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On 11 April 2011, the UK Independent Commission on Banking (the "Commission
") published its eagerly awaited interim report (the "Interim Report
") on its proposals for reforms to the UK banking sector.1
As previously reported, on 16 June 2010, the UK Chancellor of the Exchequer, George Osborne, announced the creation of the Commission at his first annual Mansion House speech at the Lord Mayor’s Dinner for Bankers and Merchants of the City of London.2
The Commission’s mandate is to consider structural and related non-structural reforms to the UK banking sector and to make recommendations to the Government with a view to ensuring greater competition and the safety of the British banking system in the event of another financial crisis. In September 2010 the Commission published an Issues Paper3
setting out its views on the possible reforms, and seeking further responses. The Interim Report is the next stage in the Commission’s engagement.
This Update considers the Commission’s key recommendations regarding financial stability and competition, the reaction of the industry so far and the potential impact of the recommendations on the UK banking and so-called shadow banking industry. Structure of the Interim Report – Further Opportunities for Comment
The first part of the Interim Report sets out the arguments why the reform is needed and explains how the proposed reforms fit into current reform initiatives aimed at improving the regulation of banks. The report then examines ways of enhancing financial stability (Chapter 4) and conditions for competition in the UK (Chapter 5). It also sets out a list of further consultation questions (Chapter 6). The vast majority of questions relate to issues discussed in Chapters 4 and 5. For instance: “should systemically important banks and UK retail banks be required to hold more equity capital than Basel III requirements
?”, “how should a UK retail ring-fence be designed?”, and “should the Commission pursue any other measures to promote competition
The closing date for responses to the consultation is 4 July 2011. As the Commission has not yet reached its final conclusions, interested parties still have time for expressing their views before the final report is submitted to the Chancellor of the Exchequer and Business Secretary in September 2011 (the "Final Report
"). Achieving Financial Stability
Chapter 4 of the Interim Report sets out a detailed analysis of stability issues in the banking sector and proposals for increasing the loss-absorbing capacity of banks and for creating some degree of separation between retail banking on the one hand, and wholesale/investment banking on the other.
In coming to its views, the Commission acknowledges that there are several approaches which, after implementation, could result in banks becoming safer. One approach would be to prescribe certain permitted structures. For instance, there could be a requirement for retail banking, and wholesale/investment banking to operate in separate unaffiliated firms. Another approach would be to seek to achieve stability by imposing very high capital requirements on banks. The Commission has chosen a more moderate combination of these approaches by proposing:
- internal ring-fencing within "universal banks" to isolate UK retail banking services; and
- higher – but not very high – capital requirements, together with measures to make bank debt effectively loss-absorbing.
Ring-Fencing UK Retail Banking Activities
The Commission believes that ring-fencing a bank’s UK retail banking activities would make it easier and less costly to sort out distressed banks as retail operations could be kept running while other operations could be subject to reorganisation or liquidation.
The Commission notes that retail customers have no effective alternatives to their banks for essential financial services. Thus, it is important to safeguard the continuous provision of these services. On the other hand, customers of wholesale and investment banking services, generally have greater choice and capacity to look after themselves and it is crucial to find ways for the providers of these services to fail safely. The Commission stressed that markets for wholesale and investment banking services (including their provision by ‘shadow banks’),4 which were more international, should be subject to policies issued at supra-national level, whereas retail banking can be subject to national policies.
As to the form that separation might take, the Commission wants to strike a balance between the benefits of making banks safer versus the resulting costs burden. Full separation between retail and wholesale investment banking, for example with restrictions on cross-ownership, might provide the strongest firewall to protect retail banking services from contagion effects of external shocks, but some benefits of universal banking would be lost. In contrast, ring fencing through separating operational systems (operational subsidiarisation) may be enough to accomplish the regulatory goals.
