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Ring-fence needs electrification, says Banking Commission report

21 December 2012

The Parliamentary Commission on Banking Standards has today published its first report. The report contains the Commission’s consideration of the Government’s draft Financial Services (Banking Reform) Bill and associated proposals which give effect to the recommendations of the Independent Commission on Banking (ICB)

Commenting on the publication of the report, the Chairman of the Parliamentary Commission on Banking Standards, Andrew Tyrie MP, said:

"Parliament took the unprecedented step of creating its own inquiry into banking standards, in the wake of the first revelations about the Libor scandal. The latest revelations of collusion, corruption and market-rigging beggar belief. It is the clearest illustration yet that a great deal more needs to be done to restore standards in banking.

The Government asked us to look at one of its main proposals for increasing financial stability – ring-fencing – as part of our work.

The Commission welcomes the creation of a ring-fence. It can, in principle, contribute to the Government’s objectives of making the banking system more secure. It is essential that banks are restructured in a way that allows them to fail, whether inside or outside the ring-fence. Ring-fencing can also help address the damage done to culture and standards in banking.

But the proposals, as they stand, fall well short of what is required. Over time, the ring-fence will be tested and challenged by the banks. Politicians, too, could succumb to lobbying from banks and others, adding to pressure to put holes in the ring-fence.

For the ring-fence to succeed, banks need to be discouraged from gaming the rules. All history tells us they will do this unless incentivised not to.

That’s why we recommend electrification. The legislation needs to set out a reserve power for separation; the regulator needs to know he can use it.

Furthermore, we need periodic reviews of the sector to reassure us that the ring-fence as a whole is working. Tougher measures may yet be required.

The Commission will take further evidence on whether full separation of proprietary trading - something akin to a Volcker Rule - may be appropriate.

Next year the Commission will also be looking at, and reporting on, what contribution changes in areas such as competition, corporate governance, supervision and regulation and the civil and criminal law could make to enhancing standards and culture in banking.”

1. Electrifying the ring-fence:

Para 93:

- The Commission ...welcomes the Government’s action to bring forward legislation to implement a ring-fence.

Para 104:

- While ring-fenced banks will carry out the majority of essential economic functions which need protecting, it is important to be clear that it is these functions that enjoy protection and not the bank itself or its shareholders or creditors. There should be no government guarantee of ring-fenced banks, nor perception of one. Neither does ring-fencing mean that risks from non-ring-fenced banks can be ignored, as such institutions will remain systemic and difficult to resolve.

Para 163:

- The ring-fence envisaged by the Government may, in the long run, not provide an adequate degree of separation. Nor may it be adequate to buttress banking standards. Additional powers are essential to provide adequate incentives for the banks to comply not just with the rules of the ring-fence, but also with their spirit. In the absence of the Commission’s legislative proposals to electrify the ring-fence, the risk that the ring-fence will eventually fail will be much higher.

Para 164:

- The Commission recommends that the forthcoming legislation add reserve powers to implement full separation.

2. Separation that can stand the tests of time:

Para 78:

- Any framework will need to be sufficiently robust and durable to withstand the pro-cyclical pressures in a future banking cycle.

Para 151:

- The Commission has concluded that a necessary form of parliamentary bulwark against erosion is the creation of a specific statutory provision for enhanced parliamentary scrutiny of the proposed use of delegated powers which have the potential to change the location of the ring-fence in a significant way.

"The Commission is concerned that the ring-fence could be vulnerable to erosion over time.

Pressure will come from many quarters.

It is all too easy, and sometimes all too convenient, to forget the lessons of the past. This cannot be allowed to happen."

3. The approach to legislating:

Para 122:

- The Commission is concerned that the heavy reliance on secondary legislation leaves open too many questions of significant policy importance.

Para 124:

- The absence of secondary legislation has seriously impeded the Commission in discharging the task which we have been set by the two Houses of Parliament.

