Government White Paper on Reform of the Banking Sector 19 June 2012 1. Introduction The Government published its long awaited White Paper on Banking Reform on 14 June 2012. Please click here for a copy of the White Paper. The White Paper is intended to implement the proposals originally set out in the final report of the UK Independent Commission on Banking (the ICB ) published on 12 September 2011 (click here for our previous briefing note on the ICB s final report) and which the Government broadly affirmed in its initial response to the ICB s recommendations on 19 December 2011 (click here for our previous briefing note on the Government s response). Contents 1. Introduction... 1 2. Ring-fencing... 2 3. Capital and loss absorbency 6 4. Competition... 10 5. Consultation... 12 By way of reminder, the key recommendations set out in the original ICB report, as accepted by the Government s response in December, were: > Ringfencing - The structural separation of UK retail banking operations from investment banking activities by ensuring such UK retail banking activities are undertaken by a dedicated subsidiary in a bank group which is limited in the other activities it can undertake. This separation would be further reinforced by minimising intra-group inter-relationships and requiring independent governance and reporting requirements, compliance with regulatory requirements on capital, large exposures, liquidity and funding on a stand-along basis. > Capital and loss absorbency - Imposing additional increased capital and loss absorbency requirements, a minimum leverage ratio and insured depositor preference for ring-fenced banks and UK-headquartered banks, as well as a resolution buffer on ring-fenced banks. > Competition Various pro-competition initiatives including, removing barriers to entry, ensuring that the entity resulting 1
from the state aid divestment by Lloyds Banking Group ( LBG ) becomes a competitor with a sufficiently strong funding position, requiring greater transparency on account terms and the provision of a free and improved current account switching service (to be fully operational by September 2013). The White Paper broadly affirms the Government s original response, moves certain aspects of the debate forward, and provides further guidance on the Government s proposed methodology for implementing the ICB s recommendation. However, much detail is still lacking, and will be fleshed out by the consultation process kicked off by the White Paper (which ends on 6 September 2012). In addition, further detail will be provided by various initiatives at an EU level (as discussed below) although these will have a longer timeframe than the White Paper consultation. The Government still plans for all primary and secondary legislation and any new regulation necessary to implement the reforms to be in place by May 2015. Compliance generally will be required by 2019, although the Government indicates that certain aspects may require longer transitional and implementation periods. A more detailed analysis of the different aspects of the White Paper and how they compare to the ICB s original proposals is set out below. 2. Ring-fencing The case for ring-fencing (as proposed by the ICB) has been accepted by the Government for some time. Indeed, UK discussions on this topic have resulted in the issue being considered by the EU by an Expert Group lead by Governor Liikanen of the Bank of Finland which is due to report over the summer. It remains to be seen how any EU initiative will sit with the UK proposals. Scope of the ring-fence > Applicability The White Paper confirms that the ring-fencing requirement applies to banks which are UK-incorporated and UK-regulated. This is subject to a threshold exemption proposed at 25 billion of mandated deposits (to be defined). UK branches of non-eea firms which meet this threshold will be required to incorporate a UK-subsidiary to carry such deposit-taking activities which will then be subject to the ringfencing requirement. Passported branches of EEA banks will be unaffected by these ring-fencing proposals altogether. 2
Contrary to the ICB s proposals, building societies will not be caught, but will be subject to separate analogous legislation more appropriate for their business model, on which more is expected shortly. > Mandated service The White Paper confirms that only ringfenced entities can provide the single mandated service of taking deposits from, and providing overdrafts to, retail and SME customers. In this regard: > SMEs: The Government proposes that the definition of small and medium-sized enterprises is based on their annual turnover assessed over a given time period. The annual turnover amount has yet to be determined, though is expected to be based somewhere in the range of 6.5 million to 25.9 million (to reflect equivalent definition in the Companies Act 2006). > High