Treasury Sub-Committee on Financial Services Regulations
Oral evidence: The strong and simple framework, HC 537
Wednesday 20 July 2022
Ordered by the House of Commons to be published on 20 July 2022.
Members present: Dame Angela Eagle (Chair); Rushanara Ali; Harriett Baldwin; Anthony Browne; Kevin Hollinrake; Alison Thewliss.
Questions 1 - 65
Witnesses
I: Simon Hills, Director, Prudential Policy, UK Finance; Robin Fieth, Chief Executive Officer, Building Societies Association; Heidi Jenvey, Director of Risk, Aldermore Bank; Nick Lee, Head of Regulatory and Government Affairs, OakNorth Bank.
Witnesses: Simon Hills, Robin Fieth, Heidi Jenvey and Nick Lee.
Q1 Chair: Welcome to the Treasury Sub-Committee on Financial Services Regulations. This is an evidence session on the strong and simple framework. This is the Sub-Committee’s first meeting, so please bear with us if we are all feeling our way a bit. Welcome to you all. Would you like to introduce yourselves?
Simon Hills: I am Simon Hills. I lead the prudential reporting and tax team at UK Finance.
Heidi Jenvey: I am Heidi Jenvey. I am the risk chief operating officer at Aldermore Bank.
Nick Lee: I am Nick Lee. I head up regulatory and government affairs at OakNorth Bank.
Robin Fieth: I am Robin Fieth. I am the chief executive of the Building Societies Association.
Q2 Chair: Thank you very much. It is a pleasure to have you with us today. The Prudential Regulation Authority has identified a complexity problem in prudential regulation, describing how compliance has a high fixed cost, which is disproportionately felt by smaller firms, even though these firms offer the smallest prudential risk. Do you agree with the PRA’s identification of the problem and its introduction of a strong and simple framework, which hopes to address it by almost distinguishing between the companies that present a higher global risk and higher prudential risk, and those that do not?
Simon Hills: Yes, very much so. UK Finance and predecessor organisations have been calling for a long time for a more proportionate prudential regulation regime that addresses that complexity problem. If you think about our smaller banks, they have a senior managers regime and an individual accountability regime, and they do not have the support that our larger member banks and building societies do to ensure that they meet complex financial and prudential regulations, which are the same whether a firm is a large, systemic high street bank or a smaller, less systemic bank, so we very much support this.
There is a missed opportunity, which is around where the ceiling of eligibility for the simpler firm regime should lie. At the moment, it has been set at £15 billion, which addresses the complexity issue, but I do not think that it necessarily allows the PRA to meet its secondary competition objective in ruling out this simpler regime for some of the squeezed middle banks that can potentially provide real competition to the high street banks. We are very much supportive of increasing that ceiling from, say, £15 billion to £25 billion. We hope that that is a measure that the PRA will consider.
Chair: We have two different creatures here: building societies as well as banks.
Robin Fieth: Maybe I can come in here, from the building society perspective. We started a major campaign in the summer of 2016, after the referendum, for a far more proportionate and appropriate prudential regime in the UK. This reflects that the European Union’s single banking book created a level playing field in the sense that everyone had to abide by the same rules, but it did not recognise that disproportionate burden.
In the same year, we did some research among building societies that showed—and you have seen this in our evidence—that the average cost of regulatory compliance for a large building society at the time was about £45 per £1 million of assets and, for a small building society, it was about £450 per £1 million of assets, so 10 times as much. That demonstrates the fixed cost, so we absolutely support the initiative.
It is still very early days in that initiative and, whether we are talking about thresholds and ceilings or about the nuances of proportionality within strong and simple, there is a long way to go to get a regime that works really well both for the prudential regulators and for firms that are there to serve either their shareholders in the case of banks, or their members and society in the case of building societies.
Chair: Nick, you want to say something. Nick and Heidi, you are both from challenger banks.
Nick Lee: That is right. I represent OakNorth Bank, and we are focused on lending to growth SMEs—what we call the missing middle. We were formed back in 2015, so we are a new bank. We were the beneficiaries of the changes in the removal of barriers to entry to banking in the UK. The PRA has done a fantastic job at lowering those barriers to entry. You have seen that there are 35 new banks that have come in since those changes.
What this initiative could do, if done properly, is look at the next challenge, which is the challenge around scaling. It is slightly damning in the UK that, since the financial crisis, none of those smaller banks has come through to be a scale competitor to the bigger players. We see this regime that is coming in as a unique opportunity that the PRA could grasp—particularly in a post-Brexit world, where it has a little more control over the rulebook—to change some of those things and remove some of those barriers to scaling that we see exist.
We are supportive of the initiative but, just as Simon has suggested, we believe that it should go further. The threshold should be much higher. We support a threshold probably up to £50 billion—and that is where we see the difference between being a systemic bank, i.e. a bank that really matters if something happens to it, and a non-systemic bank in terms of the UK—to push it much higher and, therefore, to reduce the burden of compliance and of rules on the non-systemic banks, with a view to helping them scale and challenge the bigger banks to bring more innovation and more competition to the UK banking sector.
Chair: Heidi, do you have a comment from a similar bit of the market?
Heidi Jenvey: Much in line with previous comments, Aldermore is, effectively, one of the squeezed middle banks sitting around the edges of the current limit. It could be looked at in an increased way to capture more banks or allow for banks such as Aldermore to target growth without switching to a different regime.
The key would be in the detail that would come from the framework, but my immediate thoughts would be that there needs to be some flexibility in that limit, because a blunt tool sometimes can be a cliff-edge approach, which would not necessarily get what we need out of the framework.
Q3 Chair: It has to be a dynamic approach, hasn’t it? The PRA has said that it is going to start at the bottom end of the market, where, by definition, the organisations that are subject to the strong and simple framework are going to be the smaller ones in the market rather than the medium-sized ones. My impression is that it is thinking of moving it up as time goes on. Is there something wrong with that approach?
Simon Hills: It is sensible to start from the bottom and then increase. There is talk of a large but simple regime in the next tier up, if you like, but my understanding of how the PRA is thinking about this is that it is going to get the simpler firm regime finalised before moving on to the large but simple regime.
We think that a simple expedient to hurry that process up would be to increase the signalling. That would bring a lot of the squeezed middle banks into scope of the simpler regime without really adding to systemic stability. Were we to increase the limit to £25 billion—I would have to get back to you on this—I suspect that we would probably add another six or seven banks and, potentially, building societies to the regime. It would not be a huge number of extra banks in scope, but it would bring into scope firms that have the real potential to compete with more established banks.
Q4 Chair: Robin, can you see a set of rules being written by the PRA with banks in mind, which do not work so well for building societies, or are you quite happy with the way that it has tried to do things to date?
Robin Fieth: There is always that risk. Can I just pick up on a—
Chair: Yes, please do, but then could you address that point?
Robin Fieth: What would have been far more helpful is if the PRA had painted the big picture at the outset. It said that it was going to start on the small sector, but it is starting to hint, as Simon said, that we are going to see the next tier up. Indeed, we have seen some stuff from the PRA in the last few days, but it would have been helpful to have seen how many tiers it is thinking about between the smallest and the systemic, just as it would have been very helpful at the outset to have had some idea as to what its thoughts were on calibration of capital at each of those levels; otherwise, we end up in potentially circular arguments.
