Independent Commission on Banking. Investment Management Association response to Interim Report

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1 Independent Commission on Banking Investment Management Association response to Interim Report The IMA represents the investment management industry in the UK. Its members managed a total of 3.9 trillion of assets at the end of 2010 on behalf of a wide range of clients including pension funds, life insurance companies and investors in retail funds. We estimate that at the end of 2010, clients of IMA members owned approaching 40 per cent of shares listed on the London Stock Exchange. Introduction and summary In this paper we avoid repetition of the general views set out in our response to the Commission s Issues Paper in November We also avoid comment on detailed questions about levels of capital or on the retail banking market, where we claim no particular expertise. We do however put forward general comments based on the following principles: As is now widely agreed, what has for many years been a suspected implicit Government guarantee of the retail banking system has now been shown by the credit crisis to be an explicit one; Equally widely agreed, such a guarantee needs to be paid for, and should be limited to those areas where there is a clear need; It follows that a key criterion in any separation of the business is the extent to which an activity or customer does or does not benefit from the Government guarantee; The only legal guarantee is that for insured deposits. But other areas may be effectively guaranteed because for certain activities for example, money transmission on behalf of both retail and wholesale customers the economic cost of not ensuring continuity are too great. Drawing the distinction will in some cases be a difficult judgement. Many of the comments which follow are therefore from the perspective of investors in equity and debt issued by banks. It will be important that whatever structure emerges should be one that will prove potentially attractive to long term holders of both. Ring fencing Ring fencing retail deposits alone may not of itself achieve much in the absence of other structural change, since insured retail deposits are already effectively ringfenced. Nor does it address the utility nature of a wide range of other bank services. Northern Rock signalled publicly the first set of problems in the UK; but arguably the Lehman collapse has caused more difficulties in the long run. We suggest that in practice banking activities fall into three broad categories, for each of which separate capitalisation from the others can be considered:

2 Retail banking: retail deposit taking (insured), current accounts, savings accounts, consumer loans, business loans, trade finance, project finance, mortgages; Investment banking: trading on behalf of clients, market making, underwriting, risk management services, securitisation, M&A; Proprietary trading: trading for own account. In addition, there will also be business activities beyond these core banking activities which are not banking and which might be separately capitalised. This includes investment management and investment advisory business, typically wealth management. An effective ring fence would be likely to require subsidiarisation, in each case separately capitalised from the others, which would as consequence include changing certain third party rights as well. There would also have to be absolute limitations on the extent to which the different businesses can enter into cross default arrangements and this is likely to impact on the cost of capital-raising. It seems to us important that as well as restructuring for a more stable future, the Commission should aim to retain the (better structured) banking groups here in the UK long term. Otherwise, taxpayers current pain would have been to little purpose. Therefore we strongly urge that incentives, most probably tax incentives, are developed in tandem with the building up of capital within the banks. Incentives could be set for finite periods, during which time capital is being built up. By way of example only, a 5 year period during which hybrid equity could be given the same treatment as debt within the bank, but held as equity by shareholders. The quid pro quo would be that the banks would have to commit to remain domiciled during the period of the incentive and for a period of, say, 3 years after. Bank ownership Stable long term ownership for the banks will be in the interests of all. Over reliance on debt to support banks in stress (bail-in, contingency capital) would, absent other reform, drive out long term investors from investment in bank debt and could do the same for some equity holders too. It would be at odds with the utility role played by banks in many different areas of business for avowedly short term investors to hold much of a bank s capital. Asset encumbrance should be considered as well as capital. With bail-in proposals looming, some investors are already turning to better secured debt, for example regulated covered bonds. However, programmes of this kind encumber a bank s balance sheet. Historically in the UK (and still currently to an extent) banks have funded themselves substantially through unsecured debt, reflecting the quality expected of any bank in business. We all want banks to continue to deliver on that promise of quality. Reliance on debt holders in resolution will not secure continuation of that promise in the future. It has been the consequence of a combination of prudent management and effective regulation. These need to remain the watchwords.

3 Responses to interim report s specific questions 1.1. Do you agree with the general position set out in this Interim Report? Yes. The arguments we advanced in our previous paper were consistent with the ring fence option favoured by the Commission. We are therefore in broad agreement with the Commission s position. However the devil is in the detail, and in the absence of detail it is not easy to see how profound the change proposed will be in reality. We would add however that there is a wide range of views among investment mangers on many of the issues covered by the interim report, including whether the ring fence is the right approach. This submission should therefore be read in conjunction with those from IMA member firms Do you agree with the analysis set out in Chapter 2? We are in general agreement with the comments on financial stability and competition in retail banking. We were however disappointed to read that the Commission had received few representations in respect of competition in wholesale and investment banking, and share the Commission s surprise at this. In our previous submission we argued that the provision of liquidity and services to the capital markets was a further way in which the banking system supports the wider economy, in addition to the four points listed in paragraph 2.4 of the interim report. This is the mechanism by which investors are able to allocate capital and enterprises to access it. We remain of that view. We believe that the situation revealed by the Rights Issue Fees Inquiry (RIFI) report is symptomatic of a broader absence of competition in investment banking. One of our member firms has recently drawn attention publicly to IPO costs as another example. The interim report comments (paragraph 2.84) that customers appear generally content with the functioning of these markets. We are not surprised that corporate clients of investment banks have not expressed concern, as this mirrors a finding of RIFI. In any corporate M&A or financing transaction, the key priority of management for whom this may be a relatively new experience is the successful conclusion of the deal. Advisory costs are a relatively small proportion of total funding and so do not receive scrutiny. The costs are borne by shareholders, not by management, who may be heavily incentivised to deliver the deal. For that reason, investment managers tend to be more vocal about this issue than company managements. We accept that this raises broad issues, not least the global nature of investment banking, which the Commission cannot be expected to consider from scratch in the time available to it. But we would ask the Commission to conclude that there are genuine concerns which merit further scrutiny by competition authorities Do you agree with the analytical framework? Yes