net worth individuals: The Government has also clarified that high net worth individuals would not be retail customers for this purpose. It proposes that such an individual will be one who: > maintains between 250,000 and 750,000 of free and investable assets (as yet undefined) over a one-year period with a single bank; and > opts to be exempted pursuant to a process similar to those under the Market in Financial Instruments Directive (MiFID) which allow an individual to opt to be treated as a professional investor. > Consultation: The Government is consulting: > on the proposed definitions and thresholds; and > on how to transition individuals and businesses which originally qualify for either exemption, but subsequently do not, from outside the ring-fence into a ring-fenced bank. > Prohibited services - The White Paper has not finalised exactly which activities and services may be prohibited from being undertaken by a ring-fenced bank. In response to lobbying, the Government has indicated some welcome relaxations to the ICB s proposals. The White Paper is consulting on these and other key questions, as follows: 3
> General product prohibitions: Whether the following list of prohibited activities for a ring fenced bank should be modified or expanded: > origination, trading, lending or making markets in securities (including structured investment products) or derivatives (but see below); > secondary market purchases of loans and other financial instruments; > conduit financing or securitisation of assets originated outside the ring-fenced bank; and > underwriting of securities issues. > General product exemptions: Whether simple derivatives products for managing interest rate or foreign exchange rate risk and simple retail investment products can be provided to customers of a ring-fenced bank, subject to protections and limits (on which market views are also sought). > Geographic scope of business: Whether ring-fenced banks should be prevented from carrying out any banking activities through non-eea subsidiaries and branches (though recognising this should not prevent them from having counterparties, hold assets and take security over assets, outside the EEA provided this does not create a barrier to resolution). > Governing law for business: Whether all major service and credit agreements of a ring-fenced bank must be governed by the laws of an EEA Member State (except in connection with wholesale funding and liquidity requirements). > Permitted counterparties: Whether ring-fenced banks should be prevented from doing transactions with certain other financial institutions (including investment banks, funds and fund management companies, insurance companies and non-ring fenced banks) other than for the purposes of payment settlement, liquidity management or under derivatives executed for risk management. > Ancillary Services - The White Paper confirms that exemptions to prohibited activities will be included in secondary legislation to allow activities carried for the purposes of risk management, liquidity management and funding of nonprohibited services. It seeks views on the scope of the 4
proposed exemptions and safeguards to be imposed to prevent abuse of such exemptions and confirms it will not impose a wholesale funding limit for ring-fenced banks at this stage. Height of the ring-fence > Separation of ring-fenced bank The White Paper broadly reaffirms the Government s support for the ICB s recommendations for a high degree of legal, operational and economic separation between the ring-fenced bank and the rest of the group. The Government continues to consult on how this will be achieved. > Large exposures - the Government will look to the recommendations of the Basel Committee s Large Exposures Report due in December 2012 when considering how to restrict large exposures between a ring-fenced entity and the rest of the group, and, in particular, whether collateral should be ignored for the purposes of calculating any such large exposure; > Intra-group transactions - the Government is considering whether: > further restrictions on intra-group transactions are required to ensure intra-group transactions are at arm s length; > intra-group restrictions are to be taken into account in determining funding limits (on the basis there should be intra-group funding limits for a ring-fenced bank); and > it is necessary to restrict or prohibit intra-group guarantees, cross-default clauses in derivatives contracts and intra-group netting arrangements between a ring-fenced bank and affiliates outside the ring-fence. > Pensions The Government intends that, by 2025, a ringfenced entity should only be liable for the pension fund liabilities relating to its employees and should have no liability to wider group pension arrangements. This would, of course, require changes in how pension funds are currently structured and the Government is seeking views on the appropriateness of its proposed deadline. > Tax - The Government is keen to ensure that the tax liabilities of banks (arising, for instance, from joint and several liability of VAT grouping) should not undermine the resolvability of ringfenced banks. It has asked for market views on how to mitigate any such risk. 5
