On 14 June 2012, the government issued a white paper on banking reform. These proposals originated largely in the UK and are closely based on the recommendations of the Independent Commission on Banking, which reported in September 2011. Assuming they are enacted, the proposals will require UK groups that include retail banks to make major structural changes to separate out their retail banking businesses.
On 14 June 2012, the government issued a white paper on banking reform (the white paper). Unlike most of the current initiatives aimed at making banks safer which implement G20 initiatives, these proposals originated largely in the UK and are closely based on the recommendations of the Independent Commission on Banking (ICB), which reported in September 2011 (see News brief "The Vickers report: the first stop on the way to banking reform", www.practicallaw.com/4-508-4530).
Assuming they are enacted, the proposals will require UK groups that include retail banks to make major structural changes to separate out their retail banking businesses.
The proposals cover three main issues:
Establishing a retail banking ring-fence.
Increasing banks' capacity to absorb losses.
Improving competition in the banking sector.
The proposals for a retail ring-fence are a UK-specific response to the financial crisis. There are currently no equivalent proposals at EU or global level, although the EU-level Liikanen Committee is considering the issue, and a key plank of President Hollande's election campaign in France was splitting retail from investment banking.
The basic concept is that banks taking retail deposits should be protected (ring-fenced) from exposure to investment banking, and should be made easier to deal with if they should nevertheless fail. This is to be achieved by requiring that retail deposit-taking should be conducted in a separate subsidiary.
Some simple commercial banking activities are also permitted within the ring-fence. These include taking deposits from, and lending to, any customer other than a financial institution. Contrary to the ICB's recommendation, the white paper also allows a ring-fenced bank to enter into simple derivatives transactions with customers, subject to certain safeguards.
However, a ring-fenced bank is not permitted to carry on any banking activities in a non-EEA legal entity or from a non-EEA branch, to avoid the potential complications of dealing with other legal regimes on an insolvency. Generally, any activities involving market risk must also be conducted outside the ring-fence.
To ensure the effectiveness of the ring-fence, there will be restrictions on the way in which a ring-fenced bank will be able to interact with non-ring-fenced entities in its group. In broad terms, a ring-fenced bank will need to treat other group entities as if they were unconnected third parties, and regulatory limits on large credit exposures will apply accordingly. Similarly, a ring-fenced bank will not be permitted to be dependent on the rest of the group for its funding.
In line with the ICB proposals, the government recommends that large ring-fenced banks should have an additional 3% equity buffer on top of the 7% Basel III minimum capital requirement (which is being implemented throughout the EU by means of the fourth Capital Requirements Directive (CRD 4) package of reforms (www.practicallaw.com/5-507-7529)).
This ring-fence buffer will not be in addition to any global systemically-important financial institution (G-SIB) surcharge: only the higher of the two requirements will be applied. Breach of the ring-fence buffer would lead to regulatory restrictions on payment of dividends and bonuses.
The ICB also recommended that UK-headquartered G-SIBs (and non-ring-fenced banks within these groups) should have a minimum level of "primary loss absorbing capacity" (PLAC) which was defined by reference to equity, longer term debt and contingent capital or bail-in bonds. Since the ICB issued its recommendations, there has been significant international consensus within the G20 countries with a commitment to a statutory bail-in tool as part of a broader resolution regime (including the G20 endorsement of the Financial Stability Board's "Key Attributes of Effective Resolution Regimes", November 2011, (www.financialstabilityboard.org/publications/r_111104cc.pdf)).
At EU level, the concept of "bail-inable" capital is now incorporated in the European Commission's proposal for a Recovery and Resolution Directive (RRD), published on 6 June 2012 (http://ec.europa.eu/internal_market/bank/crisis_management/index_en.htm). The government expects to give the authorities this statutory bail-in power as part of UK implementation of the RRD. The EU definition of eligible liabilities (those capable of being bailed in) is wider than the original PLAC definition: it covers a broader range of a bank's unsecured liabilities with original maturity of over one month, although the normal creditor hierarchy will be respected.
The RRD requires institutions to hold a percentage (to be prescribed by the authorities on a bank-by-bank basis) of own funds and eligible liabilities, and this mechanism will be used by the UK authorities to ensure that UK-headquartered G-SIBs hold up to 17% of bail-inable capital (own funds and eligible liabilities).
Under the RRD, certain liabilities are excluded from the scope of the bail-in tool. The government is using the white paper to gain views on the application of bail-in to derivative liabilities which may cause valuation difficulties, as the RRD proposal allows some flexibility for national authorities on this issue. The government suggests that derivatives that are not centrally cleared may be more difficult to value (and thus incapable of being bailed in).
The government has agreed with the ICB's proposals that deposits eligible for protection under the Financial Services Compensation Scheme should be preferred debts. A change to the Insolvency Act 1986 will be proposed so that, from 1 January 2019, insured deposits should be made preferred debts.
Basel III and CRD 4 are also introducing a supplementary leverage 3% ratio requirement of a bank's capital compared to its gross (non-risk-weighted) assets. The white paper proposes adopting the Basel III minimum standard of 3% in order to be internationally consistent (the ICB had recommended up to 4.06% for ring-fenced banks).
The ICB noted disproportionately high prudential requirements for new and small banks relative to large banks, which could pose a potentially excessive barrier to entry or expansion. The white paper announces that the Financial Services Authority and the Bank of England are conducting a review of the approach to prudential supervision to be adopted by the successor regulators, the Prudential Regulation Authority and the Financial Conduct Authority (FCA).
The white paper states that the government will hold the banking industry to its commitment to deliver a new current account redirection service (the so-called "7 day switching service") by September 2013.
In response to the ICB's concerns about a lack of transparency, the Office of Fair Trading (OFT) has announced that it will conduct another review of the personal current account market in late 2012, following on from its 2008 market study (www.practicallaw.com/3-383-1282). The OFT will take forward the ICB's recommendations on including interest foregone on bank statements and annual summaries. As a first step, the OFT will hold a roundtable in October 2012 to gather views from stakeholders.
The white paper also announces that the FCA will undertake a fundamental review of how transparency will be embedded in the FCA regime and will publish a discussion paper in the first quarter of 2013. The FCA's review will, in particular, consider what measures could be introduced to improve the quality and quantity of the information that customers receive, helping them to make more informed choices and exert competitive pressure on firms.
The banking community has generally welcomed the changes to the ICB proposals made in the white paper as acting to restore confidence in the banking sector while not unduly burdening banks. It remains to be seen whether similar proposals in respect of ring-fencing are more widely adopted across Europe.
The government aims to introduce the necessary primary legislation by the end of this Parliament (May 2015) for implementation by 2019 in line with the original ICB timetable.
Andrew Marsh and Melanie Fitzsimons are Practice Development Lawyers at Freshfields Bruckhaus Deringer LLP.
White Paper "Banking reform: delivering stability and supporting a sustainable economy", www.hm-treasury.gov.uk/d/whitepaper_banking_reform_140512.pdf; comments are required by 6 September 2012.