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UK Government White Paper on ICB reforms

The UK Government published yesterday (14 June) a White Paper Banking reform: Delivering stability and supporting a sustainable economy on its plans to take forward the Independent Commission on Banking (ICB) recommendations on reforms to the banking sector. 

Two years have passed since the Chancellor of the Exchequer, George Osborne, announced the creation of the ICB in his Mansion House speech on 16 June 2010. The ICB, chaired by Sir John Vickers, was given the mandate to consider structural and related non-structural reforms to the UK banking sector to promote financial stability and competition. Given the wide-reaching and complex nature of the reforms, significant progress has been made, even though much of the detail has yet to be settled. The White Paper follows a December 2011 Government Response to the ICB Final Report, published in September 2011, which broadly supported the ICB recommendations, notably to build a ‘ring-fence’ around retail banking. It committed to completing the necessary legislation to give effect to the ring-fence by May 2015, with full implementation by the beginning of 2019. While the Government has confirmed its intention to continue along this timeframe, there is no longer any reference to banks being expected to be compliant with the ring-fence ‘as soon as practically possible’ following legislation.

The Government response last year, while confirming the direction of travel the reforms would take, left many questions unanswered. Some of these have certainly been addressed, albeit at a high level, but the White Paper contains an additional 49 questions which are open for consultation. This means that clarity over much of the detail remains elusive.

The answers or directions that the White Paper does provide tend to reduce the impact on banks of the ICB’s recommendation. For example, the leverage ratio will be set at a flat 3% rather than increased on a sliding scale as suggested by the ICB.  There is now a de minimis threshold which exempts banks from ring-fencing requirements, unless they have at least £25 bn of mandated deposits.  A separate limit on wholesale funding for ring-fenced banks has also not been taken forward. On the other hand, some of the governance arrangements seem somewhat tighter than originally proposed by the ICB. The title of the White Paper recognises the twin needs of balancing stability and supporting a sustainable economy. This suggests a subtle shift in focus from the original financial stability and competition remit of the ICB, which may reflect the current precarious conditions in the Eurozone and the implications for the UK economy. In this light, any departure from the ICB’s original position may be seen as a pragmatic response by the Government. However, Sir John Vickers has said when he launched the ICB’s report that to “pick-and-mix” from his package of ICB proposals would be a grave mistake.

The White Paper contains some “news”. As was widely trailed in the press before publication of the White Paper, the Government has stated that a ring-fenced bank may be permitted to provide simple derivatives products to its customers, subject to a number of conditions. As part of establishing the operational links the ring-fenced bank can have with the rest of the group, the treatment of pensions has been clarified, but in a way that requires the separation of the pension fund for employees of the ring-fenced bank from those of other group entities. In addition, the Government proposes to amend the Financial Services and Markets Act 2000 to enable the FCA and the PRA to levy the industry for the costs incurred by HM Treasury in carrying out its representational responsibilities with international bodies such as the FSB, BCBS and IAIS. Although the additional costs to industry are likely to be relatively small, this would set an interesting precedent considering government departments are generally funded through public spending.

This year has also seen important developments at the EU-level that are related to the ICB recommendations. Negotiations on the Capital Requirements Regulation (CRR), which will raise the level and quality of capital banks are required to hold, are advancing. The UK is confident that the Council Presidency CRR text as currently drafted would allow it to implement the ICB recommendations in full. Last week’s European Commission proposal for a Recovery and Resolution Directive (RRD) contains provisions relating to the bail-in of liabilities in resolution, and the White Paper indicates that the UK expects to implement bail in through the transposition of this Directive. In addition, in January 2012 the European Commission set up a High-Level Expert Group (HLEG) on structural aspects of the EU banking sector, tasked with assessing the case for any ‘Vickers’ or ‘Volcker’ inspired structural EU-wide measures. The HLEG is due to report back on findings in the autumn.

The remainder of this briefing note sets out some of the key provisions in the White Paper and their implications for banks.

Timelines and details

In December last year the Government announced its intention to proceed with the implementation of ICB proposals in stages, with all recommendations fully implemented by the beginning of 2019. The Government also intended to have primary and secondary legislation related to the ring-fence completed ‘by the end of this Parliament in May 2015’. More importantly for banks, they were told that they will be ‘expected to be compliant [with the ring-fence] as soon as practically possible thereafter’. The White Paper, while broadly consistent with the above dates, seems to provide some more flexibility in the deadline to implement the ring fence. The Government no longer singles out a separate, more ambitious deadline for implementation of the ring-fence, instead saying that all legislation should be completed by May 2015 and all measures should be complied with by 2019. This should provide some relief for banks.

