Change and consequence Examining the impact of ring-fencing on the UK banking industry

Transcription

1 Change and consequence Examining the impact of ring-fencing on the UK banking industry

2 cgi-group.co.uk/financial-services 2 Executive Summary The Banking Reform Bill which is currently going through the UK Parliament is one of the most profound pieces of financial services legislation in recent years. One key requirement is for UK banks to ring-fence their retail and small business customer lines into a separate bank, thus protecting them from the more risky investment banking business. This will have profound structural implications across technology, operations, governance, legal areas and clients. Having examined this legislation in detail we believe that the ring fencing measures contained in the secondary legislation will have unforeseen implications. The bill does not permit the ring-fenced bank to have exposures to other financial institutions except in the areas of payments and trade finance. This could lead those clients to take even basic business elsewhere and thus impact the profitability of the ring-fenced bank. Restricting the ring-fenced banks overall credit exposure to financial institutions may also have a negative impact on agency banks. The latter s exposures may be cut, making it harder for them to effect payments and potentially compelling them to join the UK payments infrastructures directly. This will result in a whole new set of challenges for the community in terms of operational complexity, cost and risk. It could also lead to some agency banks leaving the business altogether. A similar result may arise from the simple fact that ring-fenced banks and agency banks will be competing in the same client space. The former not only have to comply with the costs of ringfencing, but also have to invest in services to banks who are in fact, competitors. This may not be considered as strategically viable business for the ring-fenced banks The legislation states that the ring-fenced bank will be expected to monitor exposures on both vostro and nostro accounts in real time. The regulator needs to be aware that in the case of nostro accounts, this is currently very difficult. Banking providers vary in the quality of real time information they provide and it is very challenging for the client banks to integrate this information into their systems and produce a genuinely real time picture. Other aspects of the legislation require further clarification: The bill s requirement that ring-fenced banks should join payment systems directly unless they are forbidden to do so or the volume/value of transactions does not justify the investment, needs to be reviewed.the operational risk and cost implications for ring-fenced banks of joining payment systems, especially foreign ones, are substantial. The legislation states that ring-fenced banks can only deal in derivatives as principle where they are seeking to hedge their balance sheet risk. The regulators will need to have a clearer technical understanding of these instruments to ensure they can delineate the difference between trading for risk purposes and trading for proprietary purposes. The location of FX spot trading also needs to be defined. One of the key aims of the legislation is to reduce the impact of larger bank failures on the economy. However it is important to remember that the smaller agency banks remain a risk as well. The failure of financial institutions such as Northern Rock and Bradford & Bingley caused considerable issues in the UK. A single failure may be easily resolved, but contagion could spread resulting in multiple failures.

3 cgi-group.co.uk/financial-services 3 Our Recommendations To regulators: Consider whether exposures to financial institutions other than payments and trade finance, may be permitted or not. Consider what assistance can be given to agency banks in terms of access to central payment infrastructures. Discuss with the commercial banks the challenges around real time cash reporting. Clarify the critera for direct membership of clearing systems that is, the minimum volumes/values and whether both UK and foreign payment systems are in scope or not. Carry out a full analysis of the agency banks sector to understand key risk types and trends. To banks: Carry out full analysis of current wholesale client limits to determine impacts of proposed credit exposure limits. Determine level and quality of current real time exposure reporting from nostro bank providers. Assess ability of systems and applications to capture this information and report as per government requirements. Establish current clearing system membership globally versus use of nostro agents. Assess nostro payment volumes in each currency to determine in which countries clearing memberships may be required. Change and consequence