Q5 Chair: Just before you answer my previous question, do you accept that this is a dynamic issue, in that, if they build the bricks at the bottom, they can change it quite rapidly, or do you think it ought to just be introduced in its final state in one big splurge?
Robin Fieth: It is a dynamic situation, but if you were to view this as a strategy you would want to see what the big picture was before you started building components. What they have done is started building the components before telling us what the big picture is. That is the way out.
Q6 Chair: Do you get the impression that they have the big picture in their mind or are evolving—
Robin Fieth: They are beginning to evolve it. We have been gently talking to the deputy governor about, for example, his Bufferati speech as being maybe a very early indication as to how their thinking might evolve for the next tier up.
On your question, the long-standing issue for building societies has been that the smaller ones, in particular, have been constrained by what is globally called the building societies sourcebook—the PRA regulation for building societies—which has not applied to banks that are also competing in that same mortgage space.
We are encouraging the PRA to think about either merging the two together or, having put the strong and simple regime in place, taking the sourcebook out; otherwise, you do not get that parity of competition. At the moment, where 90% of the mortgage market is fixed rate, the constraints of the sourcebook can be really quite difficult for the smallest players, so there is that bit to keep a very close eye on.
Chair: Nick, you were expressing a view in your facial expressions about whether the mediums should be involved or we should build up from the bottom. That seemed to indicate that you wanted to say something.
Nick Lee: Yes. My concern is the time that it is going to take to build from that very small layer up and up. My guess is that it will probably be 2025 by the time policy comes through and is consulted on for that smaller layer. The problem statement, as we see it, is bigger than that, and something needs to be done sooner. It is a time issue from my perspective. If we just allow a small drip feed, we will probably be looking at some point into the next decade before the squeezed middle is included in this, and we will not be doing anything about the challenges around banking competition in the UK.
Q7 Chair: Heidi, talking about the scaling challenge, to what extent is the regulatory regime the issue for banks that want to scale up? Are you coming to the Committee and saying that banks will not be able to scale up, simply because of the regulation that is expected around them, if strong and simple does not apply?
Heidi Jenvey: It comes down to the fact that you usually have a five-year planning cycle and, if you are planning for growth in that cycle that will put you into another regulatory regime, you have to then think that you are operating in that regulatory regime and, therefore, that will bring forward all the change, because you will have to build the infrastructure and to start planning.
The fixed cost problem that you alluded to earlier is something that you would have to plan for and mobilise. These sometimes require significant infrastructure and IT systems, and so, by having the limit where it is currently, with quite a few banks quite near it, you would probably find that they would have to opt out of it naturally anyway, because there would be no room to grow.
Making it a little bigger, for a start, would allow more breathing room, but, equally, there needs to be more nuance to that hard limit, because you need to be able to factor in a bank operating a five-year planning horizon. Even if it is not touching that ceiling today, it will have to plan for it and start to build the infrastructure. Therefore, there needs to be a little more detail around how it is phased in, how you switch from one to the other, and what it would mean in terms of other regulations—so how it relates to something like MREL—which could have a significant impact on your cost of funds. It will then be a commercial decision, because it will hit your bottom line.
There is a lot of complexity that this scope of the particular simple limit may have downstream impacts in other areas of policy, which would have some consequence.
Q8 Harriett Baldwin: From a policy perspective, this is a very technical area, but from a strategic point of view, presumably you are all agreed that we want to avoid a situation where we have financial institutions that are too big to fail, that we want to have an environment where challenger banks can start up, succeed and grow, and that we must not end up with what we had perhaps 10 years ago, after the financial crisis, which was a state-owned oligopoly in this sector.
I want to drill down a bit into some of Dame Angela’s questions and the answers you gave, because it is very interesting that you represent a range of sectors. We also have a couple of challenger banks, and I want to understand, first of all, when we mention this issue around scaling up challenger banks, which is a bigger issue. Is it the balance sheet levy, which can act as a bit of a deterrent to growing above a certain size, or is it other factors that are addressed in this strong and simple consultation?
Nick Lee: It is probably more around the technical side. The capital requirements that are there for banks on the standardised approach versus the bigger banks that tend to be on the IRB approach are a big impediment to growth. Unfortunately, the MREL requirements that were looked at by the Bank of England late last year did not change. Heidi touched on those. They do have a very negative impact on banks wanting to grow beyond the £15 billion to £25 billion mark.
Q9 Harriett Baldwin: Just for the box office audience that is watching this session, can you spell out what MREL stands for?
Nick Lee: Yes, it is the minimum requirement of eligible liability—it doesn’t roll off the tongue, I appreciate. Effectively, it is there to make sure that banks do not have to pull on the taxpayer, should they become insolvent.
Coupled with that MREL regime, there have been significant and positive changes for the regulator in terms of the capital regime. Banks now, on average, hold a lot more capital than they did before the financial crisis. Our argument has always been that, with the MREL regime, and now the strong and simple regime, there seems to be a ceiling of about £15 billion where both regimes either stop or start. Therefore, you input significant additional costs on those banks that are looking to scale.
With the MREL requirements that the Bank of England reviewed last year, we, together with 10 other squeezed middle banks, came back and did some analysis to show that, because of those MREL requirements, something like £45 billion of additional lending would not happen to the real economy over the next five years.
Q10 Harriett Baldwin: So, for you, that would be your biggest barrier, then.
Nick Lee: It would be MREL and capital requirements, but also the compliance requirements that are there and usually apply to all banks. There are some slight differences, but really the cost of applying those to all banks is the same. If you are a very small bank, that is quite a big cost headwind that you have to face into, at the same time that you are trying to scale. Scaling is not easy on its own without any of these other barriers. It is an incredibly hard job.
Q11 Harriett Baldwin: So that is your ranking. Would you agree with that at Aldermore?
Heidi Jenvey: One of the issues that you have in being on a simpler regime is that you do not have as much sophistication in your approaches to managing your risks, and therefore the level of capital that you have to hold is usually a blunter tool and has to be at a higher level to accommodate that. The bigger banks have an advantage, in the sense that they use their internal ratings models, which gives them a lot more risk sensitivity. In a mortgage, for example, that could allow them to hold significantly less capital than a challenger bank that has to use a standard set of rules.
What I am unsure of about the strong and simple approach is whether that difference would be mitigated, because, if we are using a simpler approach, that may not address that particular problem, which does not allow the smaller banks to compete as easily with the large banks, because they just do not have the sophistication in their ability to understand and measure risk.
Q12 Harriett Baldwin: Would you also put the ranking as being that the biggest barrier to scaling up is the minimum regulatory liabilities?
Heidi Jenvey: Yes and no. There are a number of complexities that would be different for each bank when they are assessing their business model, their growth ambitions and their target markets. Fundamentally, when you get bigger, you have more scale to invest in understanding and building more sophisticated ways to measure things like risk and regulatory capital, which gives you much more differentiation when you are coming to work out what products are suitable at what price.
Therefore, it is more challenging, as a smaller bank, to build that relationship with a fairly crude level of capital. If it is a higher level of capital, that can sometimes be a disadvantage.
Q13 Harriett Baldwin: The other context that I wanted to understand in terms of this work is how it is fitting in with the work that Basel is doing in terms of Basel 3.1. It is the major international regulator. Is this process quite well aligned with what is happening at Basel?
