UK Government publishes response to the Independent Commission on Banking.

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1 UK Government publishes response to the Independent Commission on Banking. Introduction The UK Independent Commission on Banking (the ICB ) published its final report on 12 September A summary of the ICB s recommendations is set out in our previous client alert. The UK Government (the Government ) has published its response to the ICB s report on 19 December In broad terms: > Consistent with previous indications, the Government has accepted practically all of the ICB s recommendations. > Implementation of the ICB s recommendations remains an ongoing work-in-progress. The Government also acknowledges that there are a number of areas requiring further consultation and analysis. > Consequently, the Government has not sought, at this stage, to clarify many of the issues and points of detail arising from the ICB s recommendations. > As a concession to UK-headquartered globally systemically important banks ( G-SIBs ), the Government is prepared to exempt certain of their non-uk operations from the requirements to hold primary lossabsorbing capacity (or PLAC ). > The Government has pledged to implement the ICB s recommendations by In terms of legislative process, the Government is seeking to enact all necessary primary and secondary legislation by the end of the current Parliament in May > In terms of next steps, a White Paper will be published by the Government in spring 2012 in which the Government will set out, in greater detail, its thinking for implementing the ICB s recommendations. This client alert summarises the Government s response to the ICB s key recommendations, together with details of the areas in which the Government will need to carry out further consultation and review. UK Government publishes response to the Independent Commission on Banking. 1

2 Ring-fencing The Government has previously already accepted the case for UK-regulated banks to ring-fence their retail operations. In its response, the Government reemphasises its belief that deposit-taking should only be carried out by ringfenced banks and reaffirms its support for the ICB s ring-fencing proposals. The Government also sets out its approach to implementing the ring-fencing recommendations, as well as identifying the areas of further consultation and analysis. However, the Government provides little clarity on various issues (for instance, in relation to the activities which sit inside or outside the ringfence). Much of this detail may not be known until draft legislation and rules are published. Ring-fencing objectives The Government supports the ICB s recommendation that the ring-fence be designed with the following objectives in mind: > Insulating vital banking services: to insulate vital banking services on which households and SMEs depend from problems elsewhere in the financial system; > Improved resolvability: to improve the resolvability of both ringfenced and non-ring-fenced banks, by making them easier to separate and to reduce the risks of contagion from failing banks; and > Curtailing government guarantees: to curtail the use of government guarantees in order to bail out failing banks. Location of ring-fence The ring-fencing requirement applies to banks which are UK-incorporated and UK-regulated. UK branches of non-uk banks will, generally, be unaffected. The Government believes that the boundary (or location) of the ring-fence should be kept flexible and that, subject to mandated and prohibited services, banks should have latitude in determining this boundary. > Approach: The Government does not intend, in legislation, to set out detailed definitions of mandated services (which must be carried out within the ring-fence) and prohibited services (which must not be carried out inside the ring-fence). Instead, the Government will seek to establish a clear set of objectives, principles and regulatory outcomes coupled with a flexible, limited set of mandated and prohibited services. > Mandated services: The Government: > agrees that mandated services shall consist of taking deposits from, and providing overdrafts to, retail and SME customers; > does not believe there is a case for prescribing further mandated services (such as the provision of credit); and UK Government publishes response to the Independent Commission on Banking. 2

3 > will carry out further analysis on the definition of SMEs. > Private banking: The Government believes that high net worth individuals should be exempted from a mandatory requirement to sit within a ring-fenced bank, and will carry out wider analysis with a view to exclude private banking from the definition of mandated services. > Prohibited services: The Government agrees that certain services must be prohibited from being carried out inside the ring-fence (in particular, services which impede resolution and/or increase a bank s exposure to global financial markets). The Government proposes: > to consult further on the characteristics of these prohibited services; > to study further: > the characteristics of financial institutions that may be permitted to be counterparties of ring-fenced banks; and > the characteristics of products prohibited by reference to their function (e.g. derivatives or trading book assets); and > to adopt a precautionary principle in determining which services are prohibited. In other words, there will be a presumption that services are prohibited until it can be shown that ring-fencing objectives are not jeopardised. > Ancillary services: The Government accepts that certain activities (which would otherwise comprise prohibited services) can, within limits, be carried out inside a ring-fenced bank. These include activities carried for the purposes of risk management, liquidity management and funding of non-prohibited services. The Government will consult further on the limits that will apply to these ancillary services. Height of ring-fence The Government strongly endorses the ICB s conclusion that there should be a high degree of legal, operational and economic separation between the ring-fenced bank and the rest of the group. > Separability: The Government is keen to ensure that the ring-fenced bank is legally and operationally separable from the rest of the Group. Further work will be undertaken to assess: > the degree of operational separability which the Government considers to be credible and effective; and > appropriate restrictions on the ownership of other financial entities. Economic links: The Government accepts that the ring-fenced entity should not be dependent for its solvency and liquidity on the financial health of the rest of the group. In relation to intra-group exposures between the ring-fenced bank and the wider group: UK Government publishes response to the Independent Commission on Banking. 3

