Banking StandardsWritten evidence from the British Bankers’ Association

1. The British Bankers’ Association welcomes the opportunity to provide input to the Parliamentary Commission’s consideration of the issues arising out of the draft secondary legislation on the provision of derivatives by ring-fenced banks.

2. The Government response to the Parliamentary Commission’s report on its pre-legislative scrutiny exercise on the draft Bill published in October 2012 explained that the Government agreed with the Parliamentary Commission that “in principle ring-fenced banks may be permitted to sell certain simple derivatives to their customers, subject to strict safeguards to ensure that derivatives do not undermine the resolvability of ring-fenced banks, and to guard against mis-selling.”1 This would appear a good starting point from which to achieve a suitable balance between enabling ring-fenced banks to be able to service directly their customer’s hedging needs and the desire to limit the complexity of products and risks involved from the perspective of both the customer and the ring-fenced bank. As the call for evidence illustrates, there remain significant intricate issues which need carefully thinking through if the limitations to be placed on ring-fenced banks through the secondary legislation are to be appropriately struck.

3. We would further add that there are also issues relating to the provisions in respect of ring-fenced banks being able to meet their customers’ trade finance needs, including the proposition that permitted services need only extend to letters of credit (so excluding, for example, cross-border guarantees and some common forms of trade loan). Although not raised in the call for evidence, we would draw to the Parliamentary Commission’s attention the importance of also getting these provisions right if ring-fenced banks are to be able to support client import and export activities.

4. This underlines the importance of the consultation on the secondary legislation expected to be undertaken over summer and the need to ensure that the draft secondary legislation formally presented to Parliament adequately addresses issues raised by the Parliamentary Commission and other interested parties.

5. The remainder of this submission is based upon the specific questions raised in the call for evidence.

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?

We can see three clear benefits for SME and other account holders being able to hedge risks arising from changes in interest or exchange rates or changes in commodity prices directly with the ring-fenced bank with which they principally undertake their banking:

The need for collateral and security in support of the risk in the derivative contract which is more likely to be readily available to the ring-fenced bank holding deposit monies and rights in support of secured lending facilities. Absent these, hedging facilities may prove difficult to source or only be available at a significantly higher price.

The ability for the customer to have their banking needs met within a single banking relationship without having to go through duplicative credit assessment processes and other administrative tasks in support of their financial services.

The added security for the SME and other account holders of the hedge and the hedged item remaining intact in the event of bank failure and therefore their continuing to be insulated against market risk.

We believe that a consequence of unduly limiting the ability of a ring-fenced bank to meet its client hedging needs may be that some may choose to open themselves up to market risk which they otherwise would have taken action to remove or mitigate.

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?

We would be concerned about a definition based upon “sole or main” if this, for example, required a bank to validate any foreign exchange hedge against the client’s order book and outgoings, which implies a degree of investigation which may prove impractical. Given that the purpose for which a product is selected by a customer is ultimately defined by or known to the customer, there may be cases where their potential need for risk management products is ascertainable, but the particular purpose of a transaction may not be clear to the ring-fence bank. We therefore would recommend a revision of regulation 4(1)(a) so that it requires a ring-fenced bank to sell derivative products only 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 known to the bank

This would be consistent with requiring the ring-fenced bank to be content that the hedge is consistent with the customer’s ordinary business without necessitating a validation process that would stand in the way of the transactions being completed effectively. We would be concerned in particular if “sole or main” inferred a strict correlation between need and usage which could prevent the customer from entering into a hedging arrangement once they had made an assessment based on an estimation of their needs.

It needs to be borne in mind that in the event that an SME is unable to hedge an exposure with a ring-fenced bank, there is a real possibility that it may remain unhedged and exposed to significant risk, as it may not be easy or cost-effective for it to maintain a secondary banking relationship with a non-ring-fenced institution.

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?

At this stage we would view it as premature to set out detailed rules, given the difficulty of establishing the intention behind a transaction. We would see the need more as being for the FCA to develop conduct rules in support of a ring-fenced bank’s derivatives product offering being suitable for its client base and processes in support of individual transactions. We note that the PRA will, in any case, have wide powers to vary the regulatory permissions of a ring-fenced bank.

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?

As the call for evidence identifies, clause 4(2)(a) of the draft of the Order proposes to restrict the sale of derivatives to those which fall within Section BIPRU 7.10.21(1) of the FSA Handbook, namely “linear products, which comprise securities with linear pay-offs (eg bonds and equities) and derivative products which have linear pay-offs in the underlying risk factor (eg interest rate swaps, FRAs, total return swaps)”.

Although we would agree that basing the definition of permitted “simple” derivatives products on instruments with linear features should enable the ring-fenced bank to meet the hedging needs of many of its customers, it would exclude others that are commonly used and not unduly complicated. We therefore see a case for the dividing line to be drawn in a different place.