- Without further information about the secondary legislation, it is not possible for this Commission to assess with any certainty how faithfully the Bill will give effect to the ICB recommendations. The jury is still out on the question of whether the Bill will implement those recommendations in letter and spirit.

"The Commission, for much of the time, was working in the dark.

It is impossible to say whether parts of the current draft Bill are fit for purpose.

Parliament, banks and others must be given the time to get it right."

4. The independence of ring-fenced banks:

Additional measures should be included in the Bill to ensure the ring-fenced bank is truly independent:

i. A strengthened mandate for the PRA

Para 139:

- A regulator enforcing rules of its own creation will have less authority in doing so than a regulator giving effect to a clear mandate in legislation with parliamentary authorisation. There is a compelling case for strengthening the regulator’s hand when it makes ring-fencing rules through such a mandate.

ii. Ensuring operational independence

Para 224:

- The Commission recommends...that the initial secondary legislation...should give the regulator a duty of ensuring operational independence for the ring-fenced bank in respect of governance, risk management, treasury management, human resourcing, capital and liquidity.

iii. A statutory duty for board members

Para 222:

- The Commission recommends that the Government insert within FSMA a legal duty on boards of directors to preserve the integrity of the ring-fence.

iv. A power to impose a sibling group structure

Para 228:

- The Commission recommends...that the regulator be given the power to require a sibling structure between a ring-fenced and non-ring-fenced bank, with a holding company. The Commission would expect this power to be exercised.

"If the ring-fence is permeable, or is perceived to be permeable, the risk of contagion will increase.

Clear dividing lines are needed between the activities of ring-fenced and non ring-fenced banks. A duty is needed on board members to ensure these lines are not blurred."

5. Other issues

i. The effect the separation of proprietary trading may have on standards

Para 94:

- The Commission has not considered fully the ramifications and practical issues of supplementing the proposed UK ring-fence with something akin to the Volcker rule. The Commission intends to take further evidence on this in the New Year.

ii. The leverage ratio should be set by the Financial Policy Committee (FPC)

Para 295:

- The FPC should be given the duty of setting the leverage ratio from Spring 2013.

"The Commission was not persuaded by the Government’s relaxation of the ICB’s recommendations on leverage.

The primary duty of setting a leverage ratio should fall on the FPC, not politicians."

iii. Bail-in powers should be included in primary legislation

Para 245:

- The Commission supports the Government’s endeavours to implement a bail-in regime in the UK. Bail-in is an important tool for resolving bank failures in a way that prevents the huge costs.

Para 242:

- Concerns remain about the design of a bail-in regime and whether it will provide confidence that the authorities would actually use their powers in the event of a crisis.

"A ring-fence alone cannot solve the ‘too big to fail’ problem. Bail-in is a crucial tool for the resolution of failing institutions.

The current proposals need strengthening in order to assure Parliament, and the markets, that we are not creating a paper tiger. Rules with real teeth are required."

iv. Basic derivatives could be allowed inside the ring-fence

Para 193:

- The Commission has concluded that there is a case in principle for permitting the sale of simple derivatives within the ring-fence. However, such permission would need to be subject to conditions. We remain concerned that allowing these products within the ring-fence may be the thin end of a wedge which could undermine the ring-fence.

"Access to simple derivatives is a necessity for well run businesses, small or large.

However, the Commission is concerned that the sale of such products inside the ring-fence may undermine it.

The Government and regulators have told us that they can define simple derivatives. We had better see the definition. If, and only if, the Government can provide one to the satisfaction of Parliament, simple products could be permitted inside the ring-fence, subject to strict controls.

The way in which derivative products are sold is a separate and concerning conduct issue; we cannot have a repeat of the recent mis-selling scandals. This is something to which the Commission will return next year."

v. Exemptions from the PLAC requirement for overseas assets should place the burden of proof on the bank seeking the exemption

Para 251:

- The Commission recommends that the secondary the burden of proof for any exemption from PLAC requirements on the bank seeking the exemption, rather than on the regulator.