Banking StandardsWritten evidence from the Bank of England
Thank you for your letter of 19 November 2012. As requested, in this note I set out options for including in the Bill powers to require reorganisation or separation, on a contingency basis, if banks were to breach the ring-fence—the so-called “sword of Damocles” reserve power. In the time available, I have not been able to do full justice to all of the legal and practical issues this might raise, but wanted to give you some tentative thoughts on a possible framework. While I have discussed these issues with colleagues here at the Bank, the views are personal ones.
The backstop power as an incentive-correcting mechanism
The first thing to say is that this reserve power is most usefully thought of as a means of reinforcing the ring-fence, not as a means of supplanting it. Suitably designed, this power would have no impact on any firm intending to abide by the letter and spirit of the ring-fence proposals. For those at risk or gaming or arbitraging the ring-fence, it would provide potentially powerful incentives not to do so.
The benefits from backstopping the ring-fence are, then, that this would create self-reinforcing incentives on the part of ring-fenced banks’ management to avoid leaks and breaches. That would make the job of policing the ring-fence, both by the board of the ring-fenced bank and the regulator, somewhat easier. In other words, a reserve power would lessen the “negotiation risk” between firm and regulator highlighted by the Governor in his testimony.
The key question is how to make such a reserve power operational. In thinking about that, it is useful to set out the ladder of actions and sanctions that could be imposed on a firm or set of firms in the event of breaches of the ring-fence. For each, the key thing would be to have absolute clarity in legislation on the scope of these actions and sanctions.
The first line of defence should be the board of the ring-fenced bank. As I said in my evidence to you, it would be extremely useful to impose on the board a duty to ensure the integrity of the ring-fence. Indeed, that duty might be extended to the board of the parent company. This could take the form of a relatively narrow duty to preserve the ring-fence or a wider obligation to support the purposes of the ring-fence—for example, continuity of service to depositors and borrowers. Such objectives would augment directors’ duties to shareholders under Company Law.
The second line of defence should be the prudential regulator, which in future will mean the PRA. Again, it would be extremely useful in this respect if the PRA were given a clear role in ensuring the integrity of the ring-fence. That might mean setting out, perhaps in secondary legislation, a clear mandate for the regulator defined in terms of policing the ring-fence, making clear the powers that exist to enforce this policing.
On powers of enforcement, under the supervisory framework anticipated in the Financial Services and Banking Reform Bills, the PRA could take the following actions if a firm were to be breaching its rules or objectives:
Impose higher capital requirements under Pillar 2, or tighter liquidity requirements.
Take action under the approved persons regime, potentially including removal of approvals.
Impose a financial penalty.
Varying a bank’s authorisations to limit or prevent activities.
Removing links to owners and group companies.
These are a potentially powerful set of regulatory sanctions for helping reinforce the ring-fence.
A further potential rung in the ladder of sanctions could be a regulatory power to require a restructuring or reorganisation of the business of any bank breaching the ring-fence. The Financial Services Bill falls short of a providing such a power. But such powers are not without precedent in other contexts. So it is plausible to think they could be made operational.
One case study here would be the draft EU Recovery and Resolution Directive (RRD), mentioned by Paul Tucker at the hearing. The range of sanctions envisaged in the RRD is extensive, including divestment, limiting or ceasing certain activities and, ultimately, requiring changes to the legal or operational structures of the firm. At the hearing, Paul said he believed that, if enacted, these RRD powers may be sufficient. The rationale for a reserve power would be slightly different than in a resolution context (continuity of core service rather than resolvability) but the underlying rationale would be the same (protecting financial stability).
A second example would be the powers of reorganisation and restructuring granted to the competition authorities under competition law. For example, the Competition Commission can seek undertakings or make orders requiring firms to divest businesses or assets which are contrary to competition objectives. And as we have seen in EU State Aid cases, significant restructuring requirements can be imposed on financial firms to meet EU competition objectives. In both cases, the underlying principle is that powers of reorganisation might be required to meet public policy objectives.
Such powers, as in a resolution or competition context, would need clear triggers and appropriate checks and balances, which would need to be set out in legislation. For example, the regulator would need to evaluate the reason for the breach of the ring-fence, assess its materiality, determine what measures had already been taken to avoid these breaches and provide an assessment of why they had been insufficient. There might also be safeguards in application of the power, for example to ensure the bank was given sufficient time to effect organisational change without incurring excessive costs.
