crises by 10% and the impact of future crises on GDP by 25%, this would result in a benefit to GDP equivalent to £9.5 billion per year in 2010–11 terms. For the draft Bill IA, a similar illustrative calculation was presented—but with lower assumptions on how far the draft Bill measures would reduce the costs of future crises (the draft Bill illustrative calculation used a reduction in the GDP impact of crises of 15%, not 25%). This was to reflect the exclusion from the draft Bill of measures such as bail-in. The adjusted illustrative calculation for the draft Bill IA therefore gave an illustrative benefit to GDP equivalent to £6.9 billion per year in 2010–11 terms.

The illustrative benefits calculated in the draft Bill IA were therefore lower than those calculated for the White paper IA—this reflects the exclusion from the draft Bill of measures such as bail-in.

To this point, the methods used in both IAs were the same. The difference in method between the two IAs was in how the illustrative annual benefits to GDP were used to calculate present value benefits.

For the White paper IA, alongside the illustrative calculation of benefits, the Government presented an analysis of the sensitivity of the illustrative calculation to the assumptions made on the pre-measures cost of financial crises. This analysis showed that if, instead of the using the ICB’s assumptions for the annual cost of crises, the lowest estimate in the academic literature, then applying the same illustrative calculation as described above would still give an annual benefit to GDP of £2 billion per year. The White paper IA thus had a range of GDP estimates from £22 billion to £9.52 billion per year. From this range, a mid-point estimate (£4.72 billion per year) was drawn, and this figure was used to calculate the “best estimate” present value GDP benefit figure, £84.82 billion.

However, for the draft Bill IA, a different approach was used. Given that the pre-measures cost of crises could be higher than the ICB’s assumption as well as lower (the ICB’s assumptions were averages of figures available in the academic literature), the Government considered it more appropriate to use as its “best estimate” the results of the illustrative calculation based on the ICB’s assumptions, ie the £6.92 billion per year figure. The present value benefit to GDP presented in the draft Bill IA was calculated using this figure, giving a present value benefit to GDP of £131.32 billion.

The increase in the present value benefit figure presented in the draft Bill IA relative to the figure in the White paper IA was therefore the result of this change in method. Had the method used in the draft Bill IA been used for the White paper IA, the present value benefit in the White paper IA would have increased to £171.32 billion (higher than the PV benefit figure in the draft Bill IA—reflecting the inclusion in the White paper of measures such as bail-in that were not included in the draft Bill), which would have given a net present benefit figure for the White paper IA of £154.72 billion.

In both IAs, the Government made clear the uncertainties involved in estimating the benefits to financial stability of the measures included, the illustrative nature of the calculations presented, and the assumptions to which they were sensitive. See paragraphs 87–94 of the White paper IA and 71–80 of the draft Bill IA for further details.

6. Para 15 states that “when secondary legislation is made, following the passage of the Banking Reform Bill, there will be further IAs covering the contents of that secondary legislation”. Please outline the framework that will be used to assess the costs of the secondary legislation, and explain the manner in which it will drive the nature of the rules produced.

In line with Better Regulation guidelines, the Government intends to publish Impact Assessments (IAs) of the provisions of secondary legislation made under the Banking Reform Bill at the same time as draft secondary legislation is published for consultation.

The process for modelling the impact of the measures in the secondary legislation will be similar to that for the impact of the draft Bill. The Government intends to ask the major UK banks to model their balance sheets first under a baseline scenario incorporating the effects of regulatory changes going ahead independently of the Banking Reform Bill and its subsequent secondary legislation, and then under a scenario including the impact of the Bill and the draft secondary legislation. As was the case for the draft Bill IA, in order to reflect the flexibility of the ring-fence, banks will be left free to choose whether activities that are neither “core” nor “excluded” are carried out inside the ring-fence or not. Comparing the modelled balance sheets under the “baseline” and “with Bill and secondary legislation measures” scenarios will allow the incremental impact of the measures in the secondary legislation to be estimated. Similarly to the IA for the draft Bill, the private cost to UK banks will be analysed in four main elements: capital costs, funding costs, operational costs and transitional costs.

Given that banks will need to take account of the full range of ring-fencing requirements in order to model how they would separate their balance sheets, it will not be possible to assess the impact of each of the provisions of the secondary legislation in isolation (either from other secondary legislation provisions or from the provisions of the Bill itself). For example, in deciding whether to place the deposits of organisations that are not SMEs inside or outside the ring-fence, banks will need to take into account not only the definition of SME set in the draft secondary legislation but also what activities are defined as “core” and “excluded” in both the Bill itself and in the secondary legislation. Secondary legislation IAs will therefore assess the impact of the measures in the draft secondary legislation in packages, not in isolation. Given that the broad principles of ring-fencing and depositor preference have already been settled, the focus of impact analysis for the secondary legislation will be to inform decisions on the precise calibration of the different policy measures: for example, the decision on where exactly to the set the threshold for defining an “SME” for the purposes of ring-fencing, not on whether SME deposits should be considered as “core”.

In assessing the impact of the measures in the draft secondary legislation, it will be necessary to make a number of assumptions, for example on the wider macroeconomic environment and on the behavioural responses of bank customers and management. The results of the cost-benefit analysis will be sensitive to these assumptions, as well as subject to uncertainty over future market developments. The key assumptions, sensitivities and risks will be set out in the secondary legislation IAs.

10 December 2012

Prepared 2nd January 2013