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UK Banking Reform: The Government's Proposals

Tuesday, January 3, 2012
Sarah Jane Leake | Bloomberg LawThe Government response to the Independent Commission on Banking – HM Treasury and Department for Business, Innovation & Skills Report Cm 8252 of December 2011 The Government has recently published its response to the Vickers Report, which was published in September by the Independent Commission on Banking (ICB).1 Its response strongly endorses the ICB's recommendations, namely to ring-fence vital banking services and to increase banks' loss-absorbency, and puts forward a number of plans to fundamentally reform the structure of the country's banking system before the end of the decade. The proposals represent "the most far-reaching reform of British banking in our modern history."2 Ultimately, they seek to create a more stable banking sector that maintains Britain's reputation as one of the world's leading financial centres, without exposing the country's taxpayers to the unacceptable costs of bank failure.

Ring-fencing

The Government agrees that UK banks should be required to ring-fence their retail deposit-taking activities in a legally and operationally independent entity that would be subject to higher prudential requirements. In its view, ring-fencing will: (1) substantially improve resolvability for both ring-fenced and non-ring-fenced banks that get into trouble; (2) reduce the risk that market volatility will negatively affect the provision of critical banking services to the real economy; and, in consequence (3) curtail Government guarantees to both ring-fenced and non-ring-fenced banks and therefore reduce the risk to public finances.

— The Principles

The ICB report laid out a number of principles on which it believes the ring-fence should be based. The Government accepts all of these, which are outlined below. Location of Ring-fence First, certain vital services should only be provided by ring-fenced banks. These services, opines the Government, should include taking deposits from, and providing overdrafts to, retail consumers and small and medium sized enterprises. The Government queries whether further services (e.g., the provision of credit to such customers) should also be mandated within the ring-fence and queries how private banking services should be treated. Secondly, ring-fenced banks providing vital banking services should be prohibited from providing wholesale and investment banking services that impede resolution and/or increase the bank's exposure to volatility (e.g., purchasing derivatives or other contracts that would require capital to be held against counterparty credit market risk). This prohibition should not, however, prevent wholesale investors from holding the debt instruments of ring-fenced banks. Thirdly, ring-fenced banks should be allowed to undertake all ancillary activities considered necessary to support risk management, liquidity management, and their non-prohibited activities. One such example would be entering into a derivatives contract in order to manage risk arising from its provision of loans to clients. The Government hopes to draw inspiration from similar rules already in place for building societies and insurance and utilities companies. Height of Ring-fence A high degree of legal and operational independence should exist between the ring-fenced bank and the rest of its group in order for the ring-fence to be effective. Moreover, given the risks involved in equity participation in other financial institutions, limits on ownership and/or participation in other financial institutions that undertake prohibited activities may also be appropriate. Economic independence is equally important. The Government agrees that the ring-fenced bank should not be dependent on the continued financial health of the rest of the group for liquidity and solvency. This is to ensure that the ring-fenced and non-ring-fenced bank can be resolved separately and to limit the transfer of risk. To this end, the ring-fenced bank should meet, at a minimum, capital and liquidity requirements on an individual basis and undertake transactions with the rest of the group on a third party basis.

— De Minimus Exceptions

While the ICB is not fully persuaded that a case for de minimus exemptions to ring-fencing exists, the Government believes that such exemptions should apply, particularly for very small firms. In the Government's view, banks that are small enough to fail without Government support are resolvable and do not benefit from Government guarantees. Therefore, imposing the ring-fencing rules would be likely to have a disproportionate effect. This issue will be subject to further consultation in the spring.

Loss–absorbency

The Government similarly supports the ICB's recommendations to increase loss-absorbency. In its view, these non-structural reforms would serve to complement ring-fencing, in particular, by making banks more able to absorb losses and easier to resolve in the event of failure, and by curbing excessive risk-taking.

— Equity Requirements

Ring-fenced banks should be subject to higher equity requirements. These banks should, opines the Government, be obliged to have an additional equity ring-fence buffer, calibrated at 3 percent of its risk-weighted assets (RWAs). A lower buffer is proposed for smaller banks (and no buffer for the smallest banks).

— Leverage Ratio

While RWAs should remain the primary determinant of loss-absorbing capital, the Government agrees that this should be fused with a mandatory, minimum leverage ratio as a "backstop" for all banks. Moreover, ring-fenced banks should meet this requirement on an individual basis and not as part of a group. Although it supports the ICB's endorsement of Basel III's 3 percent minimum leverage ratio, the Government queries whether there is a case for applying a higher minimum leverage ratio to some of the country's larger banks.

— Bail-in

The common consensus among regulators and politicians alike is that, in the future, taxpayers should not be required to bail-out failing banks while investors remain protected. To ensure against this eventuality, the G-20 has endorsed the Financial Stability Board's recommendations3 that resolution authorities should be equipped with tools to bail-in unsecured and uninsured creditor claims to help absorb losses and recapitalise a bank close to collapse. The Government supports the ICB's recommendation that resolution authorities should be given a statutory bail-in power, not only to assist in the resolution of failed banks, but also to help troubled investment firms and financial holding companies (at present the UK's existing resolution regime only covers deposit-taking institutions). Conscious, however, that the issue of bail-in is currently being debated at European and global level,4 the Government will return to this issue later on this year, in light of further regulatory developments.

— Depositor Preference

While there is no internally agreed approach to depositor preference, the Government supports this principle. Supporting the ICB, the Government argues that all deposits (whether within the ring-fenced bank or not) insured by the Financial Services Compensation Scheme should rank ahead of other creditors, to the extent that those creditors are unsecured or secured just with a floating charge. However, given international disharmony on this issue, the Government considers further consultation necessary. In particular, it queries whether depositor preference should be confined to insured deposits or extended to all deposits.

— Primary Loss-absorbing Capacity

The Government agrees that systemically important banks should be required to hold a minimum amount of loss-absorbing capacity on a group-wide basis. However, if a bank can show that its non-UK operations do not pose a risk to financial stability in the UK, this requirement should not apply to those operations. A primary loss-absorbing capacity of at least 17 percent of RWAs is considered appropriate for the UK's largest banks, although this will be subject to further consultation in 2012.

Costs & Benefits

The Government estimates that these proposals, if implemented, will cost UK banks an aggregate cost of between

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