The Government response to the ICB

The UK Government’s formal response to the recommendations by the Independent Commission on Banking (ICB), chaired by Sir John Vickers, was published yesterday (Monday 19 December).

In his statement to the House of Commons following the publication of the ICB’s final report (12 September), Chancellor of the Exchequer George Osborne outlined the ICB’s key recommendations – (i) building a ring-fence around retail banking; (ii) ensuring banks have bigger capital cushions to absorb losses; (iii) introducing depositor preference; and (iv) increasing competition in the banking sector – saying that the Government “welcome the recommendations in principle”.

It was widely expected that the Government would support the ICB proposals, while perhaps making some changes at the margin, and its response has on balance confirmed these expectations. However, it has given itself some room for manoeuvre in a number of areas including: (i) a possible exemption from the primary loss absorbing capacity (PLAC) requirement for ‘eligible’ non-UK operations of G-SIBs; (ii) a possible de minimis exemption from ring-fencing rules; (iii) scope for appropriate balance and flexibility in the rules on governance of ring-fenced banks; and (iv) allowing some long-term debt to be subject to secondary bail-in only. On other issues the Government takes a somewhat harder stance than the ICB, including: (i) enhancing the regulatory framework for payment systems, including bringing the Payments Council more clearly within the scope of financial regulation; and (ii) giving resolution authorities bail-in powers not only for banks but also investment firms and financial holding companies. The Government intends to consult further on many other points next year, following the publication of a more detailed White Paper in Spring 2012, and has invited comments on some aspects of its proposals ahead of then.

The Government has committed to completing the necessary primary and secondary legislation to give effect to the ring-fence by May 2015, i.e. the end of this Parliament. In an apparent tightening of the ICB’s timetable “banks will be expected to be compliant as soon as practically possible thereafter.”

Details to follow

In his September statement to the House of Commons the Chancellor cautioned that the changes proposed are “far-reaching and complex” and that “detailed work will start immediately.” We agree that the devil will be in the detail. We expected the Government response to provide further detail and clarification on a number of issues. Whilst the response addresses each of the ICB recommendations, it also leaves a number of loose ends, although it highlights the further work / consultation required / underway. It seems that the industry will need to wait for the White Paper to begin to get real clarity on several issues, including the precise timeline for implementation, the definition of mandated, prohibited and ancillary services, where the Government is open to changes, and the scope of depositor preference.

After the ICB final recommendations were published, we identified a number of areas that we thought required the most immediate attention by the Government. Some were addressed by the Government yesterday, whilst on others the uncertainty continues. The six key questions raised by the ICB final report and the consequences of the Government’s response are set out below.

1. Interaction with EU rules

When the ICB final recommendations were published, the Government pledged to “discuss these changes with international partners to ensure consistency with international agreements and EU law.” This is important, as concerns were raised that some recommendations – most notably those on higher core tier 1 minimum capital levels and the bail-in elements of the PLAC requirements – may not be compatible with current EU initiatives such as the capital and liquidity framework (Capital Requirements Regulation – CRR) and Cross-Border Crisis Management (CBCM) proposals. The capital and liquidity rules are currently undergoing consultation in the EU Parliament and Council, but as they stand are maximum-harmonised, meaning that the UK may not be allowed to apply its own ‘Finish’ as envisaged by the ICB, despite comforting words from the Commission on this point. Similarly, the CBCM official proposal is yet to be published by the EU Commission, but their consultation proposed that resolution authorities be given significant power to write off equity and write down or convert subordinated debt – where exactly the Commission will come out on bail-in powers and how that will compare with ICB proposals is still unknown.

The Government’s response recognises that the current draft of the CRR restricts the ability of EU Member States to impose their own ‘Finish’ and states it will continue to work with the EU institutions to ensure the required flexibility is reflected in the final rules. However, it provides little further detail on “Plan B”, i.e. how it would implement this element of the ICB package in the absence of securing the required amendments. This continuing uncertainty may complicate the planning process for UK banks. On the question of bail-in and the link to the CBCM, the Government is rather clearer on how it plans to proceed. Whilst it agrees with the ICB that the resolution authorities should have a statutory bail-in power to assist in bank resolution the Government has indicated that it will develop and implement the bail-in tool in a manner consistent with the EU framework.

