Banking Reform: Ring-Fence Needs Electrification Says Commission

23 12 2012

ImageVaultHandler.aspxThe Parliamentary Commission on Banking Standards (“the Commission”) published its first report on 21 December 2012. I would like to thank Michael Jacobs of Herbert Smith for bringing it to my attention via his Linkedin comment. Moreover, I would also like to thank Professor Bainbridge for encouraging me to delve deeper into the idea that the Libor problem is best analysed through the lens of enterprise liability versus agents’ civil and criminal liability. Quite rightly, the Professor prefers the latter deterrent. Why should shareholders and other innocents pay for the inadequacies of governance in the corporate sphere? Surely, instead, the bankers and traders who fixed and manipulated Libor should be criminally punished.

Although regulators were aware of Libor being manipulated as early as 2007 ( for example in 2008, Mervyn King himself told Parliament that Libor “is in many ways the rate at which banks do not lend to each other, … it is not a rate at which anyone is actually borrowing”), no action was taken to punish wrongdoing until this year. And when something was finally done, rather than the real culprits being held accountable, massive fines were imposed. Inevitably, shareholders were punished and equity was destroyed. Not a great solution by any stretch of the imagination.

The Commission’s first report, which will be followed by a final report in the new year, observes that “public confidence in bankers and banking has been shaken to its roots” and that the “culture of culpable greed far removed from the interests of bank customers” is embedded in short-termism. For the most part, customers – the very taxpayers who have bailed out the failing banks in 2007 and 2008 – are seen as “a short-term source of revenue rather than a long-term client.” In considering the crisis in banking standards and culture and the proposed measures to tackle the crisis, the Commission set out five main areas for potential reform.

These include how (1) banks are structured (2) banks compete (3) banks run themselves (4) banks are supervised/regulated and (5) the law, including criminal and civil sanctions, applies to banks and bankers. The Commission explained that “the broader questions of standards, culture and corporate governance will be dealt with in greater detail” in the (impending) final report next year (2013).

All this comes against the backdrop of the Vickers report produced by the earlier Independent Commission on Banking (“ICB”, whose twofold task was to find ways to prevent another taxpayer bailout and to look at competition on the high street) which provided banks the opportunity to ring-fence high street operations by 2019. Under these plans (costing £7 billion) up to £2 trillion are envisaged to be protected behind a firewall which would shield high street banking from the activities of “casino” style investment banking. In respect of financial stability, the central points advanced by the ICB were:

  • The ring-fence should guard domestic retail banking services while global wholesale/investment banking should be outside. Although it was suggested that between one-sixth and a third of the £6 trillion of bank assets should be inside the ring-fence, the ICB was ambiguous about whether banking to large companies should be in or outside the ring-fence.
  • The ring-fence ought to be “high” and that the ring-fenced part of the bank, legally and operationally separate from the parent bank, should have its own board.
  • Ring-fenced banks should have a capital cushion of up to 20 per cent – comprising equity of 10 per cent with an extra amount of other capital such as bonds. The largest ring-fenced banks should have at least 17 per cent of equity and bonds and a further loss-absorbing buffer of up to 3 per cent if “the supervisor has concerns about their ability to be resolved without cost to the taxpayer”.
  • Capital could be shifted from the ring-fenced bank to the investment bank if the capital ratio of the ring-fenced bank did not fall below the 10 per cent minimum.

Critics slammed the Vickers report for allowing banks too much flexibility. The term “Libor” was footnoted in it twice, but maybe the Libor scandal was beyond the reports terms of reference. Or was it? To make up your own mind(s), please see full terms of reference here. Insofar as corporate governance is concerned, the Commission observed – see para 216 – that “the ICB was virtually silent on corporate governance in its interim report. In response to requests for its views, including from the Treasury Committee, the ICB’s final report addressed it briefly.” Sizing up this lacuna, the Commission recommended that:

222. There is likely to be a tension between the integrity of the ring-fence and the duties that directors of ring-fenced banks will owe to the parent company and through them to shareholders. This tension will be present regardless of the whether directors of the ring-fenced bank are employed elsewhere in the group. It is not possible under current company law to create a subsidiary which is entirely independent. The Commission recommends that the Government insert within FSMA [Financial Services and Markets Act 2000] a legal duty on boards of directors to preserve the integrity of the ring-fence.