Simon Hills: It is important that the PRA is doing this work now to identify what the scope of the regime will be, and we have to recognise that the PRA has worked hard, enthusiastically and co-operatively with industry in putting this together. Basel 3.1, to be introduced at the beginning of 2025, will be a complex project to implement. It may very well, for some asset classes, require banks to hold increased levels of capital, and I would love to come back to the Committee perhaps next year when we know what the PRA is thinking about.
Yes, there is a crossover into Basel 3.1, in that firms that could be in the simpler firm regime have the opportunity to stay with the current regulatory environment, which is very sensible. It avoids marching people up to the top of the hill and then down again the other side, if they are exempt at some point, which is why we would like to encourage the PRA to get on with it. Wouldn’t it be great if the simpler regime were finalised by, say, the end of 2023, so that banks can then understand, in the context of Basel 3.1 implementation plans, whether they want to be this side or the other side of the 3.1 line?
Q14 Harriett Baldwin: So the UK Finance view is that this is good progress, and your members are happy where the line has been drawn in terms of the different sizes of firms.
Simon Hills: No, we would say that there has been great progress, but we need to set the ceiling below which the simpler firm regime will be set higher at £25 billion.
Just picking up on the points that Nick and Heidi were making in relation to MREL, it is quite a technical area. MREL kicks in at a woolly level between £15 billion and £25 billion. If a firm is approaching £15 billion of assets, it will have a discussion with the supervisor as to whether it has to start raising MREL. The amount of MREL that it has to raise depends on its pillar 1 and pillar 2A capital levels. It is quite complex, but if a bank is on the standardised approach rather than an advanced approach, it tends to hold higher levels of pillar 1 and pillar 2A capital, meaning that it has to hold proportionately more MREL per pound of risk asset, if you like.
Q15 Harriett Baldwin: So the No. 1 thing that you are feeding into the consultation is for a higher level where it becomes too big to fail.
Simon Hills: Yes—put elegantly, if I may say so. That would also allow us to think about whether the MREL limit should be set at £15 billion or £25 billion. Clearly, £25 billion is the point at which firms must hold MREL. Below that, there is a bit of a discussion that goes on with their supervisor.
Q16 Harriett Baldwin: Is there not a risk that the £25 billion again becomes a cliff-edge deterrent to growing further?
Simon Hills: There is that risk. Firms like Aldermore or OakNorth that can, in due course, offer real innovation and competitiveness are probably in that £15 billion to £25 billion zone, and so, by including them in the simple firms regime, we will increase competition in the market.
Harriett Baldwin: Does the whole panel agree with that?
Robin Fieth: We are more agnostic about the increase in the limit. I would say that out of self-interest for building societies, because there is only one building society with assets in that middle class, and it is already on IRB, so it would be excluded anyway. It is not that we disagree, but we are not going to be a strong advocate for it. We are, for our own sector, very content at £15 billion, but we recognise that there are different demands elsewhere in the market.
One of the really important points here, which goes back to the fundamental big picture point, which we sometimes lose in the term “secondary competition objective,” is that it is absolutely in the UK’s national interest to have a properly diverse, competitive and resilient financial services sector, and particularly banking sector. The lens that we are really looking at this through is how it facilitates and supports that real diversity, whether that is mutuals or smaller and challenger banks, as wholehearted competitors and constituents of the sector, both in good times when we are just offering competition in choice, and in difficult times when we are offering different forms of resilience. That is a point that we would always have as the big picture frame for this.
Q17 Anthony Browne: I should declare that, in my previous job, I ran the British Bankers’ Association and led negotiations on this with regulators. Simon Hills used to work for me and he did a very good job.
Just for the record, Nick for OakNorth and Heidi for Aldermore, what assets do you have at the moment? Nick, you are arguing for £50 billion, so I assume that you are—
Nick Lee: We are way below £50 billion.
Q18 Anthony Browne: What are your latest published figures?
Nick Lee: We are around £5 billion as it stands at the moment, but with ambitions to grow.
Anthony Browne: Yes, I was just wondering how much.
Nick Lee: We have a fair amount of headroom.
Heidi Jenvey: We are just under £15 billion.
Q19 Anthony Browne: So the £15 billion would not help you that much, because you would be there quite quickly.
Robin gave some figures for the compliance costs of this in terms of administration. Heidi, you touched on the cost of capital. Which is the real constraint to growth in terms of competition? It is the cost of capital, isn’t it? In that case, if you had a simplified regime that reduced administrative burdens but increased the capital requirements, that would damage competition more rather than help it. Is that right?
Heidi Jenvey: There is definitely a possibility that that could be the case, particularly if you are looking in more specialised areas of lending that do not necessarily fit into what is a very generalised set of rules. That is already quite evident in the current Basel requirements that are in place for standardised. Basel 3.1 seeks to address some of that with increased risk sensitivity.
However, if we were to look at the strong and simple framework, that may be at odds with that harmonisation with the internal ratings-based approach that the big banks would be using, so there is certainly a possibility.
With any set of rules, there will be winners and losers, for want of a better terminology, and some assets may well be beneficial under a crude set of rules, while others may not be, so it is not necessarily a one direction that it could happen.
Anthony Browne: It could reduce capital requirements for lending to small builders but increase them for mortgages, or something.
Simon Hills: Shall I pick up on the cost of capital point, where I agree with you that it is about cost of capital?
Anthony Browne: Yes, rather than the administrative costs.
Simon Hills: I will come to the administrative costs in a minute, because there are some benefits arising from that as well. It is the cost of MREL. This is an instrument that is quite complex to understand. It is bought by investors in the international capital markets, who like to buy large chunks of MREL. Our smaller member banks, when they get into that MREL corridor, will not have to raise huge amounts of capital. There are illiquid instruments that you have to pay up for.
On your administrative point, whereas our larger member banks have compliance and risk teams that they can outsource the management of these issues to, senior managers, who, individually, are accountable in our smaller banks, without necessarily the same degree of support, probably spend proportionally more of their time thinking about these sorts of issues, rather than how we are going to grow the business to £50 billion over the next five years.
Robin Fieth: In the mutual world, it is different, because the cost of capital is far more nuanced. Therefore, the administrative burden becomes far more significant, because every pound that is spent on unnecessary administration is a pound that does not make it to the bottom line to invest in the future natural capital of the organisation.
When you think of the purpose of making surpluses in building societies, it is about building capital for the future and investing in the future; it is not about rewarding external shareholders. That is just the nature of the businesses.
One of the really quick wins here, which we are pushing the PRA on—and it seems to be a bit reluctant—is to look, for example, at the unnecessary burden of regulatory reporting, which is incredibly expensive and complex and, frankly, a lot of it seems not to be needed. One of my chief executives gave me an example the other day of pillar 3 reporting, which for a reasonably sized society is onerous. He said, “In the last quarter, we had four hits on our website on our pillar 3 report.” One was him as the chief executive, one was the chief financial officer, and he thought that the other two were probably job applicants who were just doing a bit of research on it.
Anthony Browne: Some of my colleagues are going to come to those.
Robin Fieth: There are areas where some of these quick wins could be taken right now. We do not need to wait for them. That would help our members.