Although the White Paper confirms the overall direction of the Government’s intentions, the detail on the policy options, in particular related to ring-fencing, remains elusive. The draft primary legislation is to follow in the autumn, but the Government has made it plain that it is likely to be high-level (e.g. defining the objective of ring-fence and its main elements) and provide for powers for the detailed policy to be implemented in secondary legislation and/or rules to be determined by the future Prudential Regulation Authority (PRA). Consequently, banks will have to wait for the details required to start thinking through the complex, inter-linked design choices which they will have to make. The operational complexities associated with the implementation of ICB recommendations, in particular ring-fencing, are likely to be enormous and are certainly unprecedented on the scale envisaged. It is thus vital that the Government and the regulator on one hand and the banks on the other have the time to work through the all important detail. Although the White Paper on the whole did not provide much (new) detail, the Government did make an attempt to, at a minimum, respond to the outstanding policy questions raised in its December paper.

Retail ring-fence

In terms of the general approach to ring-fencing regulation, the Government announced in the White Paper that in primary legislation it only plans to define i) objectives; ii) main elements; iii) technical matters for which the regulator will need to make rules; and iv) powers to make further provisions in secondary legislation. The White Paper suggests that the only activity that should initially be ‘mandated’ (i.e. only provided from within ring-fenced banks) is accepting deposits. Secondary legislation will further be used to ensure that this is only limited to deposits from individuals and SMEs. Further detail is provided relating to definitions of SMEs and high net worth individuals (HNWIs) for the purpose of including them in scope of ring-fence. In both cases, a quantitative limit/threshold of a sort is proposed (annual turnover for SMEs and ‘free and investable assets’ for HNWIs).

In relation to ‘prohibited’ services (i.e. those that ring-fenced banks are not allowed to provide) the White Paper states that one of those – dealing in investments as principal (other than for liquidity purposes) – will be defined in primary legislation. The Government will take the power to define additional ones in secondary legislation. In terms of geographical restrictions, a ring-fenced bank should not carry out any activities through non-EEA subsidiaries or branches, although the Government acknowledged that it is working on a possible exception for those located in Guernsey, Jersey and the Isle of Man with the relevant regulators. The Government will also take a power to prohibit ring-fenced banks from entering into certain transactions with certain financial institutions – both of which are defined – with some exceptions.

The Government’s decision to allow ring-fenced banks to provide ‘simple’ derivatives products to its customers, albeit only if certain conditions are met, is a major new development. The Government will set out in secondary legislation conditions under which ring-fenced banks may deal in investments as principal, and an initial attempt to define potential conditions is made in the White Paper. The issue of defining exactly what will be allowed and what will not be is likely to be a major source of contention. The concern is that, in order to prevent ring-fenced banks from ‘exploiting’ the rule, the Government and the PRA will descend into laborious and detailed rule-making along the lines of what is happening in the US with the Volcker Rule, where consultation on what constitutes ‘permitted proprietary trading ran into hundreds of pages. In addition to the significant ‘concession’ on simple derivatives, also important is the Government’s decision not to introduce a separate limit on wholesale funding for ring-fenced banks. This move is likely to be welcomed by the banks’ Treasury functions, which no longer face the threat of having to adhere to an across-the-board limit on the diversity of a ring-fenced bank’s funding base.   

Little new is said on the topic of legal, operational and economic separation, with the Government stating that the detail will be set out in regulatory rules and generally appearing quite open to firms’ own interpretation of, for example, how they organise their operational structures to ‘prove’ operational independence. One notable exception to this is the treatment of pensions. The Government is clear that it wants the ring-fenced bank and other group entities to have separate pension funds. Banks are likely to have until 2025 to achieve full separation of their pension schemes. Given the inherent problems (i.e. deficits) with pension schemes, banks will need to press on with tackling this complex and multi-layered task. In addition, some further clarity was also provided on the scope of application, with the Government confirming that there will be a de minimis exemption from ring-fencing requirements, with the threshold set at £25bn of mandated deposits. The same exemption threshold will also apply to branches of non-EEA headquartered firms, and if breached will require the firm in question to incorporate a subsidiary in the UK. However, at the moment no branches are believed to be close to the threshold.