4 cgi-group.co.uk/financial-services 4 Introduction Earlier this year, CGI published a white paper on the Vickers report assessing the potential impact of the Government s recommendations on the operational and technology practices of UK banks as well as on wider business strategy. The world has moved on rapidly since then. One of the main recommendations of the report, account switching is now a reality. On 16th September 2013 the new current account switching service went live. In addition, the Parliamentary Commission on Banking Standards (PCBS), publishing its recommendations on improvements to the banking industry, has gone one step beyond the current concept and recommended a study on full account portability. This would allow customers to retain the same account number no matter where they banked and would fundamentally alter the current banking infrastructure. The PCBS has also addressed price transparency, another key area of the report which is recommending a formal review by the Competition and Markets Authority in this area which is scheduled for completion by Another key recommendation of the report was the ring-fencing of UK banks retail and small business customers away from the more risky investment banking business. This has been further defined in the new Banking Reform Bill, currently before the House of Lords for approval. In July 2013, HM Treasury also published secondary legislation, thus beginning the process of putting flesh on the bones of the Bill and provided the wider industry with an opportunity to comment through an open consultation process, which was completed on 9th October. This white paper takes a fresh look at the broader impacts of the current proposed legislation on the banking market in light of the recent publication of secondary legislation. In view of the fact that account switching is now live and that the review on price transparency will not be completed until 2015, this paper will focus on the implications of ring-fencing. Banking Reform Bill overview In essence the government has adopted a two pronged approach to banking reform: Firstly by translating key recommendations of the Vickers Report into law via the Banking Reform Bill. The bill addresses the principal issues of ring-fencing, loss absorbency requirements and preference of insured depositors over other creditors. It also states that banks must pay the membership fees of the central bank for joining key financial industry bodies. Secondly by setting up the PCBS to conduct an inquiry into the culture and standards of UK banking. The PCBS was set up in July 2012 primarily in response to the LIBOR scandal, to look at how trust in UK banks can be restored. Its recommendations were published in June The PCBS report was published just as the Banking Reform Bill was going through Parliament and so the Government will now need to examine the report to see how its recommendations can be incorporated into the legislation. Legislation will then have to be converted by the Prudential Regulatory Authority (PRA) and the Financial Conduct Authority (FCA) into detailed regulation. Current estimates are that the legislation will receive final approval by the end of this year and the conversion into regulation will be completed by the end of spring 2014.

5 cgi-group.co.uk/financial-services 5 Key milestones of the Banking Reform Bill Vickers Report published September 2011 June 2012 White paper response from the Government Draft Banking Reform Bill published by Parliament for consultation and reviewed by PCBS December 2012 October 2012 PCBS publishes its response Government response to PCBS pre-legislative scrutiny February 2013 June 2013 PCBS report on banking standards Draft secondary legislation published for consultation July 2013 October 2013 Consultation response period ends Primary and secondary legislation passed into law January 2014 September 2014 Converted into regulation Banks must comply with ring-fencing and loss absorbency requirements January 2019 Change and consequence

6 cgi-group.co.uk/financial-services 6 Ring-fencing The proposals in the Vickers Report on the ring fencing of UK banks have now become one of the main and publicly visible features of the Banking Reform Bill. The bill has created the concept of a ring-fenced bank where services dedicated to retail and small business customers are legally, operationally and economically separated from the rest of the group. It defines the ring-fenced bank s core activities as: 1. facilities for the accepting of deposits or other payments into an account, which is provided in the course of carrying on the core activity of accepting deposits; 2. facilities for withdrawing money or making payments from such an account; 3. overdraft facilities in connection with such an account. In terms of prohibited activities the ring-fenced bank is not permitted to deal in investments as principal, that is it is not permitted to be a market maker in securities and derivatives trading. Also, it cannot engage in commodities trading. The secondary legislation consists of four statutes or orders covering ring fenced bodies and addresses the following: the permitted core activities of the ring-fenced bank those activities which are excluded Banking Reform (Loss Absorbency Requirements) order specifying the level of capital a bank needs to survive potential losses fees and regulation for prescribed organisations which defines how banks have to contribute to fees incurred by the Bank of England for the latter s membership of international organisations such as the Financial Stability Board. This paper will address bullet points 1 and 2. A summary of the core and prohibited activities along with how this impacts the client service model is provided in the following diagram.