> Disclosure The Government has dropped the requirement for a ring-fenced bank to make disclosures as if it is separately listed on the London Stock Exchange. 3. Capital and loss absorbency > Ring-fence buffer - The Government will impose on each ringfenced bank an additional common equity tier 1 ( CET 1 ) buffer of 3 per cent of its risk weighted assets ( RWAs ). This ring-fence buffer is in addition to the Basel III minimum common equity requirements of 7% of RWAs, meaning that ring-fenced banks will need to operate with a minimum equity requirement to RWAs of up to 10%. The full 3% requirement will, however, only apply to the largest ring-fenced banks, while the smallest will have no buffer requirement. Scaling between 0% to 3% of RWAs will occur for banks in between the smallest and largest. Previously, one key area of government concern with the ringfence buffer was that it went beyond the maximum CET 1 capital requirements provided for in the Capital Requirements Regulation/Capital Requirements Directive IV ( CRR/CRD IV ), which was intended to be a maximum harmonisation regime and provide a single rule book for all banks in the European Union. The Government was of the view, when its original response to the ICB Report was published last December, that neither the Pillar II discretion nor the macro-prudential buffer requirements in CRR/CRD IV could be relied upon to justify this higher requirement. However, the inclusion in the 21 May 2012 version of CRR/CRD IV (which is currently being negotiated between the Council of the European Union and the European Parliament) of a systemic risk buffer, which permits a national regulator to impose an equity capital buffer requirement on banks authorised in its jurisdiction of up to 3% of RWAs (without prior European Commission approval), appears to have allayed this concern. The Government states that the systemic risk buffer should be the most appropriate channel for the ring-fence requirement. The White Paper confirms that the ring-fence buffer is not to be added to any surcharge that may be imposed on the bank as a global systemically important bank ( G-SIB ), and that, if a bank is part of a G-SIB or a G-SIB itself, only the higher of the two requirements apply. Both requirements are to be additional to any counter-cyclical buffer imposed on the ring-fenced bank. 6
Breach of the ring-fence buffer will lead to the same penalties as breach of the Basel III capital conservation buffer, namely restrictions on capital distributions such as dividends. > Primary loss absorbing capacity (PLAC) The ICB recommended that UK-headquartered G-SIBs with the highest G-SIB surcharge (2.5% or higher) and all ring-fenced banks with a ratio of RWAs to UK GDP of 3% or more should hold primary loss-absorbing capacity ( PLAC ) of at least 17% of RWAs. Smaller banks are permitted to hold less PLAC, and the amount required to be held is determined (based on a bank s ratio of RWAs to UK GDP) on a sliding scale to from 10.5% to 17% of RWAs. PLAC should, according to the ICB, only comprise equity, additional tier 1 capital, tier 2 capital and long-term debt subject to a statutory bail-in power (see Bail-in below). The PLAC requirement would apply to UK-headquartered G-SIBs at the level of the consolidated group, as well as to each UK entity on a solo basis. While the Government has agreed to a large extent with the ICB s recommendations on PLAC, it has put its own stamp on the proposals in certain key areas, such as the content of PLAC and the scope of the requirement: > Eligibility: First, while, in principle, PLAC should comprise equity, additional tier 1 capital, tier 2 capital and bail-in able long-term unsecured debt, the Government is of the view that: > subordinated debt currently in issuance that does not qualify as additional tier 1 or tier 2 capital should, nevertheless, be eligible to count as PLAC; and > in addition, there may be a case for allowing other unsecured long-term debt instruments to count towards PLAC, at least during a transitional period and possibly in the longer-term. > Meeting the PLAC requirement: Secondly, the Government makes clear that, if banks meet their minimum regulatory capital requirements, it will not specify how the total PLAC requirement is met. Given that large UK-headquartered G-SIB banks operating under the CRR/CRD IV regime would, in most cases, be subject to a capital requirement of between 13% and 15.5% of RWAs, they will only need between 1.5% and 4% of additional PLAC (beyond the CRR/CRD IV capital 7