The Commission is therefore considering other forms of subsidiarisation, including, for example, a retail ring-fence under which retail banking operations would be carried out by a separate subsidiary within a wider banking group. This would require universal banks to maintain minimum capital ratios and loss-absorbing debt for their UK retail banking operations, as well as for their businesses as a whole. Subject to that, banks could transfer capital between their UK retail and other banking activities. The retail ring-fence rules would apply to any UK based bank seeking authorisation from the UK regulator (currently the Financial Services Authority)5 to conduct UK retail activities. Thus, the rules would not apply to a global universal bank based in London which does not conduct UK retail activities, nor would it, it seems, apply to branches of non-UK banks conducting retail activities in the UK, or perhaps even, say, a French or German based subsidiary of a UK bank providing retail services into the UK from France or Germany.
The Interim Report also discusses the US "Volcker Rule" form of separation which prevents deposit-taking banks from engaging in so-called proprietary trading. The Volcker rule had been introduced in the US by the Dodd-Frank Act and prohibits deposit-taking banks from conducting proprietary trading and limits their investments in hedge funds and private equity funds. In the Commission’s opinion, it is however unlikely that a Volcker Rule approach would be appropriate for the UK, given that the activities of proprietary trading units within UK universal banks had typically represented a very small component of bank assets and that it is not easy to isolate proprietary trades from customer facilitation trades in client-facing units, where trading activities are usually much larger.
It is open to debate whether a retail ring-fence would give more or less banking stability than full separation between retail banking and wholesale/investment banking. Ring-fencing would be less costly to banks because they would retain significant freedom to transfer capital. The required UK retail capital level would constrain banks only when they wanted to go below it to shift capital elsewhere, for instance to their wholesale/investment banking operations.
Equity Surcharge of at Least 3% Above Basel III Requirements
The Commission believes that banks must have greater loss-absorbing capacity and/or simpler and safer structures. Achieving greater loss-absorbency requires that banks hold more equity capital relative to their assets and that creditors (not taxpayers) take any losses if necessary.
In the Commission’s view, large UK retail banking operations should have a core tier one capital ratio of 10% (compared to the 7% baseline ratio of equity to risk weighted assets in the Basel III framework). The Commission believes that the capital standards applying to the wholesale/investment banking businesses of UK banks need not exceed international standards provided that those businesses have credible resolution plans (including effective loss-absorbing debt) so that they can fail without risk to UK taxpayers.
The Commission proposed to focus its work on further consideration of introducing over time greater loss-absorbing capacity for systemically important banks comprising: (i) an equity surcharge of at least 3% above Basel III requirements; (ii) additional loss-absorbency provided by debt through bail-in6 mechanisms and possibly contingent capital; (iii) and some form of depositor preference. The critics of the Interim Report argue that the Commission failed to set out solutions for systemically important financial institutions ("SIFIs") and global banks. The Commission highlights that the Financial Stability Board (the "FSB") is developing a policy framework to address, inter alia, the risks SIFIs pose to financial stability. The FSB’s proposals include a loss-absorbency surcharge, which should be determined by the end of 2011, and effective supervisory oversight of SIFIs. In addition, the Basel Committee on Banking Supervision and the FSB are currently setting out the criteria for identifying global SIFIs (the "G-SIFIs").7 The Commission noted that the FSB’s policy framework also recommended the implementation of international supervisory colleges and mandatory international recovery and resolution plans for G-SIFIs, both to be led by the home supervisor of each cross-border firm. The G-SIFI policies adopted by the home supervisors would then be subject to appraisal by the FSB’s Peer Review Council to ensure they are sufficiently robust and mutually supportive.
However, the Commission's proposed capital requirements for UK systemically important banks could place UK banks at a disadvantage to other banks and may make the UK market less competitive. Also, given that these proposals would only apply to UK based banks, there is also a risk of a regulatory arbitrage.
One of the mandates of the Commission was to make recommendations to improve competition in UK retail banking. Notably, Lloyds Banking Group was the only institution singled out by the Commission for specific reforms. Following the release of the Interim Report, Lloyds Banking Group, which has a market share of up to 30% in high street banking, is likely to face intense political pressure to sell even more branches than the 600 it is already having to divest under state aid rules. However, some industry observers believe that providing a new entrant with 200 or so more branches would have little impact on enhancing competition in the UK.