7 cgi-group.co.uk/financial-services 7 Ring-fenced bank Clients Consumers SME (<GBP6.5 million turnover) High net worth individuals Corporates Financial Institutions (No exposures except payments and trade finance) NBFI (No exposures except payments and trade finance) Non ring-fenced bank Clients High net worth individuals (>GBP 249,999 investable assets) Corporates (>GBP6.5 million turnover) Financial institutions NBFI Services Permitted services Deposits Overdrafts Payments Trade Finance Simple derivatives Loan Securitisations (own) Services Permitted services Complex Derivatives Commodities Trading Securities Trading Payments Trade Finance Operational subsidiary Independent company providing payment services to ring-fenced and non-ring-fenced banks Change and consequence

8 cgi-group.co.uk/financial-services 8 Key considerations Exposures of ring-fenced banks to other financial institutions The Treasury has real concerns about the exposures, which ring-fenced banks will have to other financial institutions. Outside of payments and trade finance no other form of exposure to external financial institutions will be allowed. It is imperative given the reasons for the creation of the ring-fenced bank that it is not exposed to undue financial risk, particularly where exposures relate to more exotic instruments. However the impact of these restrictions on profitability also needs careful consideration, particularly within payments and trade finance. Ring-fenced banks may well need to support the trading activity of their SME and corporate clients which means that these services could form a major part of its business portfolio. However one challenge here is that both types of business are often driven by a reciprocity model, which means that levels of incoming and outgoing business can be heavily dependent on each other. For example, Bank A in the UK seeks to win the payments business of Bank B in the USA, but the latter will expect some form of business in return. This may be similar payments business in its local currency or it may involve wider requirements such as lending facilities. A prime example of the latter is Turkey where local banks insist that any foreign bank who requires their payments or trade finance business must participate in their own securitisation deals for local corporates. Therefore if a foreign financial institution is debating where to place its payments and/or trade finance business, its decision may be heavily influenced by the level of reciprocal business from the ringfenced/non-ring-fenced bank. If the former is restricted in the types of lending it can offer, it may well lose the business to the latter. Therefore some thought should be given to the impact of the reciprocity issue on the profitability of the ring-fenced bank and whether any other exposures can be permitted, (e.g. third party securitisation or project finance deals where there is a real economy transaction).

9 cgi-group.co.uk/financial-services 9 Impact on agency banking Another related issue is the effect that restrictions on the ring-fenced bank s payments exposures to financial institutions may have on the agency banking model in the UK. The clearing banks have traditionally provided access to the payment infrastructures for both foreign as well as smaller local banks, sponsoring them for systems such as BACS and Faster Payments. As mentioned, in the new world the larger foreign financial institutions are more likely to use the non-ring-fenced banks for payment services where their credit requirements may be more easily and cost effectively met. However what about the agency banks who are the mid to low tier financial institution customers? While the bi-lateral payments exposure limit (2% of capital) may not create an issue, the aggregate exposure limit of 10% may mean that some UK banks reduce or eliminate their exposures to their agency bank customers, particularly if they are large in number. Thus the latter could find their payments being held or not made due to lack of funds. This in turn could lead to reputational damage for them or their customers. The agency banks could of course approach the non-ring-fenced banks for these services, but the nature and volume of the former s business may not be regarded as profitable by the latter. This may in turn compel agency banks to consider direct membership of the UK payment infrastructures. While this may stimulate competition in the payments market, some agency banks may be discouraged by the cost and operational complexity of joining these systems. Change and consequence