Q20 Anthony Browne: The point of my question is that, at the moment, we are discussing what the level of the strong and simple regime is, but we do not know what form it would take. You could end up with something that requires you to have higher capital requirements than at the moment and might make you less competitive.
I chaired a meeting with Andrew Bailey, when he was head of the PRA, with a bunch of challenger banks about this, and this was about the time of the Brexit referendum and all done under the fact that we now control our own prudential regulation rather than having EU rules. He said, “Be careful what you wish for, because you could end up making it less competitive.”
Nick Lee: That is part of the difficulty with this consultation paper, because you just do not know what that capital regime is going to look like, and we will not know probably until next year. Again, we come back to the speed and the timing of this. It is far better to try to put it all together and give clarity.
On the cost of capital, MREL is a big thing. We will likely have to hold double our pillar 1 and pillar 2 as we hit £15 billion. There is a big decision that has to be made by challenger banks as they hit that level about whether they and their investors want to do that. It is a significant step up. The PRA and the Bank of England have added steps into that process to make it slightly easier over a longer period, but it is still an incredibly difficult investment decision if you are going to just tip over to that particular threshold. That is why we would suggest looking at it on a systemic and non-systemic basis, being bolder and more ambitious, particularly on capital as well.
Q21 Anthony Browne: That was going to be my next line of questioning. You are not systemic banks and, theoretically, the Bank of England and the PRA are not no-failure regulators. Theoretically, they are allowed to let institutions such as yours fail and you will not be bailed out by the taxpayer. We had Andrew Bailey here last week and I asked him that question about being a no-fail regulator, and he fudged it slightly but pointed out that, in practice, it will never let anyone fail. Based on what you just said, do you think you should be allowed to fail?
Nick Lee: Yes, and my past role was at the PRA, where I worked in the small banks sector and led the work on the new banks start-up unit. Part of that was about not having a zero failure regime and allowing banks to fail. Nobody wants that. That is absolutely not what anybody wants.
Q22 Anthony Browne: No, but you should allow small banks to fail, as they do regularly in the US.
Nick Lee: Absolutely, because that is where you get the innovative business models coming through. As long as there is no detriment to depositors, and the compensation scheme can cover, there should be a way that we could do that. Correspondingly, there should therefore be a way of us being more proportionate on the capital side of things as well.
Robin Fieth: On the capital side—and, again, this is quite nuanced—the ideal outcome would be one where the PRA is slightly uncomfortable and practitioners are slightly dissatisfied. As you know, previous expectations are that the PRA would be very comfortable and that the sector would be very dissatisfied.
Q23 Anthony Browne: Heidi, from Aldermore’s point of view, do you agree with OakNorth that it should be a regime that accepts failures of small banks?
Heidi Jenvey: I can talk just from my broader collective experience of working in a number of UK challenger and small banks. You absolutely need to have that for innovation. You will not encourage unique and creative business models that find new products and new ways to serve customers without having a little flexibility, and so I do think you need to have some level of failure that is tolerated.
Q24 Anthony Browne: Lower capital requirements, and a more proportionate regime as a result, are part of that trade-off.
Simon Hills: Yes, I think so. As we have all said, it is difficult to understand yet what the capital and liquidity requirements will be in terms of this new regime. Until we understand that, we are flying in the dark a little bit. As I said earlier on, let us hurry this up.
Q25 Alison Thewliss: I have some questions around the scope and complexity of firms. Robin, in your written evidence, you stated that loans to UK expatriates secured on their UK properties—for example, when they are working abroad—and savings and mortgages for customers in the Channel Islands, Isle of Man and Gibraltar should be included in the scope of strong and simple. Could you tell me a bit more about why you feel that these are lower risk, perhaps, than the other EU countries?
Robin Fieth: This is a specific point that has come out of the second consultation from the PRA. It is more about the technicalities of how they have drawn definitions than anything else. The definition that they have adopted in the consultation paper is based on where the borrower resides, or the obligor, as it is called technically. What we are talking about here is mortgages where you have a UK citizen who is living overseas and has a property in the UK, and the mortgage is on the property in the UK. They are probably expatriate workers and it is their UK home or something of that sort.
This is quite an important area of business for a number of building societies, and because the security and the risk is in the UK, our view is that they should be treated as UK and not overseas assets. The reason that it is important is that one of the exclusion factors for strong and simple that the PRA is proposing is if your balance sheet is more than 50% overseas assets. It is about the classification of overseas assets, so that is the first point.
The second point that you referred to, which we were looking at, is that a small number of building societies, for example, have relatively small operations in Crown dependencies—Gibraltar, the Channel Islands and the Isle of Man—and they are very similar to being UK operations. Although technically they are not in the UK, but in Crown dependencies, they are by nature UK operations, so we are suggesting that those should be within the envelope of strong and simple. It is that sort of technical argument. In terms of risk, we certainly do not think that the fact that you have an expatriate borrower on a property in the UK represents any greater risk at all, because the security is in the UK.
Q26 Alison Thewliss: In terms of customers being a lower risk than EU countries if they are based in the Channel Islands or the Isle of Man, is there any comparison there?
Robin Fieth: It is not about where the customers are but where the operations are. These are small operations in the Channel Islands and the Isle of Man, so it is not where the customer is living.
Q27 Alison Thewliss: Could the proposal result in small firms being reluctant to take on business from UK citizens who live abroad?
Robin Fieth: Yes. One of those features in the Brexit negotiations and the Brexit outcome was that concern. There are restrictions now on the ability of UK banks and building societies to market, for example, to expatriates living overseas. If it becomes difficult, you tend to get, at the extreme, what you could call financial exclusion, although probably not in this particular case. If the regulation gets too heavy, lenders tend to avoid that part of the market.
Q28 Alison Thewliss: What is the value of that market at the moment?
Robin Fieth: I am going to have to come back to you on exact values, but we do know that three or four building societies have more than 15% of their balance sheets represented by expatriate lending. They are relatively small building societies, so it is not a massive market, but it is still quite important.
Alison Thewliss: It was just to get a picture of the size of that.
Robin Fieth: We will come back to you with the numbers.
Q29 Alison Thewliss: That would be useful. Heidi, you mentioned earlier the issue with internal ratings-based models, and you talked about the uncertainty of how those should be treated. I just wondered whether you had a view as to how they should be treated.
Heidi Jenvey: Internal ratings-based models?
Alison Thewliss: You talked about the uncertainty of how firms with internal ratings-based models should be treated in relation to the strong and simple framework. You said there was uncertainty but you did not really give a view as to which one you preferred as a result.
Heidi Jenvey: In the scope criteria, there are a number of firms that will be aspiring to use internal ratings-based on models, so that they may get to that level that bigger banks have in their sensitivity. The current scope recognises that, once those firms reach that approval of using internal ratings-based models, they have to then switch to the full suite of regulation.
Coming back to an earlier point that I made on how this will then interact with other areas of policy, to go through the internal ratings-based process to get a waiver to use internal models is a very large, complex and arduous process. What is less clear is how that is meant to work hand in hand with this framework. I completely understand that you switch on to the new set of regulations once you get an approval, but, when you are going through that process, it is less clear how you would then phase into these requirements.
Historically, when banks are going through this transition, they would already be on the full suite of regulations, so it is a bigger step change, and there is not much detail on how that will be managed.