4 > the ring-fenced bank will be required to meet capital and liquidity requirements on a solo basis; > the ring-fenced bank will need to apply the large exposures regime for third parties to its wider group; and > the Government may impose additional specific restrictions on the amount of funding the ring-fenced bank receives from the wider group. > Tax and pensions: There are certain circumstances where the ringfenced bank may be liable for obligations of the wider group (for example, VAT and deficits on pension schemes). The Government will seek to mitigate their impact although how it will do so remains unclear. > Governance: In relation to the ring-fenced bank s governance arrangements, the Government is mindful of the need to achieve (and will consult on) the appropriate balance between, on the one hand, ensuring its independence from the rest of the group and, on the other hand, ensuring that the group s strategy is not complicated by separate board and other governance arrangements. De minimis exemptions The Government also proposes re-assessing whether there should be de minimis exemptions to the ring-fence requirement. For instance, the Government may consider: > Small banks: whether banks below a certain size should be excluded from the ring-fencing rules; > Small amount of mandated or prohibited services: whether entities that undertake a small amount of mandated or prohibited services could be excluded; or > Individual transactions: whether individual transactions could be excluded. Capital and loss absorbency The ICB s final report introduced a number of recommendations on increased capital and loss absorbency requirements for ring-fenced banks, as well as a minimum leverage ratio, insured depositor preference and higher levels of loss absorbency for UK-headquartered banks. The Government is, broadly, supportive of this package of recommendations and sees these reforms as an important complement to ring-fencing. We summarise below these proposals and whether and how the Government intends to implement them. UK Government publishes response to the Independent Commission on Banking. 4

5 Minimum equity requirement The ICB proposed the introduction of an equity ring-fence buffer above the Basel III baseline of 7% of risk-weighted assets ( RWAs ). This buffer applies to the ring-fenced bank only (and not to the wider group). The ICB has proposed that the size of the buffer be set on a linear scale from zero to 3% (depending on a bank s ratio of RWAs to UK GDP). The Government supports the introduction of this additional equity buffer. In this regard: > EU compatibility: The proposed ring-fence buffer (which may result in an aggregate equity requirement of up to 10%) may result in UK banks exceeding the levels prescribed in the Capital Requirements Regulation (the CRR which seeks to implement Basel III in throughout the EU) of 7% to 9.5% (for G-SIBs). The CRR is intended to prevent EU member states from gold-plating the Basel III capital requirements by imposing higher standards under domestic law. However, the Government intends to ensure that there is sufficient flexibility within the CRR to set higher capital requirements for UK ring-fenced banks. The Chancellor of the Exchequer, George Osborne, has noted that both Sweden and Spain are also aiming to impose higher requirements for their banks and are seeking support from the EU in this regard. > Size of buffer: Whilst the Government sees merit in the ICB s proposed methodology of setting the buffer by reference to a bank s ratio of RWAs to UK GDP, the Government is prepared to consider other methods of calibrating the size of the buffer. Primary loss absorbing capacity (PLAC) The ICB recommend that: > Quantity: UK-headquartered G-SIBs with a 2.5% G-SIB surcharge (e.g. HSBC) and all ring-fenced banks with a ratio of RWAs to UK GDP of 3% or more, should be required to hold PLAC of at least 17% (reducing, for smaller banks, on a sliding scale to 10.5%) of RWAs; > Quality: PLAC should consist of regulatory capital and long term unsecured debt that is clearly identified as being subject to a primary bail in power; and > G-SIBs: UK-headquartered G-SIBs will need to adhere to these PLAC requirements at the level of the consolidated group, thereby including all their non-uk operations, as will UK-domiciled banks on a solo basis. The Government is strongly supportive of the requirement to hold PLAC. However: UK Government publishes response to the Independent Commission on Banking. 5