10 cgi-group.co.uk/financial-services 10 In addition these banks will be competing with the ring-fenced banks in the same business area while the latter will be providing them with payment services at the same time. That may well affect the products and tariffs from the larger players. Indeed there is also a question as to whether the larger banks will even want to service them given their growing competitive status. Again this may compel the smaller banks to join the payments schemes directly which, as mentioned earlier, will have cost and operational complexity implications. It will also have risk implications since the smaller players will have to manage settlement and liquidity against a much wider range of players. It may be advisable for the Government to consider measures that would make it easier and more economic for smaller banks to access payment systems directly. The Government may also wish to carry out an assessment of the operational, capital and liquidity risk implications for this community in terms of direct membership. The topic of risk raises an additional issue. The ring-fencing of the larger banks in the UK is designed in part to improve overall financial stability through reducing their size and making them safer to wind up in a crisis. This is re-enforced by other measures such as additional capital. However the risks associated with the smaller banks should not be forgotten. While the failure of a small bank in isolation may have limited impact, a wider failure across this market could have a potentially more serious repercussion. This was clearly seen historically with the failure of institutions such as Northern Rock and Bradford & Bingley. Therefore it is important that the Government have a clearly defined methodical risk approach to these small players. Historical risk trends in this sector should be clearly defined and if possible risk categories should be assigned to groups of banks. Real time exposure reporting The bill wishes to limit the payment exposures on both nostro and vostro accounts. Furthermore it states that banks have to monitor these exposures in real time which will be a particularly major challenge in the case of nostro accounts. Traditionally banks have relied on overnight statements from their foreign bank providers for their accounting and although intraday tools are available, integrating that kind of information into bank systems is not always easy. Even when intraday information is available, it can be hard to determine the precise timing of flows. Timings of the actual settlement of flows are not consistently captured or measured either. If the timing of final settlement is not clear, real time exposure measurement and reporting can only be approximate. Nostro account monitoring is of course key not only because banks can maintain large balances overnight with their foreign bank providers, but also because these balances could be seized by a local liquidator in the event of the failure of that provider. So it is imperative that banks can monitor their balances in real time so that they can react quickly to market developments. These banks and the regulators both need to have far more intensive discussion in this area to understand what the challenges are and how they can be resolved. It is also noticeable that all references to exposures in the legislation are to financial institutions. However banks can also incur exposures to Financial Market Infrastructures such as clearing systems, central securities depositaries and clearing houses. Banks typically have to fund obligations to these systems in real time and failure to do so can have potentially severe implications, both for the individual banks (e.g. penalties, reputational damage) and for the system as well. Therefore the Government also needs to consider whether it wishes to limit the exposures here as well or whether it will accept the market infrastructure rules.

11 cgi-group.co.uk/financial-services 11 Direct clearing membership Ring-fenced banks will be required to join all payment systems directly, according to the legislation, unless they are not eligible to join or the cost to join is disproportionate to the extent of the volume that they will put through the relevant system. Two questions arise: Does this cover all payment systems globally? The legislation uses CHAPS and BACS as examples, which would suggest a UK focus. What is the minimum number or value of transactions that a bank needs to do before direct membership becomes obligatory? The Government needs to clarify both issues. Ring-fenced banks may do a considerable number of non-gbp payments, especially if they have SMEs or corporates trading overseas. As already mentioned in connection with agency banks, direct membership of payment systems does not just have cost, but operational complexity and risk implications as well. Whenever the ring-fenced bank joins any clearing system whether abroad or in the UK, it will incur exposure to other members of that system. The more systems the ring-fenced bank needs to join, the greater the challenge of managing those exposures. All of this may well be aggravated by operating in foreign countries with distinct legal and market practices. The legislation also needs to specify alternative scenarios if volumes are too small, that is: can the ring fenced bank use local correspondents in other countries or even the non-ring-fenced bank? Change and consequence

12 cgi-group.co.uk/financial-services 12 Derivatives The proposal around derivatives may present some monitoring challenges. The instruments that can be used are those that relate to interest rates, currencies and commodities. This is further refined to forward, futures and swap contracts. Having said that, the ring-fenced bank cannot deal in investments as principal; it then goes on to set out an exception where it uses derivatives to manage its own risk. The regulators will need to give careful thought to how this will be monitored. The ring-fenced banks will also have to demonstrate via their reporting mechanisms that all trades are for risk protection and balance sheet management. Even simple derivative products have their complexities and determining whether an instrument is being traded for pure risk or for profit will not necessarily be easy. The legislation also states that the ring-fenced-bank can offer more complex derivative products, providing that it is done on an arms-length basis. There will need to be a clear agreement between the ring-fenced and non-ring-fenced bank (or indeed other third party bank) to ensure this delineation is clearly observed. Finally it is not clear where FX spot trading is going to sit in the new world. This is not a derivative product and it can be used for either customer or proprietary activities. Clear guidance on where it will sit, is needed. Non EEA subsidiaries The ruling on non EEA subsidiaries needs more clarification. The legislation states that the ring-fenced bank cannot have subsidiaries outside the EEA carrying out financial activities which would be regulated in the UK. However they can have subsidiaries such as service companies which carry out activities that are not regulated in the UK. Does that mean ring-fenced banks can continue, for example, to run IT operations in India to service their payments business? General commercial It will be interesting to observe how retail and SME customers will respond to being told that they can only hold deposits with a ring-fenced bank. For many it may make little difference, but there are others who may question the minimum threshold of 250,000 investable assets and want to understand how the figure was reached. This could become even more of an issue if the non-ring-fenced-bank offers better rates of return. The government could easily find itself being accused of effectively denying choice to certain sections of the public in the conduct of their financial affairs.