and G-SIB requirements) to meet the 17% requirement. Most banks may find that they have sufficient existing subordinated or longer-term debt to meet this additional PLAC requirement. > Non-UK operations: Thirdly, the Government has clarified that the PLAC requirement will not apply to a UK G-SIB s non-uk operations unless the firm s UK activities are significant and failure of its UK operations would pose a risk to UK or EEA stability. The White Paper suggests that a UK G-SIB with less than 25 billion of deposits and which does not have a large UK presence beyond its ring-fenced bank should not be required to hold PLAC against RWAs in respect of its overseas operations. The PLAC requirement would also not apply to overseas subsidiaries that: > raise the majority of their funding locally; > manage their relationships with other subsidiaries and their parent on an arm s length basis, and > have adequate recovery and resolution plans. > Consequences of breach: Fourthly, the Government makes clear that any breach of the PLAC requirement does not cause a trigger for resolution, which a breach of the firm s minimum regulatory capital requirements does. Instead, it is likely that the sanction for breach of the PLAC requirement will be the same as breach of the capital conservation buffer, namely that it will trigger restrictions on capital distributions. > Bail-in There were two aspects to the ICB proposal on bailin: > a primary statutory bail-in power allowing resolution authorities to either write down, or convert into equity, long-term unsecured debt (where that debt is clearly identified as subject to a bail-in power); and > a supplementary secondary bail-in power that related to other unsecured liabilities. Since the publication of the ICB s report last September, the EU has been working on a resolution and recovery framework and, following a final consultation exercise which closed earlier this year, published a new directive on 30 May 2012 (the RRD ). 8
The RRD specifically includes a bail-in power (click here for our briefing note on this). The White Paper reiterates the difficult issues to be resolved relating to bail-in, for instance: > identifying relevant instruments for bail-in; > making foreign law governed instruments subject to a UK statutory bail-in power; > respecting existing creditor hierarchies on insolvency; > identifying appropriate triggers for use; and > managing the tax treatment of instruments. The relationship between the RRD and the White Paper is unclear, although the White Paper states that the Government expects the UK to implement bail-in through the transposition of the final version of the RRD. It seems that the Government considers the RRD to be work-in-progress as the White Paper appears to re-open some of the issues raised in the European Commission s own consultation (which is now closed). For example, article 38 of the draft RRD appears to set out the position that bail-in type powers shall not apply to liabilities of less than one month maturity but this is specifically raised for consultation in the White Paper (see also the different approaches on depositor preference below). The White Paper also seeks market views on whether a mandatory requirement on banks to issue a tranche of longterm debt that would be subordinated to senior unsecured liabilities in insolvency and that could be bailed in prior to senior unsecured debt would be a way of mitigating the risk bail-in is designed to address. However, it is not clear how such a tranche would sit in the existing hierarchy of subordinated debt and whether there would be any appetite for such instruments. > Depositor preference The White Paper adopts the ICB s recommendation that all deposits insured by the Financial Services Compensation Scheme (the FSCS ) rank ahead of unsecured creditors or creditors secured with floating charges. The Government now seeks views as to whether depositor preference protection should be extended to entities that are not insured by the FSCS (such as pension funds, charities and local authorities). It remains unclear how the Government s proposal to introduce depositor preference protection remains consistent with EU- 9