4 3.1. Are there other reform initiatives, beyond those set out in Chapter 3 and Annex 5, which you consider it essential for the Commission to examine further? No 4.1. Should systemically important banks be required to hold more equity than Basel III requirements? If so, how much? The failure of systemically important institutions is, by their nature, more likely to lead to levels of disruption which in practice require Government intervention than that of others. In the UK, the contrast between the failures of RBS and Dunfermline Building Society respectively well illustrates this. The former case has had major consequences for UK taxpayers, whereas the latter was able to be dealt with under the Banking Act For this reason we think it perfectly reasonable that systemically important institutions should be required to hold more capital: the consequences of failure are greater, so the insurance premium should be higher. We do not have a view on the specific size of the additional capital requirement other than that it should be appropriate to the business undertaken, and should look through all types of balance sheet structure Should UK retail banks be required to hold more equity than Basel III requirements? If so, how much? This question raises the important point of international competitiveness. While we have no views on the correct level of regulatory capital for UK retail banks as such, we do consider that whatever emerges should not put at risk the UK s current preeminent position as an international financial centre. Therefore we believe it is important to ensure that capital is built up, and that the banks are also incentivised to remain domiciled in the UK. We comment on this also in response to other questions. It would be a perverse outcome if UK taxpayers were left with little more than existing losses to contemplate. We would not wish to strait-jacket supervisors in relation to particular cases. Decisions to require more capital or discount more heavily certain types of hybrid instrument, notwithstanding Basel III, should remain within the discretion of supervisors Do you agree that bank debt should be made more loss-absorbing using some or all of contingent capital, bail-inable debt and/or depositor preference? If so, which of these tools do you support and how should they be designed? In principle it is correct that bank debt should be capable of absorbing loss before taxpayers are called upon as indeed they would in the event of insolvency. But there are some formidable practical issues. Banks are financed by a mixture of debt and equity, which serve different purposes from an investor s perspective. Bank debt has traditionally been seen as a high quality security suitable for strategies where a high degree of matching is required, although since the crisis life company exposure has reduced significantly. Debt which is explicitly capable of absorbing loss may be a lot less suitable for such portfolios, though the associated yield premium may make such instruments more

5 attractive to managers of high yield or strategic bond portfolios. The volumes under management in the latter are however significantly less that in traditional investment grade portfolios. Contingent capital has attractions over bail-ins in that there is clarity about the circumstances in which conversion or a haircut occurs. In contrast, bail-ins may leave this at the discretion of regulators, which would create uncertainty for investors. The first challenge for co-cos would be demand from investors: the inherent uncertainties would be bound to make it a more expensive source of funding than now. The second would be the possibility that some trading strategies might seek to trigger and exploit the conversion. Bail-ins are currently under discussion in the context of the Capital Requirements Directive, which is expected to be published shortly. There is at present considerable uncertainty about what will be proposed, which makes it very difficult to draw firm conclusions about the likely impact on the market and on investor appetite. But it seems likely to result in significant change in priorities on liquidation or restructuring, for example by exempting commercial deposits from bail-in. This will in turn have an impact on investor views if senior creditors are subordinated to other senior-type creditor or if the no creditor worse off approach does not apply to some types of creditor. Their response is likely only to result in greater asset encumbrance. Depositor preference has similarities to bail-in in that it also changes creditor priorities. Insured deposits may appear in the depositor s hands as if it has a form of priority, but as the guarantee is provided from the industry at large through the FSCS and not from within the institution s own balance sheet, altering this would make very significant changes to other creditors. Many creditors are able to take security through collateral or to buy priority through purchasing covered bonds. As a result the likely returns for the remaining unsecured creditors many of whom would be suppliers and lessors would be much lower than under the current position In relation to structural reforms to promote stability, do you agree that the Commission should focus its work on a UK retail ring-fence? Yes. This may result in higher costs of equity for banks, but that would be because the more transparent structure was removing an implicit taxpayer subsidy from large parts of the business. Arguably, this would be the consequence of any reform which successfully narrowed the scope of the guarantee What are the costs and/or benefits of a UK retail ring-fence, and what approaches could be taken to analysing them (noting Annex 3)? We have nothing to add to the approach to Annex 3. We are not clear that the impact of all likely increases in funding costs has been factored in (eg the higher costs of financing non-ring-fenced activity see answer to question 4.6 below) 4.6. How should a UK retail ring-fence be designed (noting Annex 7)? The starting point should be the test described in the introduction to this note is this an activity whose cessation would cause so much economic cost and dislocation that in practice the Government would be obliged to provide support of some kind? In this context, support would be defined quite widely: it would include, for example, business where action by regulators to arrange a sale or transfer of the