The ICB recommended that resolution authorities should have a ‘primary’ bail-in power, allowing them to write down or convert to equity long-term unsecured debt in resolution to improve financial stability and the resolvability of institutions in trouble. Where the ‘primary’ bail-in power is not sufficient to resolve the entity, they should also have a ‘secondary’ bail-in power allowing bail-in, in theory, of all other unsecured liabilities. While the Government broadly supported these recommendations, they have now been superseded by last week’s RRD proposals which included substantial bail-in provisions. As confirmed in the White Paper, the Government expects ‘to implement bail-in through the transposition of this Directive’. While we discussed the Commission’s proposals in detail in Deloitte’s European Requirements on Recovery and Resolution briefing, there are some additional points worth highlighting.

The RRD proposed a resolution hierarchy, intended to complement and, where necessary, supersede national insolvency law; following Common Equity Tier 1, Additional Tier 1 and Tier 2 instruments, subordinated debt should be bailed-in ahead of all other eligible liabilities with losses allocated equally between liabilities of the same rank. While introducing legislative ‘primary’ and ‘secondary’ bail-in powers for certain liabilities, as recommended by the ICB, would be inconsistent with the RRD proposal, the Government has proposed an alternative: to require banks to make explicit in the terms of at least some long-term unsecured bonds that they would be subordinate to senior unsecured liabilities in insolvency. This would mean that they would be bailed-in ahead of senior unsecured debt and all other equally ranked liabilities. The aim is to maintain the principle of the ‘primary’ bail-in power, without necessitating legislation.

In terms of minimum bail-in requirements, the RRD proposals allow some flexibility for the UK, albeit within a framework to be specified by the Commission in Delegated Acts. The White Paper states that banks’ Primary Loss Absorbing Capacity (PLAC) should contain long-term unsecured debt that is subject to bail-in, with the possibility of requiring, subject to further discussion, that this should be made up of the long-term unsecured bonds that specify subordination in insolvency in their terms, as discussed above. The Government recognises the potential uncertainty of the tax treatment of debt instruments qualifying as PLAC and intends to look into this and legislate, where necessary. Except for a view that there should be a ‘transitional period’ for bail-in, there is limited detail on how this should be achieved. The important question of ‘grandfathering’ of liabilities is not discussed in any depth. The Government acknowledges that the transition to bail-in should be considered in light of international and EU developments.

Depositor preference

Following further consultation on scope, and in line with the ICB’s recommendation, the White Paper confirms the Government’s intention to introduce ‘depositor preference’ for deposits insured by the Financial Services Compensation Scheme (FSCS) up to the insurance limit. This means that in the event of bank failure FSCS-insured depositors would be paid out ahead of other unsecured creditors.

Depositor preference is not a new idea, but one which exists in other countries today, notably in the US. The Government’s intention behind this is broadly to: (i) reduce potential compensation pay-outs by the FSCS following bank failure (and by the Government/taxpayer acting as back-stop); and (ii) promote financial stability through reducing contagion risks associated with the industry funding of the FSCS and incentivising those creditors lower down in the queue to exert market discipline on banks. However, this is by no means a straightforward issue and one which has potentially significant consequences for the price and availability of bank funding as investors who perceive themselves as being disadvantaged by depositor preference see their risks increase. With the vast majority of FSCS insured deposits likely to be mandated within the ring-fence, there are also likely to be different funding implications on either side of the ring-fence.

While the Government is pressing ahead with this proposal, significant uncertainty remains. First, the Government has still not made a final decision on scope and is seeking views on expanding it in two areas: (i) preferring deposits up to the equivalent FSCS deposit insurance limit held in non-EEA branches of UK-incorporated entities, in light of possible concerns regarding cross-border resolvability; and (ii) preferring other deposits such as those placed by charities and/or local authorities to reduce risks to socially valuable liabilities or public funds.

Second, the Government notes that the introduction of depositor preference is ‘subject to the outcome of the RRD negotiations’. While the RRD specifically proposes to exempt insured deposits from bail-in, the Deposit Guarantee Scheme (DGS) (the FSCS in the UK) would be liable, up to the amount of insured deposits, for the amount of losses it would have had to bear had the institution been wound up under normal insolvency proceedings, provided that the resolution authority’s action ensures that depositors continue having access to their deposits. In insolvency DGSs would be required to rank pari passu with unsecured non-preferred creditors. As acknowledged by the Government, ‘the current RRD proposal would curtail the benefits’ of depositor preference. Therefore, it seems we are still a long way from any degree of certainty on this issue.