6 > Appropriate level: The Government acknowledges that the level of 17% selected by the ICB requires further consultation and analysis to confirm its appropriateness. > Non-UK operations: The Government has relaxed the requirement that UK-headquartered G-SIBs must hold PLAC across their global operations. Please note that: > This exemption would apply only if it can be shown that any non- UK operations do not pose a risk to UK financial stability (and the UK taxpayer). > One way that a bank could prove this, according to the Government, is by having a group resolution plan which allowed its foreign entities or operations to be shut down without any spillover of losses to UK group entities. > If the exemption applies, the loss-absorbing capacity of those non-uk operations need not exceed any international or local standards. We expect this exemption to be of material interest to certain banks headquartered in the UK, particularly HSBC. Leverage ratio The ICB recommend that all UK-headquartered banks should maintain a Tier 1 leverage ratio of at least 3% (which corresponds to the Basel III minimum ratio). In addition, all ring-fenced banks with a RWA to GDP ratio of 1% or more should have their minimum leverage ratio increased on a sliding scale up to 4.06% (which would apply for ring-fenced banks with RWA to GDP ratio of 3% or more). While the Government accepts that the Basel III minimum leverage ratio of 3% should apply to all banks, it did not endorse the proposal for a leverage ratio of 4.06% for the larger banks. In this regard, the Government considers that: > Further analysis: further work is required to be done to analyse both whether an increase for bigger banks is actually merited and if so, whether different leverage ratios should apply to banks with different business models; and > Buffer: it may be best to impose the leverage ratio not as a hard regulatory minima, but as a buffer, with sanctions such as restrictions on dividend payments for a breach. Bail-in In relation to the ICB s bail-in recommendations: > Primary bail-in: The Government gives full backing to the ICB recommendation that resolution authorities should have a statutory UK Government publishes response to the Independent Commission on Banking. 6

7 bail-in power, allowing them to either write down or convert into equity long term unsecured debt, provided such debt is clearly identified as subject to a bail-in power. > Secondary bail-in: However, the Government is less supportive of the ICB recommendation that resolution authorities have a secondary bail-in power that relates to other unsecured liabilities, if the exercise of primary bail-in is insufficient. The Government believes a number of problematic issues would be need to be resolved first. For instance, it foresees that imposing losses on short-term funding and uncollateralised derivative exposures may actually exacerbate disruption in the financial markets at the wrong time. > European dimension: The Government makes clear that the design of the bail-in tool (as well as what types of debt it should apply to) will need to be developed consistently with the bail-in powers set out in the EU crisis management framework. Depositor preference The ICB recommended that all deposits insured by the Financial Services Compensation Scheme rank ahead of unsecured creditors or creditors secured with floating charges. Having considered the advantages and disadvantages of this proposal the Government, on balance, has come out in support of depositor preference. However, the Government believes that further analysis and consultation is needed on its scope - in particular whether depositor preference applies to all deposits or just to insured deposits. Resolution buffer The ICB recommended that, if a bank supervisor has concerns about the resolvability of a UK-headquartered G-SIBs (or any ring-fenced bank with a ratio of RWAs to GDP of 1% or more), that bank will need to hold a resolution buffer consisting of up to 3% of additional loss-absorbing capacity. The Government accepts this proposition and, in this regard, has: > Supervisory flexibility: affirmed its belief that bank supervisors should have considerable flexibility in determining when (and how) the resolution buffer is to be applied; and > RRPs: stated that the resolution buffer should not be seen as an acceptable long-term substitute for a robust recovery and resolution plan. Competition The Government s response to the competition recommendations made by the ICB can be summarised as follows: UK Government publishes response to the Independent Commission on Banking. 7

