The final report of the Independent Commission on Banking

Transcription

1 slaughter and may The final report of the Independent Commission on Banking Some implications for private banks BRIEFING october 2011 Introduction The Final Report of the Independent Commission on Banking (ICB) published in September 2011 (the Report) sets out a number of recommendations and reforms to improve stability and competition in UK banking. A central recommendation of the Report is that certain mandated services that are essential to a retail banking operation particularly accepting deposits from individuals should be carried out by ring-fenced retail banks, which would have to be legally and operationally separate from other parts of the group or organisation of which they form part. These ring-fenced banks will not be permitted to provide certain prohibited services, such as trading book activities and transactions giving rise to exposure to financial organisations, that are typical of wholesale or investment banking. The term private bank encompasses a number of different types of organisations. In some cases, private banks do not in fact carry on traditional deposit-taking activities, but focus instead on asset management and hold cash as an incidental activity. In other cases, private banks offer a full range of banking and investment advisory and management services. In most cases private banks define themselves by reference to their customer base typically high net worth or ultra high net worth individuals or families and their related trusts. In this paper, we consider how the proposals in the Report, if implemented, might affect a private bank with a UK authorisation. At this stage the ICB s recommendations are in the form of a series of principles and do not amount to draft rules; the full impact of the reforms will therefore only begin to become apparent when the detailed rules have been proposed. It is, however, possible now to make some assessment of the potential impact of the proposed reforms. For a more detailed general commentary on the potential impact of the reforms recommended in the Report, we would refer you to our September 2011 briefing paper entitled Resolving the Dilemma of British Banking. The first ring-fence principle - mandated services Paragraph 3.13 of the Report sets out the first ring-fence principle, relating to mandated services. The principle is that: Only ring-fenced banks should be granted permission by the UK regulator to provide mandated services. The Report makes clear that the rules that would implement this principle would only apply to banks that need to seek a UK permission to conduct banking activities. They would therefore not apply to an EEA entity operating in the UK through a branch that is entitled to operate in the UK under the European passport regime, since that would not involve the UK regulator granting permission (see footnote 9, page 38 of the Report).

2 Mandated services are those banking services where: (a) even a temporary interruption to the provision of services resulting from the failure of a bank has significant economic costs; and (b) customers are not well equipped to plan for such an interruption. Mandated services currently comprise the taking of deposits from, and the provision of overdrafts to, individuals and small and medium-sized organisations. The second ring-fence principle prohibited services The prohibited services that ring-fenced banks would not be permitted to provide are described in paragraph 3.39 of the Report. These are services that meet any of the following criteria: (a) make it significantly harder and/or more costly to resolve the ring-fenced bank; (b) directly increase the exposure of the ring-fenced bank to global financial markets; (c) involve the ring-fenced bank taking risk and are not integral to the provision of payments services to customers, or the direct intermediation of funds between savers and borrowers within the non-financial sector; or (d) in any other way threaten the objectives of the ring-fence. These criteria are supplemented by a non-exhaustive list of services that are to be regarded as prohibited. These services include any service not provided to customers within the EEA; any service which results in an exposure to a non-ring-fenced bank or a non-bank financial organisation (subject to limited exceptions); any service which would result in a requirement to hold regulatory capital against market risk; the purchase or origination of derivatives or other contracts which would result in a requirement to hold regulatory capital against counterparty credit risk. It is clear that there is still some work to be done in order to identify precisely what activities will in fact be permitted and what activities will be prohibited. For example, the illustration (in figure 3.6 of the Report) of what would fall inside and outside the ring-fence indicates that structuring, arranging or executing derivatives transactions would need to be carried on outside the ring-fence, regardless of whether the transaction is carried out as principal or agent; by contrast, it is suggested in paragraph 3.43 of the Report that a ring-fenced bank could legitimately act as agent for a customer in arranging an interest rate hedge. Application to private banking customers The Report makes clear that, in deciding what are mandated services, the term individuals excludes the limited number of private banking customers for whom the two specified criteria are not met (see footnote 11, page 38 of the Report). The rationale for this exclusion is explained in paragraph 3.17 of the Report. That paragraph also gives some explanation of how the exclusion might be expected to apply in practice. The rationale for the suggested exclusion of this particular group of customers is that they are well equipped to plan for an interruption to their banking services and thus do not meet the second criterion. It is suggested that such individuals are likely to use more than one bank, should have sufficient resources to assess the safety of their bank 02 SLAUGHTER AND MAY

