Banking StandardsWritten evidence from Santander UK
RESPONSE TO THE PARLIAMENTARY COMMISSION ON BANKING STANDARDS CALL FOR EVIDENCE ON DERIVATIVES
(A) Introduction
(a) Santander UK welcomes the opportunity to respond to this call for evidence.
(b) Santander UK has consistently argued for the need to allow ring-fenced banks to act as principal in the sale of risk management products. It has been the concern of Santander UK that if ring-fenced banks are not permitted to originate these products and provide them to businesses (most notably, SMEs) then a significant number are likely to be blocked from accessing them all together.
(c) Santander UK has also consistently argued that these products can be provided by ring-fenced banks without any significant impact on their resolvability or stability.
(d) We welcome the conclusion of the Parliamentary Commission on Banking Standards that ring-fenced banks should be able to act as principal in the sale of simple risk management products, subject to the conditions which it set out.
(e) We feel that the draft Statutory Instrument on excluded activities and prohibitions (SI) related to the Banking Reform Bill has the ability to meet the second and third conditions of the Parliamentary Commission; namely to define simple customer derivatives in a way which is limited and durable and to place limits on the proportion of a bank’s balance sheet that can be taken up by customer derivative products.
(f) We also believe that the SI can contribute toward the first condition of the Parliamentary Commission, namely to provide safeguards against mis-selling. As can be seen in Santander UK’s response to this call for evidence, restricting the range of risk management products to those which are relatively easy to understand and act in predictable ways, will contribute toward a regulatory regime which can protect effectively against the risk of mis-selling.
(g) However, Santander UK considers that conduct risk can never properly nor effectively be addressed through the Statutory Instruments of a Parliamentary Bill. As conduct risk is concerned with how products are sold, rather than the nature of the products sold, it will inevitably be present regardless of the restrictions on products provided for in the SI. Conduct risk is most properly and effectively addressed by an empowered conduct regulator. Santander UK welcomes the creation of the FCA and has every confidence it will be able to fulfil this task.
(h) Santander UK further notes that this is more properly an issue for the conduct regulator as risk management products may be sold by ring-fenced banks, non-ring-fenced banks and other specialist financial companies. Therefore, measures in the Banking Reform Bill to guard against mis-selling cannot provide for an effective market-wide solution.
(i) We believe that the SI as drafted goes some way to ensure that the rules on the provision of risk management products are limited and durable. With some adjustments, we believe that the SI will be able to fully achieve this aim. Santander UK also welcomes the inclusion in the Banking Reform Bill of measures to “electrify” the ring-fence. This measure, which will permit the regulator to impose full separation on banking groups seen to be gaming the ring-fencing rules, will act as a powerful additional tool to ensure the durability of the rules.
1. Is it appropriate for SMEs to be able to hedge risks arising from price fluctuations directly with a ring-fenced bank, rather than with a non-ring-fenced bank, and if so, why?
1.1 Santander UK considers it essential that SMEs are able to hedge risks arising from price fluctuations directly with a ring-fenced bank.
1.2 Even for some very small SMEs, being able to access products which enable them to hedge the risk arising from exposure to foreign exchange rates or interest rates are essential to help their businesses grow. This is especially true for those SMEs seeking to export goods to new markets overseas, or managing supply-chains in more than one currency zone. Both of these activities are increasingly common, even for very small businesses, as the market in which they operate becomes more global and more competitive. With this in mind, it is essential that the Banking Reform Bill preserves choice for SMEs that consider hedging risks with standalone products to be the best route for business growth and success.
1.3 As set out in our response to the Commission’s call for evidence on the draft Banking Reform Bill in October 2012, Santander UK believes that for many SMEs, buying risk management products from ring-fenced banks is the most appropriate option. This is due to the relationship which the SME will have with the ring-fenced bank and because the products will be much more affordable for SMEs if they are originated and purchased from a ring-fenced bank. In fact we believe that if businesses are unable to access simple risk management products from ring-fenced banks, then it is highly likely that many SMEs which want or need these products will not be able to access them at all.
