Although there has been some watering down of the ICB recommendations, the core proposals on the ring-fencing of retail banks and on minimum loss absorbency requirements remain firmly in place. The Government's own estimates of the costs to the banking sector are a one-off transitional cost of £2.5 billion and annual costs of £4-7 billion. By any measure these are significant and reflect a massive and costly transformation agenda for many banks, with major implications for business models and for the viability of some lines of business.
Comments on the White Paper are due by 6 September. The Government will then introduce legislation, to be enacted by May 2015 and to be implemented by banks by 2019.
Rather than just summarise the White Paper, we highlight a number of key issues that banks should be considering, both in responding to the consultation and continuing their planning towards implementation.
Impact on banks' business models
Notwithstanding the remaining uncertainties, it is clear that the combination of ring-fencing, loss absorbency and competition proposals will have major implications for banks' business models. Banks will need to assess the commercial viability of their current business activities, in response to the wide range of issues posed by the implementation of the ICB's recommendations.
The operational costs and structural restrictions imposed by ring-fencing
- The systems and controls required to collect and monitor the data and information required to operate the ring-fence will be expensive. Collating the data and information to police the boundary as to which SMEs and wealthy individuals fall in and out of being 'mandated' depositors, and whether derivatives, intra-group transactions and transactions with other financial institutions fall the right side of the line for a ring-fenced bank to undertake, will be complex and costly.
- 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 type 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.
- 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. This could have an impact on 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 would impose restructuring and operational costs on banks that currently operate retail networks outside the EEA.
The financial costs of holding 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% 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 uninsured and unsecured creditors demand higher returns to compensate them for the prospect of being bailed-in.
- Requirements to make current account switching easier, and to provide greater disclosures to individual and SME customers, will have costs for banks.
- Although the outcomes are unclear at this stage, the proposed changes to the governance of payment systems could have far-reaching implications for the services that banks will have to provide to their customers as part of their payment and settlement systems.
- The FSA and Bank of England review of barriers to entry in the banking sector, and the FCA's emphasis on competition, could reduce profitability in some areas of business.
Considerable uncertainty remains in the detail because much is left to the regulator and the resolution authority to determine
The White Paper has made some progress in providing more detail of how ring-fencing will operate. For example:
- The legislation will mandate that the taking of deposits from individuals and SMEs can be undertaken only in a ring-fenced bank. In consequence, only ring-fenced banks will provide overdrafts to these depositors. The Government expects (but will not mandate through legislation) that the provision of credit and of payment and settlement services to these customers will also be undertaken by ring-fenced banks.
- The definition of an SME deposit should be based on annual turnover (averaged over a period to avoid the need to shift deposits into a ring-fenced bank every time turnover falls below the threshold), with the limit set between the current Companies Act thresholds for the definition of small and medium sized enterprises – so between £6.5 million and £25.9 million.
- High net worth individuals can be exempted from placing their deposits in a ring-fenced bank, but only if they have free and investable assets in a single bank (the White Paper suggests a threshold of between £250,000 and £750,000) and if individuals actively choose to place their deposits in a non-ring-fenced bank on a properly informed basis.
- Ring-fenced banks will not be allowed to deal in investments as principal. They will be restricted in dealing with other financial institutions and in undertaking investment banking type products and services except for managing their own balance sheet risks, funding and liquidity management, and for providing simple derivatives to customers.
But in other key areas the White Paper sets out some high-level principles but leaves the detail to be determined by the regulator (FSA and then PRA) and the resolution authority (Bank of England). This will helpfully reinforce the close links between ring-fencing and other aspects of resolution, but will also leave open the timing of when these details will be determined and applied, and the extent to which they will be applied to all ring-fenced banks or on a more case-by-case basis.
Height of the ring-fence – although the White Paper is specific on the governance requirements for a ring-fenced bank it does not specify in any detail what else ring-fenced banks will have to do to demonstrate their separation and independence in terms of operational infrastructure, or the basis on which ring-fenced banks could offer payment services to non-ring-fenced banks. These are key areas for the practical implementation of ring-fencing by banks.
Products and services – the regulator is left to determine what constitutes simple derivative products that a ring-fenced bank could offer to individuals and SMEs, and will presumably have to determine which structured retail deposits could be provided by a ring-fenced bank.