A final rung on the ladder of potential sanctions might be to require a restructuring or reorganisation not of an individual firm, but of the system as a whole. This is a significant power. Asking the regulator to execute such a re-organisation across the financial system as a whole would be a significant task, both operationally and politically. And the threshold for executing this power would need to be demonstrably higher—for example systematic failure of the ring-fence. In this situation, it is possible that a fundamental defect in the ring-fence had arisen, for which separation might not necessarily be the right solution.
It is reasonable to think that a decision of this magnitude might legitimately lie with Parliament, rather than with a regulator with delegated powers, as the Governor made clear at the hearing. So an alternative to a wide-ranging, across-the-system, power would be to pre-commit to a Parliamentary review of the operation of the ring-fence at some pre-determined point in the future. This option was raised by the Governor at the hearing. This would help strengthen incentives to comply with the ring-fence, while leaving the ultimate decision to Parliament.
Unintended consequences
Finally, at the hearing you asked about potentially unintended consequences which could arise from having a reserve power on the statute books. One possibility here is that the power might exacerbate uncertainty or risk-aversion on the part of banks, perhaps causing them to hoard capital or liquidity instead of lending, or unwilling to innovate in new financial products for fear of falling foul of the ring-fence.
On the face of it, it is difficult to see why hoarding financial resources would be a natural response to the addition of a reserve power. Nor is it obvious that this would stifle financial innovation, which can anyway take place in the non ring-fenced bank. Nonetheless, fear of the unknown plainly could be a factor shaping the decisions of a ring-fenced bank. If so, three factors would be crucial in mitigating this risk, all of them in the spirit of requiring as much clarity as possible.
First, this strengthens the case for absolute clarity about the position of the ring-fence. That would mean having the objectives and the position of the ring-fence set out clearly, perhaps in secondary legislation. The same would be true of the duties of both ring-fenced bank directors and the regulator in policing the ring-fence.
Second, there would need to be clarity about the triggers which might prompt intervention by the regulator, including the ultimate sanction of reorganisation. These might specify how the risk posed by a breach of the ring-fence might translate into regulatory sanction.
Third, there would need to be clarity about the constraints within which the regulators would need to act when making a decision about reorganisation. These could be similar in principle to the “no creditor worse off” provisions under the existing resolution regime, suitably adapted. Both the second and third issues would require further work.
I hope these preliminary thoughts are useful to you and the Commission when reaching decisions on this very important issue.
Andy Haldane, Executive Director
6 December 2012
Submission from Vedanta Hedging
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?
Vedanta Hedging is regulated by the Financial Services Authority to advise both large institutions and small firms on derivatives
It is our opinion that small firms in the UK should have access to derivatives.
1. RATIONALE FOR SMES USING DERIVATIVES
1.1. For SMEs that import, export or have a material exposure to foreign currency movements, derivatives can help them to budget and plan their business more effectively. Significant currency swings can easily erode tight profit margins in an increasingly global and competitive marketplace.
1.2. SMEs that have a substantial amount of borrowing relative to the value of their assets (gearing) may also wish to use some type of derivative to protect themselves from rising interest rates. In the same way that an individual obtaining a mortgage will have an option of repaying their loan on a fixed, floating or tracker basis, SMEs should also be able to make such risk management decisions.
1.3. Some larger SMEs who have a material exposure to the price of a commodity, such as oil or copper for example should also be able to use derivatives to help manage their risk.
2. CREDIT RISK
2.1. The vast majority of derivatives that may be appropriate for an SME for the above risk management purposes will carry a contingent liability for the provider of that derivative. There are of course simple derivatives such as currency options, or interest rate caps which do not have any on-going potential liability since they are paid for up-front. An SME may not want to use this type of derivative however.
2.2. A bank that is providing some debt facilities to an SME will almost certainly have some security over some of the assets of the SME (typically a legal charge on property). For such a bank, it is relatively straightforward for it to allocate a portion of this security to underwrite the contingent liability for the derivative.