1.4 Inclusion within the ring-fence for these products is desirable on the grounds of customer service and long term relationships. Particularly for smaller SMEs, the ring-fenced bank is likely to be the customer’s primary banking relationship. As per Santander UK’s relationship model in our corporate and commercial bank, this means that businesses across the country will have a local relationship director (or in the case of other banks, dedicated branch staff) who has taken time to get to know the customer and has a long-term interest in maintaining a close relationship with them. If an SME is forced outside the ring-fence to a wholesale or investment bank it is unlikely to be able to access the same network of local bank staff and certainly will not be able to deal with a bank or banking team that has the same relationship with it.
1.5 Inclusion within the ringfence for these products is desirable on the grounds of cost and access. When the ring-fenced bank holds the primary banking relationship with the SME, it is able to use collateral already posted for other banking services (such as a standard business loan) to act as security on the hedge. If these businesses were forced to go outside the ring-fence to procure these products (or even purchase them from a ring-fenced bank acting as agent for a non-ring-fenced bank in its group), they would either have to take short term unsecured products, or the non-ring-fenced bank would require cash-backed or carved our security packages. It is very unlikely that an SME would be able to provide these, effectively restricting them from accessing the products at all.
2. Is it appropriate to permit ring-fenced banks to sell derivatives to customers when the “main” purpose is to hedge risks, rather than simply when the “sole” purpose is to do so?
2.1 Santander UK agrees that ring-fenced banks should only be permitted to provide derivatives which are designed to hedge a customer’s legitimate business risks. This is achieved by: (a) restricting the product set which is permitted within the ring-fence; and (b) linking that product set with the purposes for which it may be used by the customer.
2.2 While element (a) specified above is met by regulation 4(1)(b), Santander UK does not believe that regulation 4(1)(a) is the most effective way of delivering element (b) of this objective.
2.3 Given that the purpose for which a product is taken by a customer is ultimately defined by or known to the customer, there may be cases where the customer’s potential need for risk management products is ascertainable (eg a business exporting or importing goods or services is likely to have a need for FX products to hedge its currency risks), but the particular purpose of a transaction may not be clear to the ring-fence bank (eg the business enters into an FX product to hedge its currency risk on a particular order).
2.4 Santander UK recommends a revision of regulation 4(1)(a) so that it requires ring-fenced bank to only sell derivative products when it has reasonable grounds to believe that the use of those products is for risk management. This would remove the ambiguity around the concept of what a customer’s sole or main “purpose” is, which may not be fully knowable to a bank. It replaces this requirement with a much clearer and more realisable obligation on a bank to only sell derivatives to customers when the bank itself, in its own judgement, “has reasonable grounds to believe that the transaction would be used for the purposes of risk management.”
3. What challenges is the PRA likely to face in defining rules to assess the purpose of derivative transactions and does the draft secondary legislation provide a clear enough mandate to support such rules?
3.1 In line with our preliminary comments, Santander UK believes that it will be difficult to define rules in secondary legislation that will be sufficiently clear and flexible to be capable of practical application by a ring-fenced bank to the specificities of each customer on a granular, transaction by transaction basis. Santander UK suggests that a preferable approach is a code published by the appropriate regulator to provide guidance to ring-fenced banks on factors or principles which would support customer transactions being for hedging purposes.
3.2 Furthermore, as the language of regulation 4(1)(a) seems to centre on conduct risk, rather than the potential prudential and systemic risks that customer derivatives may pose to a ring-fenced bank, Santander UK suggests that the FCA is the more appropriate regulator to define any rules or code.
4. Is a restriction based on BIPRU 7.10.21(1) appropriate for limiting the provision of derivatives to simple products which serve the majority of SME needs?
4.1 Santander UK is concerned that a restriction based on BIRPU 7.10.21(1) would be much too restrictive to meet the needs of many SMEs seeking to hedge risk. We do not believe that BIPRU 7.10.21 gives an appropriate meaning to “simple” derivatives.
4.2 For instance, a restriction of this kind would prevent the sale of “vanilla options” and “Asian options”. Despite the complex names which these products are given in the FSA Handbook, they are all used by SMEs to manage different kinds of risk due to the additional flexibility and protection that they provide without adding undue complexity; both for the customer and the ring-fenced bank.