2. Application of PLAC

The ICB recommended that the largest UK banks hold, at group level, a minimum total of 17% in PLAC, comprising of minimum 10% in core tier 1 capital plus 7% of other capital and bail-in bonds. This recommendation applied both to ring-fenced and non-ring-fenced activities. The application of the PLAC requirement to non-ring-fenced activities would have meant that the investment banking business of UK banks to which the ICB recommendations applied would potentially be subject to a higher standard than their competitors.

The Government has somewhat relaxed the ICB recommendations by opening the possibility of an exemption from the PLAC requirement for UK-headquartered G-SIBs. Under Government proposals, such institutions would have to meet minimum PLAC requirements across their global operations, as well as in the UK, except where they can demonstrate that any non-UK operations do not pose a risk to the UK taxpayer, in which case, the loss-absorbing capacity of those foreign operations need not exceed any international or local standards. Little detail is given as to how exactly this would be evidenced, apart from suggesting that a robust, credible plan for the resolution of foreign operations separately from the resolution of UK operations may be a prerequisite.

3. Leverage requirements

The ICB proposed that all ring-fenced banks should maintain a tier one leverage ratio of up to 4.06%, depending on the relative size of their risk-weighted assets (RWAs) to UK GDP. This requirement would need to be met on a solo basis.

The Government largely supports the ICB’s proposal, endorsing the need for a mandatory, minimum leverage ratio for all banks and for these requirements to be met on a solo basis. However, it does not endorse outright a pro rata increase (up to 4.06%) in the minimum leverage ratio for large ring-fenced banks. Instead, further work will be done to determine if there is a case for increasing the minimum ratio and whether different minimum ratios should be applied to banks with different business models – here a specific mention is made of banks whose assets largely consist of prime residential mortgages.

4. Competition objective of the Financial Conduct Authority (FCA)

The ICB recommended that the FCA be given a clear primary duty to “promote effective competition”, a recommendation which has since been commented on by both the Financial Services Authority (FSA) and the Joint Committee of Parliament that conducted pre-legislative scrutiny of the draft Financial Services Bill.
The Government has taken the comments from the ICB and the FSA on board and has pledged to give the FCA an objective of ‘promoting effective competition in the interests of consumers’. A greater, more explicit role for the FCA in promoting competition will affect the FCA’s approach to regulation, and will need to be matched with proportionate powers. The Government acknowledges this issue but provides no further insight as to what additional powers and responsibilities it may give to the FCA, instead committing to consider the recommendations put forward by the Joint Committee in this respect.

5. Insured depositor preference

Another ICB recommendation was that all (FSCS) insured depositors should rank ahead of other creditors (unsecured or with a floating charge) in the event of insolvency / resolution – known as depositor preference. This proposal would make it more likely that, in the case of failure, these depositors would be paid out in full. But as this would occur anyway (via the FSCS), it would in fact benefit those who finance the FSCS (the banks, ultimately underwritten by HMT).

The Government supports the ICB’s recommendations on depositor preference in principle, but calls for further analysis and consultation on its scope. In particular, it hints that additional analysis is needed to explore the possibility of extending depositor preference to either all deposits made by those eligible for FSCS coverage (i.e. not just up to the FSCS limit) or a different (as yet undefined) sub-set of depositor. The Government’s inconclusive statement of support and call for further discussion will be of interest to the banks, which had previously expressed concerns that depositor preference as envisaged by the ICB could result in owning bank senior unsecured debt becoming less attractive and push up banks’ borrowing costs.

6. European Economic Area (EEA) limits

The ICB proposed that ring-fenced banks be prohibited from transacting with entities based outside the EEA, which could have significant consequences for banks and building societies, many of which have subsidiaries in the Channel Islands (outside the EEA) which are primarily used to gather deposits and on-lend to the parent.

The acknowledgement of this relatively technical but nevertheless important point in the Government’s response is encouraging. Whilst no further detail is given on how it will tackle this issue, the Government notes that the treatment of UK Overseas Territories and Crown Dependencies is an important point for some UK institutions and explicitly states its intention to conduct further analysis in this area.

And finally

The Government also published its own cost benefit analysis of the proposals. Private costs (to the banks) are estimated at £3.5 - £8bn a year, broadly in line with ICB estimates. Some of these costs represent, in effect, reduced support from the rest of the economy, so the ‘social’ cost is much less (£0.8 - £1.8bn). Benefits are said to be significantly above (social) costs, at close to £10bn.

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