2.3. If a ring-fenced commercial bank was not able to provide derivatives to its SME customers, it would presumably have to suggest to its customer (on an agency basis), other banks and institutions that could provide it derivatives. The SME however is unlikely to have material banking relationships (if any) with more than one bank. Therefore, if the SME has their borrowing with ‘Ring-Fenced Bank A’ for example they will need to provide extra security to ‘Investment Bank B’ in order to obtain a derivative from Bank B. This would have to be in the form of cash collateral, or equity in their property for example, which are unlikely to be options that an SME would want or be able to provide. This in effect means that the SME would not be able to use derivatives for risk management.
2.4. Even if the SME does wish to provide additional security to Bank B, the overall costs of hedging are likely to be higher for both the SME and the bank because there is no common usage of the same security for the SME from the ring-fenced Bank A.
2.5. It is worth noting that if the SME was forced to seek derivatives from Bank B, this is forcing the SME to be exposed to increased credit risk on Bank B. This is because Bank B is by definition a ‘riskier’ bank because it is a non-ring-fenced bank. Bank B will be a more complex bank than Bank A and is less likely to be able to rely on the Government for support if required. Bank B is a bank that is likely to be a bank more suitable for large companies or financial institutions. Just as there can be break-costs payable for an SME if they terminate a derivative ahead of expiry subject to market movements, there could also be a breakage gain for the SME. If Bank B failed, it may not be able to pay the SME the breakage gain owed to it under the derivative.
2.6. It could be asked if an SME could adequately or inexpensively hedge their exposures through alternative means such as exchange-traded hedging products, rather than using an Over the Counter (OTC) contract from their bank. The simple answer to this is no, because if it is appropriate for an SME to hedge their exposure, they must only do so via a derivative that is suitable for them. This means that the derivative must be of the right length, notional amount and amortisation profile to match the underlying borrowing. Exchange traded contracts do not allow such flexibility and are typically for sizes that would be too large for an SME. It may be possible for exchange traded derivatives to be provided for smaller notional sizes and duration’s, but these have not yet been developed and will require both cost and time to develop. A further issue with exchange traded derivatives is that they may also not match the underlying basis required by the SME, for example Base Rate. With OTC derivatives, a bank can provide a Base Rate derivative to an SME, whilst the bank (not the SME) absorbs the basis risk of doing so.
3. MIS-SELLING / CONDUCT
3.1. We do not believe that the above question can be answered without addressing the issue of the mis-selling of these products.
3.2. We disagree with part of the findings from the FSA on the 29th June 2012 which are particularly focussed on complex products (for which they use a set of products that could be described as ‘structured collars’). This is because, in our view, even ‘simple’ products such as an interest rate swap, a fixed rate loan, or interest rate collar have and can be mis-sold. In cases where the derivative was provided for longer than the loan, for a larger amount than the loan, or the SME was not clearly shown the potential for large break-costs, there can be mis-selling even using ‘simple’ products. In fact, on an equivalent basis, there will be many instances where it does not matter whether the SME was provided a ‘complex’ structured collar, or a ‘simple’ interest rate swap; the break-cost from either product at current levels of low interest rates will be very similar. The point we make here is that it is the manner and conduct in which these derivatives are sold, which is far more important than a label of a ‘simple’ or ‘complex’ derivative.
3.3. As we have already stated in our oral evidence to the Committee on 26th September 2012, this does not mean that derivatives are inappropriate for SMEs.
3.4. There are actually already robust rules provided by the FSA (the Conduct of Business Sourcebook) which require banks to assess the suitability and appropriateness of these derivatives for SMEs. Part of the problem has been that the compliance functions within these banks have failed in their duty to sufficiently check how and what the sales advisors were providing to the SMEs. In turn, the FSA has also failed to monitor and challenge the banks’ compliance functions for the adherence to these FSA rules in substance, rather than just via detailed written terms and conditions they provided to SMEs.
3.5. It is our view, that the derivatives provided within a ring- fenced bank should be of a relatively simple nature. Although more ‘complex’ derivatives can be appropriate for SMEs, they can require a greater level of comprehension and analysis which some SMEs may not be able to undertake. By ‘simple’ derivatives, we mean derivatives where there are no knock-in / knock-out or digital options (a feature of ‘structured collars’) and no ability for the bank to unilaterally extend or cancel the derivative. These ‘complex’ products typically involve the SME selling one or more ‘options’ to the bank. These types of derivative can be viewed as more akin to ‘speculative’ products rather than ‘hedging’ products. For example, a multi-callable swap whereby the bank can terminate the swap early cannot be considered a hedge because as soon as the bank feels interest rates are likely to move higher, they will cancel the swap. This means the protection is removed just at the time when it is likely to be required.