In the Commission’s view,8 conditions are generally poor for consumer choice in the banking sector, due to difficulties in switching accounts, difficulties in understanding and comparing products, and barriers to entry facing new players who might have a better customer offering. The Commission believes that a radically improved system for switching accounts could and should be introduced at a reasonable cost. The Commission argues that this would help to reduce obstacles to switching, which constitute one of the main barriers to entry, as well as blunting competition between established banks. Commentators suggested that a redirection service for switching current accounts could be introduced within two years at a cost to the industry of about £2bn.
The Commission noted that in the run-up to the recent crisis some financial activities were conducted in the shadow banking sector simply to avoid bank regulatory requirements. In the Commission’s view, non-banks may well be better-placed than banks to conduct some financial activities, and limiting the implicit government guarantee for banks may also encourage some activities to move out of the banking system. The Commission believes that to the extent that shadow banks can safely remove risk from the banking system, an increased role for them will be positive for financial stability.
The Financial Policy Committee of the Bank of England will have tools designed to moderate credit and asset prices, and to bring non-banks within the regulatory perimeter. The Commission believes that European Union proposals to standardise OTC derivatives where possible, and clear them through a central counterparty, will also help contain systemic risk by strengthening market infrastructure across the financial system as a whole. However, the prospect of tighter regulation shifting activity outside of the banking system is nonetheless a key consideration for the Commission.
Pursuant to Annex 2 of the Interim Report on non-bank financial institutions, a key question is how the non-bank financial system and its relationship with the banking system will evolve. The Commission believes that it will only be positive to shift risk away from the banking system if the negative externalities associated with non-banks are smaller.
The Financial Stability Board9 has formed a task force that will set out potential approaches for the monitoring of, and regulatory tools to address the risks posed by, shadow banks and has published a Background Note on the issues.10 Basel III also addresses many of the regulatory loopholes which banks exploited prior to the crisis. For example, the new liquidity requirements make it much more expensive for banks to back-stop an off-balance sheet entity. In the Commission’s view, direct regulation of shadow banks and/or regulation of banks’ interactions with shadow banks could lean strongly against incentives to engage in regulatory arbitrage.
Possible Impact of the Recommendations
The reforms discussed in the Interim Report will directly affect UK-authorised banks with significant wholesale and retail activities in the UK. Bankers expect that the reforms may cost as much as £5bn in extra funding and capital costs. Ring-fencing is however a far less expensive option than a wholesale break-up, or forcing banks to separately capitalise their sprawling investment banking operations. The Commission recognises that the proposed reforms would require some potentially costly adjustments and that the exposure to increased regulation may affect attractiveness of the UK for certain operations of the directly affected banks. The Commission believes that the effect of the reforms would be positive if they succeeded in improving domestic financial stability. However, there is a risk that some banks may shift their headquarters to less regulated jurisdictions. This would not necessarily mean that leaving the UK market altogether, as UK branches of non-UK EU banks would, at least at this time, not be affected by the proposals; EU banks are able under EU banking rules to branch into the UK as a matter of right under the EU "passport".
It is difficult to assess the real impact of the Commission’s recommendations on banks and shadow banks as the Interim Report is not binding. Furthermore, there is still time for interested parties to make their views known. The Final Report will also not be binding on the Government, although, it is likely that the Government will follow the Commission’s recommendations in the Final Report, due in September 2011.
1 The Interim Report is available at http://s3-eu-west-1.amazonaws.com/htcdn/Interim-Report-110411.pdf
4 The term ‘shadow banks’ refers to non-banks that conduct banking-type activities.
5 The FSA will cease to exist in its current form, and three new regulatory bodies will be established: the Financial Policy Committee (FPC), the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). The UK Government remains committed to implementing the new architecture by the end of 2012.
6 Bail-in refers to the imposition of losses at the point of non-viability (but before insolvency) on bank liabilities that are not exposed to losses while the institution remains a viable going concern. Whether by way of write down or conversion into equity, this has the effect of recapitalising the bank. It does not however provide any new funding.
7 The institutions are due to be identified by mid-2011.
8 See Chapter 5 of the Interim Report.
9 The Financial Stability Board is made up of a number of national financial authorities and international standard setting bodies. Its aim is to co-ordinate the development of effective regulatory, supervisory and other financial sector policies.
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