Q30 Alison Thewliss: Can you see a way of managing it, or would you be looking for something different?
Heidi Jenvey: With a lot of these things, the idea and the intent are welcomed, but the devil will be in the detail on how individual regulations, which are highly legalistic and quite substantial, will be navigated through for the firms that are going through the process.
Q31 Alison Thewliss: Simon, could you tell us whether your members have expressed any particular concerns about the types of activity that have been excluded from strong and simple?
Simon Hills: Not particularly, to be honest. There are a number of criteria. The main one that has excited discussion is around the size threshold. Similar to Robin’s members, there have been concerns about the definition of where an obligor sits. Is it somebody who happens to be living overseas at the moment but is borrowing against a UK-based asset protected by strong English and Welsh or Scottish law? The asset is here, so we can make sure that it is a decent asset.
There are other issues at the margins, but we support the structure of the criteria at the moment, although I do pick up Heidi’s point about transitioning from the strong and simple regime as one grows one’s bank into the fuller suite of perhaps a large but simple regime. More clarity sooner would be really welcome, given that, as Nick said, the senior managers of our banks plan for five years ahead.
Q32 Alison Thewliss: Yes, absolutely. Nick, would you say that your bank has any particular issue about the types of activity that have been excluded?
Nick Lee: No, not on the activities. One thing that I would flag, though, is that there is a contradiction in the CP versus the existing capital requirements. The CP suggests that banks that are lower risk are those that operate predominantly in the UK, which sounds sensible. In the existing pillar 2A capital requirements for standardised banks, if you operate solely in the UK, and you do not lend in Greece, Germany or anywhere else, you are penalised. It adds a capital charge to your pillar 2A calculation for being a UK-centric bank.
On the one hand, the CP is arguing that banks are less risky if they operate only in the UK and, on the other hand, the existing regime suggests that banks are riskier if they lend only in the UK, because we have an additional capital charge. It is those kinds of things that we would value a quick resolution on from the regulator, having a sense of, “Well, one version or the other, please”.
Alison Thewliss: Both cannot exist at the same time.
Nick Lee: Yes.
Q33 Alison Thewliss: Picking up on Simon’s point, to what extent do you feel that the rules, from a complexity perspective, are future proof? Firms will grow; I am sure that you will want to see that growth. Do the rules really take that into account as things may get more complex? You talked about the leap between the two, Heidi.
Heidi Jenvey: One of the main constraints with any hard and fast limit is that, with any regulation, if it is to be changed, it requires some time for that to work through. Therefore, if there is a fairly dramatic shift in the UK banking market that requires the asset cap or one other part of the regime to be altered, that will not happen quickly. It will take time, it will take consideration and it will take consultation. Therefore, the better answer is to have the flexibility baked into the framework, so that the regulator can react more quickly.
Q34 Alison Thewliss: The rules need to be updated to raise limits, because running a simple bank in the future might require running some kind of payment system. Do you need to build these things into the rules?
Heidi Jenvey: It is very hard to forecast every single scenario and every type of new entrant bank that may come under the framework. One of the complexities and challenges of any set of standardised rules is that you will not be able to accommodate everyone. One of the balancing acts that the PRA really needs to focus on is how you have a fairly good answer for most banks, but which is not going to fit everyone.
Robin Fieth: The thing that is generally lacking in these things is an absolute commitment to review dates, because we cannot predict sufficiently what we are going to need or what the banking regime should look like in five, 10 or 15 years. We have some pretty good ideas, but a commitment to review every three or five years gives them an obligation, which otherwise tends to get pushed down the road a bit too far.
Nick Lee: I would argue that the thresholds never seem to move. We have had MREL at £15 billion to £25 billion. That was brought in, say, in 2015. Inflation and everything else has happened since then. You would have hoped that those thresholds would get moved up, because our balance sheets grow on that basis. They do not seem to move, so you almost trap more firms in that without that change.
Alison Thewliss: So some sort of floating threshold.
Nick Lee: Yes, some revaluation review at some point, but, again, the MREL threshold did not move in the last review, and that was set five, six or seven years ago now.
Simon Hills: So some indexation, but, as you say, subject to review and not an automatic increase in line with GDP or money supply.
Q35 Alison Thewliss: Yes, because otherwise would it not seem that a whole bunch of firms would then begin to get dragged into things unnecessarily?
Simon Hills: Yes.
Q36 Kevin Hollinrake: I am sure that officials from the PRA and the Treasury are listening as we speak, so this is your chance to set out how you think things should change for the better. Nick, you made a submission pointing out some potential changes. You pointed out particular issues around pillar 2A and how that operates—it does not operate very effectively. Do you want to set out how you think all this regime should change? I am talking about capital requirements.
Nick Lee: There should certainly be a review of pillar 2A requirements. In the submission I mentioned concentration risk, which, as I said in my last statement, is pretty mechanical in how it works. The other challenge that we have around capital as a growing bank is that we have our capital assessed by the PRA only once every three to five years, and our balance sheet and the risks in it look a lot different between year one and year five.
Often, some of the capital requirements that hit you in year one, particularly around concentration requirements, are a lot higher when you have a smaller balance sheet. As that balance sheet grows and the risks are spread over a bigger balance sheet, your capital falls as a proportion. We are not in the position that we can have that capital reviewed once every year, as we did.
Q37 Kevin Hollinrake: Is that what it should be? Is that a big job for the PRA to do?
Nick Lee: Having worked there, it is, Kevin; I will be honest with you. The PRA will require additional resource. It does it at the moment for the big banks. We believe that, as it set up a new banks unit, it should set up a scaling bank or building societies unit, where it can put some more resource in to be able to do capital assessments more frequently.
That leads to a better outcome for the regulator, because it has a more risk‑sensitive capital requirement, and it should hopefully lead to a better outcome for banks as well, which have a bigger proportion of capital requirements in a very competitive world.
Q38 Kevin Hollinrake: You also talked about geographic exposure; you referred a second ago to how you are penalised in terms of the capital requirements if you are too exposed to the UK. It sounds odd.
Nick Lee: It does, absolutely, and our view is that there should be some element of diversification around the UK captured in a discount, if you like, if you can show that your book is well spread across the UK. That would also probably support making sure that lending goes out to all areas of the UK, rather than just sitting in the south-east and London. That is certainly a way that the regulator could look at concentration risk.
There is a reduction in risk where you spread your lending more widely across the UK. There should be a discount, if you like, to your capital requirement rather than just a simple add-on for being a UK bank. At the moment, we could go and lend in Greece, Italy or somewhere else, and we would have potentially a lower capital requirement. We do not want to do that. We want to lend to businesses in the UK.
Q39 Kevin Hollinrake: So there are a couple of things—a scaling unit, so that you could quickly review the concentration risk, but also something that, if you can show your portfolio is more spread around the UK, that capital requirement is lower.
Nick Lee: Absolutely.
Q40 Kevin Hollinrake: Are there any other thoughts on that in terms of the annual review of concentration risk and stuff?
Robin Fieth: What you do for rapidly growing banks should be different from what you do for businesses in long-term sustainable growth. I mean that in the building society sense of the word, where long history shows that they grow really well, at between 6% and 10% a year. If you try to grow a mutual much more quickly than that, it tends to run out of capital quite quickly because, as we were talking about earlier, it self-generates its capital. I am talking about the smaller ones here, rather than the societies that will go out on to the markets to raise external capital.