223. The Commission further recommends that the Government set out, in its response to this Report, a full account of how directors would be expected to manage the relationship between such a duty and their duties to the shareholders. The Commission considers that an element of conflict between the duties may be unavoidable, and that this will constitute a permanent challenge for any structural solution which falls short of full structural separation.

Acutely aware of the problems in the banking sector, the Commission – which noted that banking crises can “come out of a clear blue sky” – also let it be known that:

78. The characteristics of financial crises and the nexus between banks, politicians and regulators together pose fundamental challenges for the design and implementation of structural separation. Any framework will need to be sufficiently robust and durable to withstand the pro-cyclical pressures in a future banking cycle. Those pressures will include the siren voices of those who contend that structural separation as implemented represents a barrier to financial innovation and growth. Politicians need to face up to the possibility that they may prefer those siren voices to the precautionary approach of regulators, particularly if, once again, it appears that banks are performing alchemy.

As one would expect, the Commission’s first report is a lengthy document and makes several recommendations. These can be summarised as:

  1. Separation that can stand the tests of time: Investigations into Libor have exposed a culture of culpable greed far removed from the interests of bank customers, corroding trust in the whole financial sector. The separation of deposit-taking from certain investment banking activities can offer benefits not just for financial stability, but also in helping to address the damage done to standards and culture in banking. The Government has proposed a ring-fence to achieve separation, but any ring-fence risks being tested and eroded over time. Pressure will come from many quarters. Any new framework will need to be sufficiently robust and durable to withstand the pressures of a future banking cycle. The precautionary approach of regulators will come under pressure from bank lobbying, possibly supported by politicians. Additional steps are essential to provide adequate incentives for the banks to comply not just with the rules of the ring-fence, but also with their spirit. In the absence of the Commission’s legislative proposals to ‘electrify’ the ring-fence, the risk that the ring-fence will eventually fail will be much higher.
  2. Electrifying the ring-fence: The Commission recommends that the ring-fence should be electrified – that banks be given a disincentive to test the limits of the ring-fence. This should take the form of two measures, set out in statute from the start, which could lead to full separation. First, if the regulator has concluded that the conduct of a banking group is such as to create a significant risk that the objectives of the ring-fence would not be met in respect of a particular bank, it should have the power (subject to a Treasury override) to require a banking group to implement full separation. Second, there should be a periodic, independent review of the effectiveness of the ring-fence across all banks, with the first such review to take place four years after implementation. Each review should be required to determine whether ring-fencing is achieving the objectives set out in legislation, and to advise whether a move to full separation across the banking sector as a whole is necessary to meet those objectives.
  3. The approach to legislating: The draft Bill [the Financial Services (Banking Reform) Bill which envisages wide ranging amendments to the Financial Services and Markets Act 2000; see also A New Approach to Financial Regulation] relies too heavily on secondary legislation, the absence of drafts of which has seriously impeded the Commission in assessing the Government’s reforms. The jury is still out on the question of how faithfully the Bill will implement the ICB recommendations. Furthermore, reliance on secondary legislation reinforces the risks to the durability of the ring-fence. It creates uncertainty for the regulators who will be charged with making the new framework operational and for the banks required to operate within it. The draft Bill proposes to leave the Government with too much scope to redefine the location of the ring-fence arbitrarily. Not only is the scrutiny provided for this inadequate, it will also provide an incentive for bank lobbying. The powers to re-define the ring-fence through secondary legislation need to be subject to more rigorous scrutiny, with changes to the location of the ring-fence to be considered by a small ad hoc joint committee of both Houses of Parliament before formal measures are brought forward.
  4. The independence of ring-fenced banks: The draft Bill does not make adequate provision to ensure the independence of ring-fenced banks from other parts of the same banking group. Several steps must be taken to reinforce that independence. The discretion granted to the regulator to set the rules on this is too great, as the regulators themselves have noted. Their mandate should be defined more clearly. The regulator should have a duty of ensuring independence for the ring-fenced bank in respect of governance, risk management, treasury management, human resourcing, capital and liquidity. An element of conflict between the duties of the directors of the ring-fenced bank to that entity and their duties to the wider group may be unavoidable, and this will constitute a permanent challenge for any structural solution which falls short of full structural separation. There should be a legal duty on directors to preserve the integrity of the ring-fence. The regulator should have the power, which the Commission expects to be exercised, to require a sibling structure between a ring-fenced and non-ring-fenced bank, with a holding company, so as to prevent a non-ring-fenced bank owning a ring-fenced bank.
  5. Limits on derivatives and the ring-fence: The sale of derivatives within the ring-fence poses a risk to the success of the ring-fence. The possible cost to customers from excluding derivatives, combined with proposed measures to mitigate this risk mean that there is a case in principle for permitting the sale of simple derivatives within the ring-fence. However, this should be subject to adequate safeguards against mis-selling. “Simple” derivatives should be defined in a way which is limited and durable. In addition to the elements of a “simple” derivative already identified by the Treasury, it is essential that the size, maturity and basis of simple products should be limited to hedging the underlying client risk. A large derivatives portfolio would still pose an unacceptable risk to the stability and resolvability of ring-fenced banks, even if it is supposedly hedged and collateralised. The Government should also impose an additional cap on the gross volume of derivative sales for ring-fenced banks in legislation.
  6. Bail-in that works: A ring-fence alone does not make banks resolvable. Without wider reforms, it is possible that a ring-fence would simply result in one too-big-to-fail bank becoming two such banks, the failure of either of which would require taxpayer support to avoid major disruption. The challenge of resolving non-ring-fenced banks also needs careful attention. Bail-in will be a crucial tool for the resolution of banks. Concerns remain about the design of a bail-in regime and whether it will provide confidence that the authorities would use their powers in the event of a crisis. Parliament will need assurance that bail-in is not a paper tiger, as will the markets. This assurance should be based on a regular report to Parliament on the development and subsequent operation of bail-in by the Bank of England.
  7. Capital and leverage: It is essential that the ring-fence should be supported by tougher capital requirements, including a leverage ratio. Determining the leverage ratio is a complex and technical decision, and one which is best made by the regulator. The Financial Policy Committee (FPC) cannot be expected to work with one hand tied behind its back. The FPC should be given the duty of setting the leverage ratio from Spring 2013. The Commission would expect the leverage ratio to be set substantially higher than the 3 per cent minimum required under Basel III.