8 Challenger bank The ICB recommended the creation of a competitor in the personal current account ( PCA ) market with a sufficiently strong funding position and a market share of around 6% arising out of the Lloyds Banking Group plc ( LBG ) divestiture. The Government supports this view, and has welcomed LBG s current discussions with the Co-operative Group in relation to a possible divestiture. Barriers to entry The Government has backed the ICB s recommendation that the Prudential Regulatory Authority and the Office of Fair Trading (the OFT ) should work closely together to review the application of prudential regulation standards and ensure that capital and liquidity requirements do not act as a barrier to entry and growth of new participants. The Government has also announced its intention to consult in early 2012 on options to bring the Payments Council within the scope of financial regulation so as to ensure a level playing field for access to payment systems for all banks. Current account switching The Government strongly supports the ICB s recommendation that a free current account redirection service be established by September 2013 to improve the process of switching between providers and ensure debits, credits and security for loans are transferred effectively. If the redirection service does not deliver the expected consumer benefits, further measures will be considered, including full account portability. Product transparency The ICB had recommended that banks should provide their retail and business current account customers with greater transparency on account terms (including details of any interest foregone relative to the Bank of England base rate) by January 2013 in order to enable customers to make an informed choice between potential service providers. The Government has indicated that it will continue to consider the best ways of promoting transparency in the market, and is looking to the OFT and the Financial Conduct Authority (the FCA ) to work closely with the banks to improve transparency across all retail products. The Government also noted its steps to improve transparency, working with business and industry groups, under the Midata programme. FCA and competition The Government agrees with the ICB that effective competition is essential in delivering the right outcomes for consumers and that the FCA has a key role to play in this respect. A new statutory competition remit will provide the FCA with a clear mandate for effective action, and the Government will consider the recommendations of the Joint Committee of Parliament (established to UK Government publishes response to the Independent Commission on Banking. 8

9 conduct pre-legislative scrutiny of the draft Financial Services Bill) that this remit should be matched with new competition powers, such as market investigation reference powers (concurrently with the OFT) and a requirement to respond to supercomplaints. Referral to Competition Commission The ICB had recommended that a referral to the Competition Commission for independent investigation should be actively considered if, by 2015, the combination of an effective challenger resulting from an enhanced LBG divestment, the creation of a strong FCA and an improved switching service has not resulted in demonstrable improvements to the state of competition in the banking market. The Government is clear that the UK s competition authorities are able to scrutinise the financial services market as they see fit, and a decision on an in-depth investigation is primarily a matter for the OFT to take on its merits at the relevant time. Timetable Implementation The ICB s final report recommended that its proposals be implemented by the start of The Government intends to proceed in stages towards this deadline. In broad outline: > Options: The ICB s recommendations will require implementation in a number of ways: > primary legislation will be required to implement ring-fencing, depositor preference and the FCA s duty to promote competition; > the implementation of bail-in will depend on how the EU crisis management framework is implemented; > other changes will be dealt with through a combination of secondary legislation and regulatory rules; > it may be necessary to amend existing legislation (for instance, in relation to building societies); and > consideration will need to be given to amendments to the CRR. > European dimension: The Government will continue to work with the European Commission, the European Parliament and other EEA states with the objective of ensuring that the UK may impose additional obligations on UK-headquartered banks that will be super-equivalent to the CRR. > Legislating for the ring-fence: The Government will ensure that primary and secondary legislation related to the ring-fence will be in place by the end of this Parliament in May UK Government publishes response to the Independent Commission on Banking. 9

10 > Transition: In relation to the ring-fence, banks will be expected to comply with the necessary legislation as soon as practically possible after such legislation comes into force. The Government will consult with banks to develop a sensible transition timetable Further consultation The Government will publish a White Paper in spring 2012 which will provide detailed guidance on the Government s proposed methodology for implementing the ICB s recommendations. This will start a formal threemonth consultation period and banks will be respond to the Government on points arising from the White Paper. Following this consultation, the Government plans to introduce primary legislation into Parliament. In the meantime, the Government will welcome earlier views from, and will be engaging directly with, interested stakeholders. Accordingly, should banks wish to comment on the Government s response to the ICB, they should do so by 12 March UK Government publishes response to the Independent Commission on Banking. 10

11 Contacts For further information please contact: Edward Chan Partner (+44) Benedict James Partner (+44) Sarah Parkhouse Partner (+44) Peter Bevan Partner (+44) Christian Ahlborn Partner (+44) Authors: Edward Chan, Kirsty Gibson, Allegra Miles, Tim Castorina This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters LLP. All Rights reserved 2011 Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC It is a law firm authorised and regulated by the Solicitors Regulation Authority. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP together with a list of those non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ or on and such persons are either solicitors, registered foreign lawyers or European lawyers. Please refer to for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com. christian.ahlborn@linkalters.com One Silk Street London EC2Y 8HQ Telephone (+44) Facsimile (+44) Linklaters.com UK Government publishes response to the Independent Commission on Banking. 11 A /0.14/23 Dec 2011