Loss absorbency and wider international considerations

The White Paper confirms that UK-headquartered G-SIBs and ring-fenced banks should be required to hold a level of PLAC, with a 17% requirement for the largest institutions. The Government recognises that the EU’s RRD proposal includes a requirement to maintain a minimum amount of eligible liabilities and that this broadly resembles PLAC. Thus, the Government stated its intention to deliver a PLAC-type requirement through the RRD. However, one of the challenges that the UK may encounter is its ability to apply the 17% PLAC requirement uniformly to all of the largest ring-fenced banks and UK-headquartered G-SIBs. RRD currently envisages some sort of tailoring of the minimum amount of liabilities that could be subject to bail-in powers based on a bank’s risk profile and composition of funding. The Government is also confident that another of the ICB’s loss-absorbency proposals – the ring-fence buffer of up to a maximum 3% – will be permissible under the EU Capital Requirements proposal. The current Council draft of the Capital Requirements Directive IV (CRD IV), agreed last month by EU Finance Ministers, includes a ‘systemic risk buffer’ provision, which should be the appropriate channel for imposing the ring-fence buffer. This and other provisions in CRD IV are however still subject to approval by the European Parliament and the Commission.

In terms of notable new developments, the White Paper states that it will not adopt the ICB’s recommendation to increase the minimum leverage ratio of 3% – as per Basel III – for the largest ring-fenced banks. However, banks should note that the Financial Policy Committee (FPC) – the UK’s macro-prudential supervisor – recommended that varying the leverage ratio should be one of macro-prudential tools available to the supervisor. In addition, the Government has decided that the additional 3% of PLAC (on top of 17%), where the supervisor is concerned about a bank’s resolvability, should be considered as part of bank’s Pillar 2 capital requirements. Finally, in the December response the Government indicated it was open to the idea of an exemption from PLAC requirements for global operations of UK-headquartered G-SIBs, provided it could be shown that ‘any non-UK operations do not pose a risk to UK financial stability’. The White Paper endorses this exemption. Interestingly, whereas in the December response the ‘burden of proof’ was on banks (to demonstrate, via a resolution plan, that foreign operations are not a risk), it is now more a case of overseas operations being ‘innocent until proven guilty’. Specifically, the White Paper now states that before overseas operations will have to meet additional PLAC requirements, certain conditions will need to be in place. This puts banks with extensive overseas operations in a relatively stronger position than before.

Payments industry

In its December response, the Government set out its intention to consult ‘early in 2012’ on options for reform of the Payments Council. The White Paper confirms that it is still the Government’s intention to consult ‘shortly’ on how best to reform strategy setting within the payments industry, with the aim of ensuring the system operates for the benefit of all users and including consumers and promotes open access for all participants. It identifies three options for reform: (i) build on the present self-regulatory system by bringing improvements to the composition of the Board to promote independence and consumer representation; (ii) create a new public body, the Payments Strategy Board, to set strategy across the UK payments industry which would be accountable to the FCA, funded via the FCA levy and be composed of senior industry and non-industry representatives; and (iii) introduce a new regulator for the payments industry which would require providers to be licensed and enforce licence conditions. The Government indicates a preference for the second option.

What next?

Given the complex and wide-reaching nature of the reforms, there was little expectation from stakeholders that the White Paper would contain all the answers. Yesterday’s proposals have provided some further clarity on outstanding policy questions identified by the Government in its December response to the ICB. However, many fundamental questions remain, such as the exact scope of depositor preference and how bail-in will be applied. The Government is seeking views on its proposals, with responses requested by 6 September 2012.

We expect the Government to publish a draft Bill for pre-legislative scrutiny this autumn, with all necessary legislation introduced as soon as Parliamentary time allows. As mentioned above, all primary and secondary legislation is expected to be complete by May 2015, with implementation by 2019. This remains an ambitious timetable for both the Government and banks, particularly taking into account the need to ensure consistency with international and EU developments, the timetable for which are likely to be ‘out of the UK’s hands’, and the significant complexities involved.

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