3 and should be able to make use of alternatives if one of their banks failed. It is also suggested that those customers should be permitted to place deposits outside the ring-fenced banks if they wish to do so, the caveat being that they should be required to certify that they understand that their deposit is being placed outside a ring-fenced bank. The Report proposes that the category of private banking customers should be narrowly defined, on the basis of customer type and awareness. Customers within this category should, at a minimum, have adequate knowledge and experience of financial matters and substantial liquid assets. It is suggested that existing regulatory definitions might provide an appropriate basis for this exemption (see footnote 16, page 40 of the Report). This is presumably a reference to the existing UK financial promotion regime relating to certified high net worth individuals and selfcertified sophisticated investors. Implications for private banks operating outside the ring-fence If, as the Report plainly contemplates, the taking of deposits from private banking customers need not fall within the ring-fence, it seems likely that the scope of this exclusion will be quite narrowly defined. It also seems likely that, if a private bank were to choose to operate outside the ring-fence, that would entail some compliance responsibilities to identify clients and possibly to monitor their status. In principle, however, a private bank needing UK authorisation should be able to operate without having to be a ring-fenced entity so long as it is suitably selective about its customers. This approach does carry some potential problems. It might be that these will be resolved when the detailed rules are available, but potential issues include: The existing definitions of high net worth or sophisticated customers do not involve any qualitative judgement on the part of the bank as to whether or not the customer in question is in fact sophisticated in financial matters. Clearly, not all high net worth customers or private banking customers are necessarily experts in finance. Conversely, some customers with relatively small deposits or incomes may be highly sophisticated. Given the need to draw clear boundaries, it would seem necessary to have an objective test as to whether an individual customer should or should not be able to deposit funds with a non-ring-fenced bank; and yet this might in turn mean that strictly speaking the criterion of the customer having adequate knowledge and experience of financial matters might not be met in all cases. The treatment of a customer who satisfies the relevant criteria at the outset but then at a later date ceases to satisfy the criteria is not clear. The Report devotes some space to dealing with the opposite problem of an SME becoming a larger company, but in that case the recommendation in the Report is that the company can choose to remain a customer of the ring-fenced bank. Where the reverse situation applies, the customer would presumably need to be directed to another bank that applies the ring-fence, but the Report is silent on the practicalities of that process. Banking groups that incorporate a ring-fenced retail bank and a private bank may have greater flexibility in this regard. The Report does not make clear whether the protection afforded by the Financial Services Compensation Scheme will be available to private banking depositors at a bank that is not ring-fenced. 03 SLAUGHTER AND MAY

4 Implications for private banks operating inside the ring-fence An alternative model might be for the private bank to become a ring-fenced bank. That would, however, entail some structural and governance changes, as the ring-fenced bank would need to operate independently of the rest of the group. Where the existing private bank has subsidiaries, those would have to be transferred so as to be held elsewhere in the group of which the private bank forms part. It would also almost certainly mean that certain services that at present are provided by a private bank would need to be provided from elsewhere in the group or by the ring-fenced bank as agent (so far as permitted by the new rules on permitted services). There are some significant uncertainties in the Report as to whether certain services that are common in the private banking world could easily be accommodated within a ring-fenced bank. In particular: The Report is silent on the question of whether investment advisory and investment management activities will be permitted within ring-fenced banks. In many private banks, deposit taking arrangements and investment management mandates interact in commercially important ways and it might be very difficult, and commercially unrealistic, to separate these two activities. It remains to be seen which way the policy debate will turn on this issue. On the one hand, investment management services that are provided to retail clients would not appear immediately to offend the principle expounded in the Report that retail banking customers ought to be insulated from the risks associated with wholesale banking and trading activities. On the other hand, investment management operations can result in significant exposures to a range of other financial counterparties such as custodians and providers of critical back- and middle-office services. While these exposures can be managed (and, in the case of custody arrangements, customer assets can be, and are, ring-fenced from the failure of the custodian in many jurisdictions), some of the associated risks cannot be eliminated. It remains to be seen whether exposures to financial counterparties associated with investment management activities, and thus the relevant activities themselves, will be prohibited within the ring-fence. The Report proposes that ring-fenced banks be prohibited from offering such products as derivatives as principal and this might prevent such banks from providing some of the more sophisticated wealth management services that are currently available on the market. There are also suggestions in the Report that the provision of derivatives as agent might fall within the category of prohibited services. The precise perimeter of this restriction is, however, currently unclear. The Report suggests that depositor preference be introduced for ring-fenced banks, meaning that depositors of such a bank would, on insolvency, have a more senior claim than other unsecured creditors of the bank. This could introduce significant complication and uncertainty where a bank has clients with both deposits and investment management arrangements. The operation of contractual set-off provisions where the bank has different relationships with a client might also need to be reviewed. Concluding thoughts We would expect that the loss of flexibility that would follow from a private bank becoming a ring-fenced bank might lead most private banks with an appropriate client base to prefer the non-ring fenced option, assuming that practical solutions can be found to deal with the issues noted above concerning customer definition and customers changing status. There could of course be some commercial disadvantages to this insofar as non-ring-fenced banks come to be perceived to be less sound than ring-fenced banks, but we would suggest that the typical private 04 SLAUGHTER AND MAY

5 banking customer would be able to distinguish between the more risky universal bank model and the innately more conservative private bank model. A further option that is likely to be available to some private banking groups will be to transfer all or part of their UK business into the UK branch of a bank that is authorised elsewhere in the EEA. As noted above, the Report acknowledges that ring-fencing arrangements may not be imposed on such banks in the UK. It should therefore be possible to combine retail and non-retail banking operations, as well as other services such as investment management, in such a UK branch. However, it would, of course, be necessary to consider other factors when deciding whether to run a private banking business from such a branch, including home state prudential regulatory arrangements, UK liquidity requirements and tax structuring concerns. If you would like to discuss the issues raised in this briefing paper, or any other financial regulatory matter, please contact one of the following or your usual Slaughter and May contact: Ruth Fox: ruth.fox@slaughterandmay.com Jan Putnis: jan.putnis@slaughterandmay.com Ben Kingsley: ben.kingsley@slaughterandmay.com Oliver Wareham: oliver.wareham@slaughterandmay.com Slaughter and May One Bunhill Row London EC1Y 8YY United Kingdom T +44 (0) Slaughter and May 2011 This material is for general information only and is not intended to provide legal advice. For further information, please speak to your usual Slaughter and May contact. oaw46.indd1011