The other point that we would make, particularly around capital—and we have had some very good progress with the PRA on this in the last two or three years—is that we should be talking about risk capital and risk weightings as being the binding constraint on banks and building societies, not leverage. That is a debate that we have had and made some real progress on with the PRA, because, when you are a monoline lender like a building society, it could, under existing regulations, be very easy to become leverage-constrained.
If we go back to MREL again, that particularly impacted MREL requirements for building societies in a way that was strongly anti-competitive, and really did constrain their ability to grow at all. We had a good outcome on that and, hopefully, that sort of debate that you can have with the PRA can be replicated elsewhere, where it is appropriate and, if you can make the right arguments, you can get a good outcome. Those are the key points on our side.
Simon Hills: Can I add to that wish list, if you like, the countercyclical buffer, which is really a macroprudential tool? Simpler firms do not pose a threat to macroprudential stability, so it might be helpful to understand why we think—
Q41 Kevin Hollinrake: Would you get rid of it entirely?
Simon Hills: For simpler banks and building societies, there is definitely a rationale for removing it, particularly because the countercyclical buffer is set off risk-weighted assets, not total assets, and larger firms tend to use the internal ratings-based approach, which gives them lower risk-weighted assets, pound for pound of absolute exposure.
Heidi Jenvey: I agree with all of the points made. Particularly, concentration risk is a very difficult area for smaller banks when they are judged on a more global scale in comparison with global banks. Therefore, when they are a completely UK domestic bank, they are measured as 100% concentrated in the UK, which should be not a bad thing, because they are a local UK domestic bank, but they get penalised under the current regime for that.
Simon Hills: This goes back to the philosophical underpinning of the Basel framework, which assumed that exposures were not correlated but infinitely diversified. The approach that said, “If you are not infinitely diversified, you should hold extra capital” is at odds with the idea that we want simpler firms to be mainly present in the UK.
Q42 Kevin Hollinrake: The total assets threshold at the moment is £15 billion. You are saying that it should be £25 billion, while you are saying it should be £50 billion—any advance on £50 billion? Heidi, where do you think it should be?
Heidi Jenvey: The £25 billion seems a reasonable starting point, as opposed to £15 billion, with the ability to opt in or out if you are below that.
Kevin Hollinrake: Sure, I get that.
Q43 Chair: Just before we go on from there, what are the dangers of doing that? Why do you think that the PRA has gone for £15 billion? We have had £25 billion over there and £50 billion over there for a bid.
Heidi Jenvey: They did some analysis on the smaller banks. It was around 60 or 70. They then looked at where they would get the best outcome in terms of banks being inside.
Q44 Chair: So you are looking at a spread of the size rather than something objective about £15 billion, £25 billion or £50 billion.
Robin Fieth: It was clear that they wanted to ensure that there was a sufficient population of small banks to fit within the regime to make it worthwhile doing, and not to have so many tiers of regulation, going back to that bigger picture, that it becomes incredibly complex.
It comes back to that big picture that we were talking about earlier. If you envisage three or a maximum of four layers between the smallest bank or building society and a globally systemic one, that feels about right. If it was six or seven layers, it would feel very complex.
Q45 Kevin Hollinrake: Just back to the concentration risk, if you made changes there, say, on annual reviews and stuff, it could help even larger banks. It would not have to apply just to small banks.
Nick Lee: There is a point that the PRA has only so many resources, and we have to accept that, but yes, it absolutely could help the larger banks as well as the smaller banks. It is a pretty mechanistic way of how concentration risk is calculated in this country. I do not think that it is calculated like that in many other countries; that is certainly not applied to the smaller bank sector.
Heidi Jenvey: The major difference is that that add-on is proportionately much less material to a larger bank. When you are a smaller bank, that add-on will form a large component of your pillar 2 capital, whereas, if you are one of the UK high street banks, it would be very minimal.
Q46 Kevin Hollinrake: Back to what Harriett was saying earlier, how do we avoid cliff edges in all this stuff? The last thing you want anywhere in a system are barriers or a deterrent to growth, but how do we smooth the system so that you can move from one level to another without it causing—
Nick Lee: That is why I was going for £15 billion. I made a comment at the start that, in my view, there should be a prudential regime for the systemic banks, which is probably above £50 billion. I am sure that it is maybe not quite calibrated. The leverage ratios are £50 billion, so the bank suggests that that might be the trigger level.
Below that, you give non-systemic banks space to grow and move up to that level. Much before then, they should have sophisticated risk management, capital liquidity systems and everything else in place to become a systemic bank.
Q47 Kevin Hollinrake: Your total assets are £5 billion, but, if you had £49 billion, would you be saying that it should not be £50 billion but £75 billion?
Nick Lee: Yes, but, if you look at the gap, Kevin, that there is between the big players in this country and everybody else, it is huge. The economies of scale that you need to be able to compete with banks of that size equates to a much bigger balance sheet, and that is why I was saying £50 billion.
Robin Fieth: There are two key points here, regardless of what the thresholds are. The first, which we were talking about earlier, is having a level of proportionality within each level of the regime. If you are in strong and simple, what you expect of a £15 billion bank or building society should not be the same as what you expect of a £200 million one.
A recurring theme in our discussions with the PRA is that, around thresholds, you should have long and gradual transition periods. If a bank chooses to get to, to take your example, £49 billion and has done nothing, it is going to have a big cliff edge, but if it knows that it is heading there and can start preparing from £35 billion, you can get it.
Encouragingly, in one of Sam Woods’ recent speeches, he started talking again about ladders here. It is about how you progressively move.
Q48 Kevin Hollinrake: They did that with MREL. The changes to MREL were like that in terms of—
Robin Fieth: Yes, a glide path. Glide paths are really important. That is why you want the proportionality within each regime as well as between them.
Q49 Kevin Hollinrake: What Anthony was saying earlier strikes at the heart of it. In the UK, we are so risk averse in letting things fail. Is that the heart of all this? Should we be less risk averse for non-systemic banks on the basis of, “Well, some are going to fail. We just have to let them fail, but better that, and giving more banks the opportunity to start up and grow, than have a very risk-averse approach.” Does that strike right at the very heart of this?
Nick Lee: I believe so. As we said in our submission, some work needs to be done on the compensation scheme on MREL, looking at the capacity of that scheme to pay out. Once you have that in place, as a regulator, you can then probably afford to take a little more risk without necessarily having to come back here as a regulator and explain what went wrong, which no regulator ever wants to do. There should be a little more risk taken by the regulators.
Robin Fieth: There is a big difference between an orderly failure and a disorderly failure. That is where the PRA is, although it does not like failures at all. The question is how much comfort or extra margin you need if you are the regulator in order to guarantee that orderly failure. Their desire for things like solvent run‑off tends towards being too far up the curve, with too much comfort for the regulator.
Chair: A risk-averse regulator—who would have thought it, especially after what happened in 2008?
Q50 Rushanara Ali: Good afternoon. Just sticking with that point, on challenger banks you have talked about some of the challenges compared to the bigger banks. Is there any circumstance in which some of the things that you are proposing could pose a systemic risk if enough challenger banks are allowed this scope that you were talking about? What should be done to avoid doing that, in the spirit of calculated risk?