3.6. In addition, with regards to the appropriateness and conduct rules regarding the sale of these derivatives, we believe that they should always be of a term less than or equal to the term of the committed facilities provided by the bank. We also believe that the notional value of the derivative should be equal to less than the value of the committed loan facilities provided by the bank that is providing the derivative. We also believe that the underlying ‘basis’ of the derivative must match the underlying index of the loan. For example, an SME with a Base Rate Loan should not be provided a LIBOR related derivative (subject to the exception mechanism below).
3.7. There may be legitimate risk management reasons why an SME may wish to request an exception from these rules. This should be permitted only after a significantly large ‘compliance hurdle’ set by the Bank. For instance, requiring the authorisation from at least two FSA Authorised individuals, a Managing Director within the Bank and Compliance.
3.8. We believe that if ring-fenced banks are permitted to provide simple derivative risk management options as per above, this will actually improve the conduct of how these products are sold. This is because there will be tighter rules governing how and what may be sold to these SMEs. If the ring- fence bank cannot provide these derivatives, and the SME must seek an alternative (non ring-fenced bank) for them, there is nothing to stop that bank providing any type of derivative, for any amount of notional size and duration. In other words, the non ring-fenced bank could still mis-sell a derivative to an SME, which would become much harder to do so for a ring fenced-bank that had to adhere to some of the principles stated above.
Submission from the Bank of England
Thank you for your letter of 19 November 2012. As requested, in this note I set out options for including in the Bill powers to require reorganisation or separation, on a contingency basis, if banks were to breach the ring-fence – the so-called “sword of Damocles” reserve power. In the time available, I have not been able to do full justice to all of the legal and practical issues this might raise, but wanted to give you some tentative thoughts on a possible framework. While I have discussed these issues with colleagues here at the Bank, the views are personal ones.
The backstop power as an incentive-correcting mechanism
The first thing to say is that this reserve power is most usefully thought of as a means of reinforcing the ring-fence, not as a means of supplanting it. Suitably designed, this power would have no impact on any firm intending to abide by the letter and spirit of the ring-fence proposals. For those at risk or gaming or arbitraging the ring-fence, it would provide potentially powerful incentives not to do so.
The benefits from backstopping the ring-fence are, then, that this would create self-reinforcing incentives on the part of ring-fenced banks’ management to avoid leaks and breaches. That would make the job of policing the ring-fence, both by the board of the ring-fenced bank and the regulator, somewhat easier. In other words, a reserve power would lessen the “negotiation risk” between firm and regulator highlighted by the Governor in his testimony.
The key question is how to make such a reserve power operational. In thinking about that, it is useful to set out the ladder of actions and sanctions that could be imposed on a firm or set of firms in the event of breaches of the ring-fence. For each, the key thing would be to have absolute clarity in legislation on the scope of these actions and sanctions.
The first line of defence should be the board of the ring-fenced bank. As I said in my evidence to you, it would be extremely useful to impose on the board a duty to ensure the integrity of the ring-fence. Indeed, that duty might be extended to the board of the parent company. This could take the form of a relatively narrow duty to preserve the ring-fence or a wider obligation to support the purposes of the ring-fence – for example, continuity of service to depositors and borrowers. Such objectives would augment directors’ duties to shareholders under Company Law.
The second line of defence should be the prudential regulator, which in future will mean the PRA. Again, it would be extremely useful in this respect if the PRA were given a clear role in ensuring the integrity of the ring-fence. That might mean setting out, perhaps in secondary legislation, a clear mandate for the regulator defined in terms of policing the ring-fence, making clear the powers that exist to enforce this policing.
On powers of enforcement, under the supervisory framework anticipated in the Financial Services and Banking Reform Bills, the PRA could take the following actions if a firm were to be breaching its rules or objectives:
Impose higher capital requirements under Pillar 2, or tighter liquidity requirements;
Take action under the approved persons regime, potentially including removal of approvals;
Impose a financial penalty;
Varying a bank’s authorisations to limit or prevent activities;
Removing links to owners and group companies.