6 business was considered an imperative rather than simply allowing it to go into liquidation. As such we would expect a somewhat different separation from that set out in Figure A7.1. This suggests that only retail deposits would have to be inside the ring-fence. But these arguably are already ring-fenced because they are insured (up to a maximum) by the FSCS. We were surprised at the apparently wide discretion that would be granted as to what should be included within the ring fence, since we would have expected this to be a public policy decision. At the very least discretion should presumably be subject to regulatory approval. Looking at the detail of Figure A7.1, we were unclear why it was suggested that current and savings accounts, consumer and business lending, mortgages and credit cards could be outside the ring fence, as these would seem to be quintessentially traditional banking activities which would meet the test described above. In contrast, (non-deposit) investment products and wealth management advice would not pass the test, since client assets would be separate from the bank s balance sheet and therefore not at risk in the event of a resolution. For example, Lehman s asset management business was able to survive its parent s collapse and has carried on as an independent business. The ring-fence should not be one-way. As well as protecting the retail banks from unsustainable losses in the investment bank, it should equally protect the investment banking operation from losses in the retail bank. The intention is to make the businesses more readily separable in a resolution. This is likely to require the institution to hold more capital that in a universal banking structure. If a ring-fence were introduced, it is likely the market would look to the underlying entities, rather than the group holding company, to make debt issuance. This would almost certainly result in a significant increase in funding costs outside the ring fence, while the ring fenced part of the business would be financed largely through deposits. The impact of this should be factored into the Commission s cost-benefit assessment. We would make one further suggestion. The Commission might consider whether banks should be provided with incentives to form the ring fence, as well as simply imposing regulatory obligations. It might, for example, make sense to hold equity within the ring-fenced entity, at least for a period to ease the transition to the new structure. Tax incentives provide powerful incentives to promote behaviour and can arguable be more effective than regulatory oversight. A tax incentive might help as well with any perceived problems for competitiveness (see question 4.8) 4.7. Should the Commission pursue any other structural reforms to promote stability? All the activities listed in Figure A7.1 are client-facing, save for proprietary trading. We think there is a strong case for separation of proprietary trading from trading on behalf of clients and, in particular, market making. In addition we think it is important for infrastructure to be designed in such a way as to facilitate continuity of services such as payment systems and even ATMs in the event of a resolution or other crisis

7 4.8. Do you agree with the Commission s assessment of the impact on the competitiveness of the City and the UK economy of the reforms it is considering? Can you provide further data and analysis in this area? We agree with the logic of the arguments here, but perception is a very important factor. If a perception were created that the UK is no longer as friendly a domicile for capital markets business as it was, that can be very damaging and very difficult to overturn. It is partly for that reason that we suggest ways should be explored of using carrot as well as stick to implement change (see answer to question 4.6) 4.9. Do you agree with the Commission s intention to consider a package of measures, and do you think that some elements could be relaxed if others were strengthened? Yes. There would need to be a thorough debate and assessment of any unintended consequences before change is implemented Over what timeframe should any reforms be implemented? It will be important to stay in step with international developments both at the global and the EU level Do you agree with the three broad measures proposed in this chapter (structural change, improvements to switching and barriers to entry, and pro-competitive financial regulation)? 5.2. Should the Commission pursue any other measures to promote competition? As indicated above in response to question 2.1, we think more needs to be done in relation to competition in investment banking What factors make smaller banks more likely to exert competitive pressure on larger incumbents? 5.4. Where are the limitations on customers abilities to understand banking costs, compare different accounts, and switch between them? 5.5. What costs might an improved switching process impose on banks and direct debit originators? 5.6. How could the costs of meeting prudential requirements be mitigated for small banks and new entrants, while ensuring safe practices in all banks? 5.7. How could small banks ability to offer a national network of cash handling services be improved? We have no views on these questions How should the Financial Conduct Authority discharge its duty to promote competition? The IMA has two main areas of interest. The first is the retail investment market, where we will be pressing the FCA to ensure a level playing field in the distribution of

8 all types of investment product, whether mutual fund, life bond, structured deposit or structured product. The second area is in the wholesale markets, where the duty to promote competition should not be pursued blindly, for example when it comes to market infrastructure. As one illustration, the equity market provisions in the first MiFID directive were intended to increase competition in order to improve market quality, but in practice resulted in reduced post-trade transparency with no reduction in dealing costs. We endorse the report s comment in paragraph 5.30 about trading on behalf of clients and own account hence our comment in response to question 4.7. Investment Management Association July 2011

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