The draft legislation and response document contain no significant shifts in policy, but the publication of the legislation confirms the Government's intention to implement the ring-fencing of retail banks in the UK, irrespective of whatever emerges at EU level following the Liikanen report recommendations.
Summary
The proposed draft legislation is a high level enabling Bill, which:
- Establishes the ring-fencing of core services;
- Defines deposit taking from individuals and SMEs as a core service and allows for further core services to be defined under future secondary legislation;
- Defines trading as principal as a prohibited activity for a ring-fenced bank, and allows for further prohibited activities to be defined under future secondary legislation;
- Allocates powers to the Treasury and to the regulators to define the scope and height of the ring fence, restrictions on group structure, exemptions and other important details;
- Provides for a banking business transfer scheme to make it easier for banks to transfer relevant deposits to a ring-fenced bank;
- Restates the requirement for UK ring-fenced banks and G-SIBs to hold primary loss absorbing capacity of up to 17 percent of risk weighted assets, comprising (a) a 10 percent capital ratio (using the systemic risk buffer power likely to be provided in CRD4/CRR) and (b) a further 7 percent in specific debt instruments that can be bailed-in;
- Establishes depositor preference in an insolvency;
- Gives both the PRA and the FCA a new "continuity objective"; and
- Enables the regulators to levy fees on financial services firms (not just banks) banks to pay for the Treasury's involvement in international bodies such as the Financial Stability Board.
The Government believes its ring-fencing recommendations to be compatible with the Liikanen recommendations. However, this will need to be validated once the Commission publishes their route to take Liikanen forward.
Implications for firms
Despite the remaining uncertainties, the combination of ring-fencing and loss absorbency will have major implications for banks' business models. Banks will therefore need to assess the commercial viability of their current business activities.
Higher capital and more expensive funding
- Ring-fenced banks and UK-headquartered systemically important banks will have to raise the capital and bail-in debt instruments required to meet the 17 percent loss-absorbency requirements.
- The bail-in proposals will lead to higher funding costs for banks in both their ring-fenced banks and their other banking entities, as purchasers of the relevant debt instruments demand higher returns to compensate them for the prospect of being bailed-in.
Operational costs
- The systems and controls required to collect and monitor the data and information required to operate the ring-fence will be expensive – for example, collating the data and information to determine which SMEs and wealthy individuals fall inside and outside the ring fence, and which derivatives, intra-group transactions and transactions with other financial institutions fall the right side of the line for a ring-fenced bank to undertake.
- It will be expensive to establish, operate and monitor the independence and separation of ring-fenced banks.
- Banks may find it challenging to service large corporates across multiple entities, where these corporates place deposits in, and borrow from, a ring-fenced bank but also require products and services that a ring-fenced bank is not allowed to provide.
- Some banking groups may find that their investment banking activities are exposed as being non-viable as a result of being sub-scale and expensive to operate and fund when they are separated out from a ring-fenced bank.
Structural restrictions
- Although mortgage securitisation is possible in a ring-fenced bank, the restrictions on the activities of these banks may make this more difficult and expensive, with implications for the supply of mortgage credit.
- Payment and settlement services may need to be concentrated in a ring-fenced bank, or duplicated across banking groups, because a ring-fenced bank will not be allowed to rely on the rest of a banking group for these services.
- The structural restrictions on subsidiaries and branches outside the EEA will impose restructuring and operational costs on banks that currently operate retail networks outside the EEA.
In the detail
Ring fencing
The draft legislation does not add to the earlier White Paper. The intention is to set out most of the detail in secondary legislation and regulatory requirements. So the enabling Bill goes no further than introducing the concepts of "core activities" and "excluded activities", while providing only one instance of each type of activity (accepting retail and SME deposits, and dealing in investments as a principal, respectively). Further core and excluded activities can be introduced under secondary legislation.
The Government also intends to set out in secondary legislation the circumstances in which ring-fenced banks can provide limited services to customers and manage their own risks through derivatives and other dealing in financial instruments. However, it is clear that recent cases of the mis-selling of derivative products to SMEs may leads the Government to impose tougher restrictions here – indeed, the Treasury is asking for advice on this issue from the new Parliamentary Commission on Banking Standards (which is due to report on 18 December this year).
Similarly, the draft legislation grants the Treasury the power to exclude small banks from the ring-fencing requirements (the White Paper suggested a threshold of £25 billion of deposits from individuals and SMEs); to allow deposits from large corporates to be held outside a ring-fenced bank if they wish; to allow high net worth individuals to choose whether to place their deposits in ring-fenced or non-ring-fenced banks; to restrict a ring-fenced bank's exposure to other financial institutions; and to restrict the geographical scope of a ring-fenced bank.
Meanwhile, regulatory rules will govern the "height" of the ring-fence, namely the extent to which a ring-fenced bank has to have legal, operational and economic independence from the rest of a banking group – including governance arrangements, intra-group transactions, group structure and disclosure.
Little progress appears to have been made on the tax issue of the impact of ring-fencing on VAT obligations. The Government will continue to explore a number of options suggested by respondents to the consultative White Paper.
Building societies are exempted from the draft legislation, but changes will be made to the Building Societies Act 1986 to bring it into line with the ring-fencing provisions.
Loss absorbency
As in the earlier White Paper, UK ring-fenced banks and UK-headquartered global systemically important banks (G-SIBs) will be required to hold primary loss absorbent capacity of up to 17 percent of risk weighted assets. This will comprise a minimum of 10 percent in the form of common equity tier 1 capital, with the rest in the form of subordinated debt and senior unsecured debt with at least a year to maturity which could be bailed-in under resolution powers.
The capital requirement of 10 percent would be consistent with the UK applying a 3 percent systemic risk buffer under the version of the CRD 4/CRR that has been agreed between the EU Commission and the EU Council. However, the specific focus on longer-term debt instruments to satisfy the bail-in requirements is drawn more tightly than the current proposals in the EU Recovery and Resolution Directive, which would allow a broader range of unsecured and uninsured liabilities to count towards a minimum requirement for bail-in liabilities.
Depositor preference
The draft legislation grants preference (in the event of the insolvency of a bank) to insured deposits eligible for compensation under the Financial Services Compensation Scheme. This is designed to reduce the cost to the FSCS in the event of a bank failure. However, this policy intention remains dependent on the outcome of the EU Recovery and Resolution Directive, which does not provide for such insured depositor preference.
Impact assessment
The costs to the banks of ring-fencing and depositor preference are estimated to be a one-off transitional cost of £1.5-2.5 billion and continuing costs of £2-5 billion a year. This in turn would reduce the long-run level of GDP by 0.04-0.1 percent; reduce tax receipts by £150-400 million; and reduce the value of the Government's shareholding in RBS and LBG by £2-5 billion.
There is no quantification of the benefits from greater financial stability.