These are a potentially powerful set of regulatory sanctions for helping reinforce the ring-fence.
A further potential rung in the ladder of sanctions could be a regulatory power to require a restructuring or reorganisation of the business of any bank breaching the ring-fence. The Financial Services Bill falls short of a providing such a power. But such powers are not without precedent in other contexts. So it is plausible to think they could be made operational.
One case study here would be the draft EU Recovery and Resolution Directive (RRD), mentioned by Paul Tucker at the hearing. The range of sanctions envisaged in the RRD is extensive, including divestment, limiting or ceasing certain activities and, ultimately, requiring changes to the legal or operational structures of the firm. At the hearing, Paul said he believed that, if enacted, these RRD powers may be sufficient. The rationale for a reserve power would be slightly different than in a resolution context (continuity of core service rather than resolvability) but the underlying rationale would be the same (protecting financial stability).
A second example would be the powers of reorganisation and restructuring granted to the competition authorities under competition law. For example, the Competition Commission can seek undertakings or make orders requiring firms to divest businesses or assets which are contrary to competition objectives. And as we have seen in EU State Aid cases, significant restructuring requirements can be imposed on financial firms to meet EU competition objectives. In both cases, the underlying principle is that powers of reorganisation might be required to meet public policy objectives.
Such powers, as in a resolution or competition context, would need clear triggers and appropriate checks and balances, which would need to be set out in legislation. For example, the regulator would need to evaluate the reason for the breach of the ring-fence, assess its materiality, determine what measures had already been taken to avoid these breaches and provide an assessment of why they had been insufficient. There might also be safeguards in application of the power, for example to ensure the bank was given sufficient time to effect organisational change without incurring excessive costs.
A final rung on the ladder of potential sanctions might be to require a restructuring or reorganisation not of an individual firm, but of the system as a whole. This is a significant power. Asking the regulator to execute such a re-organisation across the financial system as a whole would be a significant task, both operationally and politically. And the threshold for executing this power would need to be demonstrably higher – for example systematic failure of the ring-fence. In this situation, it is possible that a fundamental defect in the ring-fence had arisen, for which separation might not necessarily be the right solution.
It is reasonable to think that a decision of this magnitude might legitimately lie with Parliament, rather than with a regulator with delegated powers, as the Governor made clear at the hearing. So an alternative to a wide-ranging, across-the-system, power would be to pre-commit to a Parliamentary review of the operation of the ring-fence at some pre-determined point in the future. This option was raised by the Governor at the hearing. This would help strengthen incentives to comply with the ring-fence, while leaving the ultimate decision to Parliament.
Unintended consequences
Finally, at the hearing you asked about potentially unintended consequences which could arise from having a reserve power on the statute books. One possibility here is that the power might exacerbate uncertainty or risk-aversion on the part of banks, perhaps causing them to hoard capital or liquidity instead of lending, or unwilling to innovate in new financial products for fear of falling foul of the ring-fence.
On the face of it, it is difficult to see why hoarding financial resources would be a natural response to the addition of a reserve power. Nor is it obvious that this would stifle financial innovation, which can anyway take place in the non ring-fenced bank. Nonetheless, fear of the unknown plainly could be a factor shaping the decisions of a ring-fenced bank. If so, three factors would be crucial in mitigating this risk, all of them in the spirit of requiring as much clarity as possible.
First, this strengthens the case for absolute clarity about the position of the ring-fence. That would mean having the objectives and the position of the ring-fence set out clearly, perhaps in secondary legislation. The same would be true of the duties of both ring-fenced bank directors and the regulator in policing the ring-fence.
Second, there would need to be clarity about the triggers which might prompt intervention by the regulator, including the ultimate sanction of reorganisation. These might specify how the risk posed by a breach of the ring-fence might translate into regulatory sanction.
Third, there would need to be clarity about the constraints within which the regulators would need to act when making a decision about reorganisation. These could be similar in principle to the “no creditor worse off” provisions under the existing resolution regime, suitably adapted. Both the second and third issues would require further work.
I hope these preliminary thoughts are useful to you and the Commission when reaching decisions on this very important issue.
Andy Haldane, Executive Director
6 December 2012