th-44The draft Bill, highlighted at point 3 above, and the policy measures accompanying it intend broadly to give effect to ICB recommendations on structure, capital and loss absorbency. But the five exceptions to this are (a) smaller banks are proposed to be exempt from the ring-fencing requirement (b) the leverage ratio for ring-fenced banks is not proposed to be increased in line with additional capital requirements (c) ring-fenced banks are proposed to be allowed to sell derivatives as principal, subject to certain conditions (d) the overseas operations of large banks might be able to be exempted from requirements to hold additional capital and (e) ring-fenced banks are proposed to be allowed to own non-EEA assets in certain circumstances.

Next year, 2013, will be important to the Commission’s work and it will “identify steps to tackle the crisis in banking standards and culture” by turning to the issues arising from its first report. These issues include:

  • The case for prohibiting groups containing a ring-fenced bank from engaging in proprietary trading, and in particular the contribution that this could make to the changes needed to banking culture and standards.
  • How the structural changes will affect standards and culture in the long run.
  • How to assess bank suggestions that setting the necessary standards for banking in UK might lead to a flight abroad.
  • Whether the sale of derivatives inside the ring-fence has a bearing on measures to prevent future mis-selling of such products.
  • The wider issues of competition and transparency raised by the ICB.

The Commission’s Chairman Andrew Tyrie MP said that “the latest revelations of collusion, corruption and market-rigging beggar belief” and “that a great deal more needs to be done to restore standards in banking.” Welcoming the creation of the ring-fence, Tyrie explained that it was “essential that banks are restructured in a way that allows them to fail, whether inside or outside the ring-fence.” But he thought that the ring-fencing “proposals, as they stand, fall well short of what is required” because “the ring-fence will be tested and challenged by the banks.” Equally, politicians “could succumb to lobbying from banks and others, adding to pressure to put holes in the ring-fence.” So for the ring-fence to be effective “banks need to be discouraged from gaming the rules.” Thus, the Commission recommended electrification and called for legislation which contained “a reserve power for separation” which the regulator knew he could use. Tougher measures were also under consideration and the Commission was in the process of taking further evidence “on whether full separation of proprietary trading – something akin to a Volcker Rule – may be appropriate.”

As explained above, next year the Commission will investigate and report on how changes in areas such as competition, corporate governance, supervision and regulation and the civil and criminal law could improve standards and culture in banking.

The Commission’s first report is available here.


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3 01 2013
The Politicoid

If this is all too much, I wrote a piece for the layman expressing why it is so important for the taxpayer that this reform is done correctly: http://politicoid.wordpress.com/2013/01/02/its-banking-reform-stupid/

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