Intra-group transactions – the regulator is left to determine limits on intra-group funding of a ring-fenced bank, and rules to limit or prohibit other intra-group transactions such as loans, asset swaps, guarantees and netting arrangements.
Some modest easing
The White Paper has made some modest concessions to banks, including:
Minimum size – banks with less than £25 billion of deposits from individuals and SMEs will not have to ring-fence these deposits. To give an indication of the type of firm on the borderline of this threshold, Yorkshire Building Society – the second largest UK building society – reported retail deposits of £26 billion at the end of 2011 (assuming that the Government introduces the same threshold in its amendments to the Building Societies Act)¹. The White Paper states that no branch of a non-EEA bank currently exceeds this threshold. This raises an interesting challenge for banks currently just below this threshold – do they grow and become a ring-fenced bank, or stand still and avoid the resulting costs?
¹ Source: Yorkshire Building Society: Report and Accounts 2011
Hedging for customers – ring-fenced banks will be allowed to provide simple hedging products for individuals and SMEs. We await the detail on what constitutes 'simple' and what is a 'hedge' for these purposes.
Wholesale funding – the White Paper does not support the ICB recommendation for a limit on the amount of wholesale funding that a ring-fenced bank could raise, preferring to rely on the Basel 3 liquidity regime.
Non-EEA customers – ring-fenced banks can take deposits from, and lend to, non-EEA counterparties, provided this is not a barrier to resolution – which will be for the regulator and resolution authority to decide.
Non-EEA subsidiaries and branches – although the starting point is that ring-fenced banks should not have subsidiaries or branches outside the EEA, there is scope to allow this where adequate cross-border resolution agreements are in place with non-EEA jurisdictions. The White Paper makes specific reference to the Government working with the authorities in Guernsey, Jersey and the Isle of Man to put such arrangements in place.
Leverage - the White Paper proposes a minimum leverage ratio for ring-fenced banks of 3%, in line with the Basel 3 capital accord, rather than the higher minimum ratio (up to 4.06% for the largest retail banks) recommended by the ICB. This is a significant difference, allowing a ring-fenced bank to be 33 times leveraged rather than 25 times.
Loss absorbency for international groups – the White Paper adopts the ICB recommendation that ring-fenced banks and UK-headquartered global systemically important banks (G-SIBs) should hold loss absorbency up to 17% of risk weighted assets (with at least 10% in the form of equity and retained earnings). However, any internationally agreed G-SIB capital surcharge should not be additive to this buffer, and for UK-headquartered G-SIBs the 17% should not apply to risk weighted assets held by overseas operations that do not pose a risk to UK or EEA financial stability.
But also some tightening
Depositor preference – the proposal in the White Paper to give preference to insured deposits will increase the cost of uninsured and unsecured deposits that will have to bear the brunt of any bail-in that falls on creditors. Banks will also presumably be responsible for explaining the implications of depositor preference to their uninsured individual and SME depositors.
Tax – no concessions are offered for VAT groupings or allowing ring-fenced banks to use tax credits arising from trading losses elsewhere in a banking group. Non-recoverable VAT can be a significant issue.
Pensions – the White Paper proposes that ring-fenced banks should have separate pension schemes for their employees, with this separation to be achieved by 2025, which recognises the current size of structural deficits in some pension funds. We anticipate long-term debate on this issue.
Questions remain about the 'fit' with other regulatory initiatives
Although the White Paper is consistent with the recently proposed EU Recovery and Resolution Directive in wanting to apply bail-in to a wide range of a bank's liabilities, it differs in some respects. This will create some uncertainty until the Directive is finalised and the UK clarifies how it will be transposed into UK legislation and regulatory requirements. In particular, the Directive differs from the White Paper in proposing that:
- Minimum amounts of bail-in liabilities should be expressed as a percentage of total liabilities, rather than as a percentage of risk-weighted assets as in the ICB recommendation and the White Paper.
- Minimum amounts of bail-in liabilities could be any unsecured and uninsured liability with more than one month original maturity, while the White Paper proposes that the 17% loss absorbency ratio should only include long-term unsecured debt instruments in addition to capital instruments.
- Deposit Guarantee Schemes (but not insured depositors themselves) should contribute to bail-in.
- There should not be depositor preference, or a class of long-term unsecured debt instruments that would be bailed-in ahead of other senior creditors.
It remains to be seen whether the Liikanen review of bank structure makes any recommendations that are inconsistent with the White Paper.