4.3 Below is an example of how each of these might be used by a customer to hedge its from foreign exchange risk:
4.3.1
4.3.2
For instance, this product might be used by a customer with a subsidiary or majority shareholding in an overseas firm. The profits of the subsidiary are in the local currency (for instance, US dollars). The UK company may wish to notionally convert this profit to sterling in every month or every quarter to help it manage its business effectively. At the end of the accounting year, when the company wants to convert this US dollar profit into sterling, an Asian option allows it to convert the US dollars at the average exchange rate the business has been using over the accounting year. This means that the notional profit which the company took throughout the year is guaranteed, regardless of whether exchange rates change against it over the course of the 12 months. Like the vanilla option above, the Asian option guarantees a minimum value of the US dollar sales income while also limiting the cost to the customer to the premium of the Asian Strike option.
4.4 These are common and straight forward examples of how SMEs use hedging products. They also demonstrate that BIPRU rules are not an appropriate tool to implement a proportionate and workable ring-fence. BIRPU is designed to ensure appropriate capital is held against market risk exposures, it is not designed to establish the types of risk management products that can be provided by a ring-fenced bank without threatening the stability or resolvability of that bank, or the wider integrity of the ring-fence.
4.5 For this reason, Santander UK recommends that that Clause 4(2) is redrafted so that it specifies clear principles for the provision of derivatives, and so that it is tailored to the objectives of the Banking Reform Bill.
4.6 Santander UK proposes the new Clause 4(2)(a) below:1
(2)
(a)
This measure prevents complex OTC derivatives being offered that track multiple indices or underlying instruments per hedged risk. The market risk arising from a product that is defined by a single underlying per hedged risk is straight forward for the ring-fenced bank to hedge and easier to replace or novate in a resolution scenario. This kind of product is also simpler for a client to understand.
(b)
This measure ensures that only products with a clearly defined maximum notional exposure can be offered by ring-fenced banks and that products with higher power payouts are excluded. Products of this nature allow both the customer and the ring-fenced bank to have a clear understanding of the worst-case scenario from the outset, making both market and credit risk simpler to determine.
(c)
This principle ensures that a definite maturity date is known from the outset. Products with this characteristic are more transparent and straightforward for the client to understand and for the ring-fenced bank to hedge.
(d)
It should always be the case that products which follow points (a)–(c) above are able to be risk managed by the ring-fenced bank using liquid interbank instruments. Santander UK recommends that this measure is added to provide an additional safeguard and to ensure that the ring-fenced bank will be able to hedge its risk even in extreme market circumstances following a systemic shock.
(e)
See answer to question (5) below.
4.7 Santander UK believes that amending the Statutory Instruments with tailored measures such as these provide a high level of protection for the ring-fence. We also believe that these measures provide clear direction to the PRA, making the rules concise and durable, yet sufficiently flexible to ensure that they remain relevant as the market develops in the future.
5. What will be the effects of the restrictions relating to evidence of the fair value of the investment, and how will it help address the Commission’s concerns?
5.1 Santander UK supports the inclusion of this measure and considers it to be an effective tool in protecting the resolvability and stability of the ring-fenced bank.
5.2 By being able to easily assess the fair value of the products, the ring-fenced bank is better able to hedge the risks arising from them. This adds to the stability of the ring-fenced bank.
5.3 The ability to assess fair value is also essential to protect the resolvability of the ring-fenced bank. In a resolution scenario, level 1 and level 2 products are easy to value and therefore easier to unwind or move to other institutions.
6. Is the proposed methodology for calculating a gross cap on the total of derivatives sold the appropriate one, and is it resistant to gaming?
6.1 Santander UK considers that the methodology proposed is appropriate for implementing a gross cap on derivatives that limits the quantum of products provided.
6.2 Given the simple, transparent and specific nature of the rules proposed, we believe that they will be highly resilient to gaming as they will provide the PRA and banks with very clear direction.
27 March 2013
1 The text in italics is explanatory notes for the purposes of this response.