Simon Hills: There is a theoretical possibility that, if a number of challenger banks pursued the same strategy that could be seen as riskier, they could collectively cause a risk. Thinking about the limit of £25 billion, if half a dozen challenger banks with total assets of £150 billion pursued an overly risky strategy, £150 billion out of £10 trillion of assets is not a large amount, but we would not want to see £150 billion worth of bank assets fail. That is why we have a judgment-based regulator that can understand what is going on in the market through its thematic reviews and start to raise a red flag, as we have seen it do in the past.
Rushanara Ali: Let us put it hypothetically. We have just seen something from the Chancellor, who is keen on deregulation, if I have understood his comments correctly.
Chair: The current Chancellor.
Q51 Rushanara Ali: Yes. Let us say there is more of an appetite for deregulation. Picking up on some of the points you have made, what would be the way—to coin a term—to have your cake and eat it and get the balance right? On the one hand you are dealing with problems that challenger banks are finding, where there is more competition. That is a throwback from the financial crisis where the big banks did not have much competition. How do you try to square that, so that there is protection against what we have seen in the past?
Simon Hills: It is down to having a well-resourced, competent regulator. Our regulatory system is much admired around the world, with a regulator and set of supervisors that can raise a red flag and say, “This has gone too far. You might be able to do this in the rulebook, but let’s have a further discussion about this and whether that is the right approach to a particular asset class.”
Q52 Rushanara Ali: Do you share this view? I sense not. The PRA has said it does not want to reduce the safety and soundness of firms through the strong and simple framework, but does want to reduce complexity. Is reducing reporting requirements without reducing total capital requirements the best way to achieve this? We have talked a bit about capital requirements, but do you share that perspective?
Robin Fieth: It is an element. I would not say it is necessarily the best way to achieve it. We have been talking a lot about capital this afternoon. An example that is often given is that, if you take a 40% loan-to-value mortgage from one of the major banks on IRB, compared with the code‑standardised weighting that is required under the Basel standardised method, the standardised bank could be putting five times as much capital against the same mortgage as a bank would. There are definitely issues around capital. There are also issues around reporting.
There is another interesting aspect. There have been many talks over the years by the Bank of England and others about the real importance of governance. We can focus as much as we like on capital; that is one of the key things, but you could argue that, in the global banking crisis, too much was caused by boards not holding their executives to account or by strategies not being absolutely clear and sustainable.
There is a much bigger picture there. When people ask us, “What about all the small building societies?”, we are very clear that, if they understand their purpose and they have a good strategy, a good board and a good management team, then they will survive, succeed and thrive. That is really important.
Q53 Rushanara Ali: Does the senior managers regime address that? Does it go far enough or do we need something more?
Robin Fieth: The senior managers regime is part of the framework, but what is so important, from years of experience as a board member in all sorts of businesses, is actually that real view of what board effectiveness looks like, what a properly balanced board looks like, and how you hold a strong chief executive to account. That is less about who is to blame if one thing goes wrong, which is more where the senior managers regime is. It is more about that overall effectiveness of the governance framework.
Simon Hills: It is about recognising that non-executive directors on boards are there to challenge the executive, as Robin was saying. Those expectations are set as part of the individual accountability regime.
Q54 Rushanara Ali: Do any of you think that we have got there yet when it comes to governance?
Robin Fieth: I would suggest that, if you ever think you have got there, you start failing.
Q55 Rushanara Ali: How far off are we?
Robin Fieth: It is not a question of how far off we are. No matter how good you think the governance of your organisation is, the minute you stop trying to improve it, it will go off the boil and start failing.
Q56 Rushanara Ali: Have you observed any tensions between personal benefit and decision-making, if you are on the board and you stand to financially gain? Are there issues around those sorts of things?
Nick Lee: I personally have not. I have been a supervisor, through the period of change that we talked about, and I am now on the other side of the fence. I agree with Robin. You can never reach the end on good governance, but the standards that I saw in my time as a regulator and the standards I see now are totally different. Certainly in our organisation, there is nobody there thinking, “Well, what could an exit look like?” It is about the viability, sustainability and long-term growth of the business. Our interests and the bank’s interest should be aligned with the regulator’s interests as well. If we have alignment on both sides, that is hopefully how we would achieve a good, growing bank.
On the supervisory side, to my comments before on the scaling bank unit, what is really important is that, as banks grow—and we are one of these growing banks—there are more risks that come for a growing bank than a bank or a building society that is of a stable balance sheet size. It is important that you then bring the right regulatory resource in to look at those scaling banks in order to minimise the probability of any problems further down the track. The issue and the challenge the PRA has is the ability to provide that additional resource, but we would champion that it should have that resource and be able to form that unit.
Q57 Rushanara Ali: How are you making those arguments? Is it the benefit to the economy argument that you are making in terms of that investment?
Nick Lee: Yes, absolutely, the benefits to the economy of us hopefully being able to be more innovative than the established banks and to get lending to growth SMEs—Aldermore and other members. There are absolute benefits. No regulator wants a failing bank.
Q58 Rushanara Ali: Are there examples where challenger banks have been found wanting and that has made the regulators more cautious?
Nick Lee: I suspect there are. I am sure there are probably examples that have happened since I have left.
Rushanara Ali: We know plenty for the other sector—the larger banks.
Nick Lee: Yes, the financial crisis was big banks.
Rushanara Ali: This is a relatively new area, so it would just be interesting to know if there have been any major concerns.
Nick Lee: You would probably have to ask the PRA to come in, but I suspect there have been examples of where they have worked incredibly hard behind the scenes—it never comes out in the press—on trying to find a buyer and selling assets of a bank, to make sure that all appears calm on the surface. We used to say it was like a swan: calm on the surface but paddling like mad beneath. That is sometimes what happens in the regulatory world, absolutely. There is no issue with that, as long as there is no impact on financial stability.
Simon Hills: A simpler firm regime may allow the PRA to redeploy some of its regulators, who would otherwise spend quite a lot of time looking at these smaller, less systemically important banks, to looking at more systemically important banks.
Q59 Rushanara Ali: After the financial crisis, the whole idea of “too big to fail” was of such a big concern that many steps have been taken since then. Within that thinking, the need for challenger banks and more competition was very much a live one. Since the various reforms have been made and there is more confidence that banks are no longer too big to fail because of the changes that have been made, is there a sense that there is no need for challenger banks? I am being provocative with this; bear with me. Does that then have a hindrance on the priorities that you feel need to be given to enable challenger banks to grow and thrive in the way that you are describing, without putting the system at risk?
Nick Lee: In my time at the PRA, there was definitely a focus on allowing new entrants to join. I am conflicted here a little bit, but it was quite successful. The UK is probably the best place in the world to set up a new bank. It certainly was over the last few years. Unfortunately, it is not the best place in the world to scale a bank, and that is the key challenge.
Rushanara Ali: You can say that about quite a few things.
Nick Lee: Yes, you can. That is the key challenge, both in banking and in the fintech space, where we are as well.
Heidi Jenvey: I can talk from previous experience. Going through a banking licence application and then trying to scale up that bank is very, very challenging. Each time you get bigger, you will find there is a new set of rules and regulations that you need to adopt. If you get any diversity, it can then increase the complexity.