It is arguable that derivatives falling within BIPRU 7.10.21(1), 7.10.21(2) and in BIPRU 7.10.21(3) should be permitted. Allowing these would enhance the ability of the ring-fenced bank to meet the customer’s needs, but at the same time exclude more complicated instruments listed in 7.10.21(4), which we agree would not be in keeping with the objective of limiting the complexity of the derivative product range and the risk exposure which they entail. Including instruments listed in 7.10.21(2), for instance, would permit cross-currency swaps, which involve exposure between two or more risk factors, and are therefore not linear, and also simple options such as caps and floors on interest rate exposures which may be better suited to the customer’s needs.

Including instruments listed in 7.10.21(3) would add options typically used to hedge foreign exchange exposures which cannot be defined at the outset of the contract, but can be based on an average over the course of a certain timeframe. This, for instance, might include a customer with a subsidiary or majority shareholding in an overseas firm where the profits of the subsidiary are in the local currency and the UK company notionally converts this profit into sterling in every month or every quarter to help it manage its business effectively. An option available under 7.10.21(3) enables the company to purchase the right to convert its foreign currency profit at the average exchange rate over the accounting year meaning 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.

Should further consideration lead to the conclusion that the products included in BIPRU 7.10.21(2) and 7.10.21(3) involve an element of complexity discernibly higher than those in 7.10.21(1), the answer may be for the conduct rules to be drawn up in such a way that the customer processes involved are aligned to the level of complexity involved.

These are issues which should be explored more fully as part of the consultation exercise on the secondary legislation due to take place this summer. It is a matter for discussion whether broadening the definition of “simple” derivative product in this was would better achieve the right balance between wanting to simplify the product range directly available from the ring-fenced bank while at the same time ensure that SME customers in particular can receive the hedging services which they need from the ring-fenced bank. We do however believe that the planned restriction based on the fair value hierarchy, upon which we comment in response to question 5, provides an anchor point for reducing complexity that potentially enables a more inclusive approach to be taken to the derivative product range that can reasonably be provided from within the ring-fenced bank.

We would further add that definition of the exposures against which a ring-fenced bank is entitled to hedge itself provided in clause 6(2) of the draft excluded activities and prohibitions order differs from the definition of exposures that the bank can offer to hedge for SME customers as defined by clause 4(1). As matters stand, the lack of symmetry means that the ring-fenced bank would be permitted to hedge a client’s exposure to commodity price changes but not to aggregate and hedge its own exposure. (This must be an oversight or be based upon provision via a different route within the draft Order that we have not as yet managed to identify.)

5. What will be the effects of the restrictions relating to evidence of the fair value of the investment, and how does will it help address the Commission’s concerns?

The call for evidence also identifies that clause 4(2)(b) of the draft of the Order proposes to require that derivatives can be sold to customers only if there is evidence available to assess the fair value of the investment concerned in accordance with IFRS 13 and that evidence would be considered to constitute a level 1 or a level 2 input within the meaning of IFRS 13.

This limits ring-fenced banks to providing derivative products that are capable of being valued using either quoted market prices or upon the basis of observable market data, but not products based upon more complex models. While this may debar ring-fenced banks from providing customers with newer products that become available, we view the restriction as being entirely in keeping with the aim of permitting ring-fenced banks to provide products which are readily understandable and which do not unduly complicate the ring-fenced bank’s risk management arrangements. In fact, we see this as the principal means through which ring-fenced banks can be enabled to provide “simple” derivative products, but for the line to be drawn at instruments embedding greater complexity and risk.

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?

The final question relates to clause 4(3)(b) of the draft of the Order proposing a methodology for setting a gross cap on the total volume of derivatives sold to clients. The difficulty with setting a hard limit at this early stage is that it is difficult to see what a reasonable pattern of activity will look like until we have a clearer picture in terms of the way in which corporates will choose to organise their banking relationships. A breach of the gross cap proposed could arise from market movements without the ring-fenced bank writing any further contracts, but it is not clear how the bank could remedy such a breach in the near term (given that no position risk requirement could be set off against any other position risk requirement).

We would therefore suggest that a firm basis for defining a gross cap should be agreed at this stage and in this respect we would recommend a definition based upon IFRS accounting and regulatory capital calculations which essentially amount to the aggregate mark-to-market value of relevant contracts gross of collateral but net of legally enforceable netting agreements. This would provide an objective and practicable base for the limitation. The application of such a limit in practice is still likely to require a degree of caution: the mark-to-market value could vary significantly from day to day without the ring-fenced bank writing any new derivative contracts. We would advocate that the cap be a threshold for enhanced supervisory interest rather than a hard limit since temporary fluctuations may otherwise result in a statutory breach and a need for the ring-fenced bank to suspend the availability of hedging services for clients (thereby exposing them to market risk).

27 March 2013

1 “Banking reform: a new structure for stability and growth”, HM Treasury and Department for Business Innovation & Skills, February 2013.

Prepared 24th June 2013