13 Change and consequence cgi-group.co.uk/financial-services 13

14 cgi-group.co.uk/financial-services 14 The legislation states that corporates and high net worth individuals will be able to self-certify that they are eligible to open accounts with non-ring-fenced banks. Banks have to follow rigorous know-your-customer procedures around account opening and there needs to be clarity whether or not they can accept the validity of these certifications without further validation. After all either group of clients could have nefarious reasons for opening a new account and no bank wishes to be subject to legal action because it failed to verify such documentation. In the case of high net worth individuals it is a moot point as to whether the entire extra administrative burden this process will generate is really necessary. Most of this group tends to use more sophisticated financial advisors such as fund managers and arguably, do not need this level of protection. A key benefit of this process from the government s perspective is a potential increase in customer churn. When customers realise that they can move to the non-ring-fenced bank, it may encourage them to review their banking arrangements in general and move out of a specific banking group altogether. Conclusion One key issue that has not been addressed in the secondary legislation so far is that of separability. The whole principle of ring-fencing is that the two sides of the group are operationally, legally and economically distinct from each other. CGI has substantial experience in managing huge operational transformations in banks and knows this will raise major questions in terms of governance, operations and architecture. For example: In practice how separate do the two sides of the fence need to be? Does it mean for example separate applications and platforms or can a shared service centre be used? How much co-operation and sharing of information will be allowed between the two sides of the fence? How will client limits be impacted? What will be the challenges around migration of data? One solution that is being seriously considered by the banks is the creation of an independent operational subsidiary to house the entire payments infrastructure. Given that this is precisely the infrastructure that needs to keep going if one part of the group falls over, how will it be funded and protected? What contingency measures will need to be put in place? What exactly will its functions be (e.g. just payments processing or wider functionality)? Banks also need to factor wider developments into their strategies, for example: How will their Recovery and Resolution plans fit into the ring-fencing scenario? What about the impacts of other measures such as the European Recovery and Resolution Plan and Dodd Frank? In the UK, the Treasury is already putting forward plans to appoint a payments regulator and change the current bank ownership model of the clearing infrastructure. How will this fit into the ring-fencing strategy? Account portability which was mentioned earlier would be another huge challenge were it to become a reality. Finally there is the other looming legislation which just seems to grow.

15 cgi-group.co.uk/financial-services 15 In a real sense the Government is pushing the UK banks towards a new landscape. One that is built on the twin peaks of financial stability and increased competition. The desired end result is a new commercial landscape, where risk is spread among a much wider group of banks, rather than being concentrated in the hands of a few key players. This should enable more efficient loss absorption in the event of a crisis. It is also a landscape where consumers can enjoy increased transparency of cost and choice between banking services. As a result the banking landscape in the UK is going to change dramatically over the next few years. The traditional concentrated business model within the current account market is almost certain to change, not only because of regulation such as ring-fencing curtailing the size of the larger banks, but also because of the growing number of new entrants. However the so-called challenger banks should not think that life will be easy. The larger banks may be reduced in size, but they have a legacy of experience and a mass of customers that will be hard to beat. Also new banks will be competing in the same business space for a limited market that is not growing rapidly and is already well served. As always it will be agility, innovation, efficiency and good old fashioned customer service that will make the difference. Plus (and this brings us back to financial stability) trust. Change and consequence

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