One thing that was very evident from a previous life was when the regulatory burden of Basel 3 came into being. Previous to that, the FSA reporting requirements were fairly streamlined and easy to manage as a small bank, but when COREP and FINREP regulatory reporting came in, you needed the proper IT infrastructure and the database to support that. That was a much, much higher fixed cost for a small bank.
To your earlier question about whether that could be looked at, the simpler firm regime could definitely have a better, more tailored set of reporting requirements that would be easier for a smaller bank. I do not think you would necessarily lose some of the benefit of having very detailed reporting. A smaller banks with a fairly mono product line probably would not have the full suite of reports even populated, yet it would still have to have the infrastructure to produce those reports. There is definitely something that could be done in that regard.
Q60 Rushanara Ali: I have a couple of final points. One is around the innovation that we are seeing in the big banks as well. They are seeing some of the innovation going on elsewhere and looking at absorbing that quite quickly. What do you think now is the value added for challenger banks and so on? While we are thinking about all of this, do you think there is a space for looking at what can be done to enable the banking sector to do more to bank the unbanked?
Robin Fieth: There is a very important precedent here. If you go back to the financial crisis and the aftermath, the major banks, which are also the major mortgage lenders, essentially spent three or four years shrinking their balance sheets. The building societies, which lend only on mortgages, in that period were taking on average around 70% of the mortgage market, against a natural market share at that time of about 18%. In that period, they grew their market share from 18% to 23%.
There was no equivalent in the SME market. When we are thinking about business lending and the levelling-up agenda, I am supporting the challenger banks here. It is not just the unbanked citizens; it is unbanked businesses. Coming back to the point we were talking about earlier, about a properly diverse and competitive UK banking market, not one that is dominated by a few large players, there is a real opportunity and a real need. The minute we start thinking that they are not too big to fail, we get back into that area of risk.
There are questions about ringfencing and the vexed subject of MREL. At what level in an organisation do you hold the bail‑in capital? That is quite important from the point of view of that systemic resilience. You will hear all sorts of arguments for and against it, because there are all sorts of vested interests for and against it, but it is worth thinking about.
There was a question asked at an event in the House just after the financial crisis. At that point, every bank’s individual risk management programmes might have looked quite sensible, but no one was looking at the systemic risk in the whole market. That is what we have to be really conscious of.
Nick Lee: In its 2019 report, the Bank of England highlighted a £20 billion‑plus gap in SME lending in the UK. There is a gap there; it continues to exist. We are trying to help bridge that gap, along with others that are coming in. That is why that door needs to be kept open to new entrants and to innovators—people coming in with new ideas about how to crack some of these problems, whether it is lending to SMEs or banking the unbanked. There are technological solutions to these problems. We need to create an environment where those ideas can thrive, bringing in the entrepreneurs with those ideas so that they can start businesses, start banks in the UK, and grow and scale those banks.
Q61 Rushanara Ali: Do you think the bigger, more powerful, influential banks have muscled in and have more power in influencing the thinking in Government as part of this review, or do you feel that smaller players have a strong enough voice in these discussions?
Simon Hills: If I can talk to the way that we have engaged with members as we have been thinking about this topic, yes, there has been interest from larger firms, but the vast majority of intellectual thought around this has come from smaller and mid‑sized banks like Nick’s and Heidi’s, as well as building societies, which are members of UK Finance. I have had no sense at all that the larger banks are seeking to damp down competition from below.
Q62 Chair: Just before we finish, Heidi, I was considering what you were saying about how difficult it is to go through the permissions you need to set up a challenger bank. I know that regime is difficult. I was thinking about Greensill Bank and its spectacular failure earlier on. They did not actually go through that process, as far as I remember. They used an appointed representative—somebody who was already given pre‑approval to go through the regime. Do you think that that is a lacuna in all of this and we ought to be quite worried about having a regime in which it is very difficult, understandably, to set up new challenger banks, while we allow the use of appointed representatives to set up a thing like Greensill, which failed so spectacularly and lost a lot of people a lot of money?
Simon Hills: That is a valid question. You are essentially asking about the regulatory perimeter and where that should be set.
Chair: I am, yes. This is the FCA rather than the PRA, of course.
Simon Hills: Where the regulatory perimeter is set is a matter for us all to be concerned about and, as Parliament challenges our regulators—the PRA and the FCA—it would be a valid question to ask.
Q63 Anthony Browne: If the regulator allowed you to fail, what changes do you think would be needed? I have not read it all, but in your evidence to us I think you said that you would need to change the Financial Services Compensation Scheme in one way. I was just looking at their website. They have overseen 28 failed institutions so far this year, none of which is a bank. What changes are needed to give the PRA confidence that people will not lose out if a challenger bank fails?
Nick Lee: It comes down to the capacity that the FSCS has to pay out without having to ask Treasury for funding. Apologies, I do not know the exact number, but it used to be somewhere in the £1 billion to £2 billion space. If you look at MREL, as I understood it, part of the Bank of England’s perspective on not raising MREL was that there was limited capacity in the FSCS and, therefore, you could not absorb a bigger failure. Let’s hope it never comes to that, but there must be a way of looking at the capacity of FSCS. Looking at the cost of holding MREL, particularly for smaller banks, it would probably make more sense and be cheaper if you looked at the funding of the FSCS—
Anthony Browne: Do it on an industry‑wide basis, rather than each individual bank.
Nick Lee: Completely. If we are honest, it tends to be the hedge funds of Mayfair that are in the MREL space for smaller banks, and they charge a pretty staggering rate for that MREL. Our argument is that it is probably always better to turn that funding to the FSCS in order to grow that FSCS pool, and therefore push up the MREL criteria or maybe even a strong and simple, so you have a stronger compensation regime.
Simon Hills: However, you still see the largest banks funding the majority of the compensation schemes. There is a tension there between different sectors in the market.
Q64 Kevin Hollinrake: So you want to go to a pre‑funded scheme.
Nick Lee: There could be some really innovative thinking in looking at what is done in other countries and what could be best for the UK. I am not suggesting it should be one model or the other.
Q65 Kevin Hollinrake: That is what they do in the States, basically.
Nick Lee: Yes. The FDIC in the States had a pool set up post the 1930s depression. As somebody said, they had 10 to 20 banking failures every year. It is a different scheme; it may not be suitable for the UK.
Chair: It is a different structure. The US banking structure is much more regionalised and localised, as is the German, than we have ever had, certainly in modern times. We must not try to fit a model to a current regime that does not recognise the shape we are, even if we wish to grow more challenger banks.
Kevin Hollinrake: Nick, you were going to say something on Greensill.
Nick Lee: I was only going to add that often the competition we face in the SME space is not from bank funders. It will be from what was a Greensill or something of that ilk.
Chair: It said it was innovative.
Nick Lee: They have to be innovative in the right way, absolutely. The rules around those non‑bank funders are very different from the rules around bank funders, for good reason. We rightly carry the cost of capital that they do not have to carry, so they can take market share, but they are in a regime that is much laxer, if I can use that term.
Chair: Hence it is inherently riskier, although that does not always come across in the way it markets itself. Well, thank you very much for your evidence. You have made very technical things seem fantastically interesting. I hope that, this being our first session of the Treasury Sub‑Committee on Financial Services Regulations, where you have gone others will follow, and it will get more and more interesting, the more we do it. Thank you very much.