level developments on the RRD. Whereas the EU is likely to adopt bail-in, the RRD provides for FSCS-protected deposits to rank alongside (and not in preference to) other unsecured creditors. The depositor preference proposal also appears to reverse the statutory trend over the last 25 years or so to cut down the scope of preferential debts. Broader policy questions may also arise from allocating preferential status on an insolvency by reference to the identity and perceived social value of a claimant. The likely effect of depositor preference will be to increase borrowing costs of banks with creditors who, as a result, rank behind the preferred depositors. This, ultimately, will likely affect the public through increased loan and mortgage costs. > Leverage ratio The ICB had recommended a Tier 1 leverage ratio for larger ring-fenced banks in excess of the minimum leverage ratio of 3% set out in CRR/CRD IV. The Government has dropped this proposal. > Additional resolution buffer The ICB also proposed that an additional resolution buffer of up to an additional 3% of RWAs should be imposed on UK-headquartered G-SIBs and certain larger ring-fenced banks where a regulator has concerns as to their resolvability. This recommendation has effectively been dropped. 4. Competition The ICB s key recommendations on competition related to removing barriers to entry, the creation of a strong challenger bank through state aid divestment, improving current account switching and product transparency and introducing competition as a statutory remit of the Financial Conduct Authority ( FCA ). The Government s response to the ICB in December 2011 was broadly supportive of those recommendations and the White Paper provides further detail on how the various recommendations will be implemented. > Barriers to entry In autumn 2012, the FSA and the Bank of England will publish a review of the prudential and conduct requirements of both the Prudential Regulation Authority and the FCA, with the mandate of ensuring that these requirements do not result in a disproportionate barrier to entry or expansion. Where possible, changes will be introduced in advance of the new regulatory structure coming into force. 10
> Challenger bank The Government has engaged with the European Commission and LBG to ensure that the LBG s state aid divestment results in as strong a challenger bank as possible. The Government also notes the sale of Northern Rock plc to Virgin Money, suggesting that it established a new market player. > Current account switching The White Paper states that the Government is holding the banks to their commitment to deliver the free current account redirection service by September 2013. If the service does not deliver the expected consumer benefits, the Government will consider more radical measures such as full account number portability. > Product transparency The Office of Fair Trading will conduct another review of the personal current account market in late 2012 taking forward the ICB s recommendations on including interest foregone on bank statements and annual summaries. The FCA will review how transparency will be embedded in its regime and will publish a discussion paper in the first quarter of 2013. In addition to the existing Midata programme (making bank account usage data available to customers in electronic form), the Government refers to other transparency initiatives underway, including the appointment of an Independent Steering Group to devise simple financial products for consumers and efforts to improve price comparison tools for personal current accounts. > The FCA and competition The Financial Services Bill introduced to Parliament on 27 January 2012 has been amended to give the FCA an operational objective of promoting effective competition in the interests of consumers. > Reform of the strategy/setting functions of the payment industry - The White Paper outlines the Government s intention to reform the strategy-setting functions of the payment industry and will shortly publish a consultation document to this effect. Regardless of the outcome of any such consultation, the oversight regime for systemically important payment systems, operated by the Bank of England, will remain unchanged and the preservation of financial stability will continue to be given priority in decision-making in relation to payments networks. 11
5. Consultation The Government is seeking views on the proposals set out in the White Paper. Should banks wish to comment on these proposals, they are requested to do so by 6 September 2012. Contacts For further information please contact: Edward Chan Partner, Banking (+44) 020 7456 4320 edward.chan@linklaters.com Benedict James Partner, Banking (+44) 020 7456 4492 benedict.james@linklaters.com Oliver Edwards Partner, Banking (+44) 020 7456 4463 oliver.edwards@linklaters.com Jo Windsor Partner, Banking (+44) 020 7456 4436 jo.windsor@linklaters.com Christian Ahlborn Partner, Competition (+44) 020 7456 3570 christian.ahlborn@linklaters.com 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 2012 Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC326345. 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 www.linklaters.com and such persons are either solicitors, registered foreign lawyers or European lawyers. Please refer to www.linklaters.com/regulation 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 emailing us at marketing.database@linklaters.com. One Silk Street London EC2Y 8HQ Telephone (+44) 20 7456 2000 Facsimile (+44) 20 7456 2222 linklaters.com 12 A15161199/0.18/20 Jun 2012