Written evidence submitted by Vicky Saporta

Following my appearance before the Committee on Feb 21, you wrote to me requesting additional information to follow up various points of discussion during the session. Please find the answers to the questions you asked below.

1)     When he gave evidence to the Committee in October, Nigel Terrington, the CEO of Paragon Banking Group, suggested that the £1.5 billion annual cap on the money that the FSCS can reclaim through the banking system was “probably requested by the PRA, to ensure that there is no contagion risk that runs to the banking sector as a whole.” What role did the Prudential Regulation Authority (PRA) have in the setting of the annual cap and, if the PRA played a role, what was the reasoning for your position? [Q564]

A PRA rule sets the maximum annual amount, or threshold, of compensation cost levies for the deposits class at £1.5bn. This threshold was set, following a public consultation by the Financial Services Authority based on modelling carried out on the impact of different potential thresholds, to reduce the contagion risk within the banking sector as a whole but it was not designed to eliminate the risk to individual firms completely. It aimed to strike an appropriate balance between affordability to firms and potential FSCS funding needs.

If there is likely to be a deposit-taker failure, and prior to the FSCS pursuing a levy on the deposit-taking class (even for an amount less than the annual cap), the PRA will make a determination whether the levy would have a significant effect on the market, a particular sector, or individual firms.  If the PRA’s determination is such that FSCS is unable to levy to meet its liabilities, the FSCS can instead approach HM Treasury to borrow from the National Loans Fund.  This loan would then be repaid by recoveries and levies over time.

In case useful I have included recent information that the Bank of England published on how an FSCS pay-out for the deposits class is funded:

How is an FSCS payout funded?

If a firm fails and enters an insolvency procedure (because, for example, it does not meet the public interest test for entry into the special resolution regime) the FSCS may effect a payout of eligible deposits.

The FSCS will seek to recoup costs from the rest of the banking industry through levies. Levies on the deposit-taking sector are currently limited to a maximum of £1.5bn per year set by PRA rules, and the actual amount of levies are set by the FSCS annually based on the FSCS’s estimate of any compensation costs (taking into account likely recoveries) for that year. It also has access to a commercial borrowing facility of up to £1.5bn.

The FSCS may also under certain circumstances request from HM Treasury a loan from the National Loans Fund, such as if the demands on the FSCS exceed the amount of financial resources immediately available to it. Any such loan (and any interest on that loan) would then be repaid from levies on the industry and available recoveries from the failed firm.

The FSCS will ultimately seek to recover the costs incurred in a depositor payout from the insolvent estate of the firm concerned – a process which could take several years to complete. However, because the FSCS is a “super-preferred” creditor, it is amongst the first in line entitled to make recoveries.” (Source: The Bank of England’s review of its approach to setting a minimum requirement for own funds and eligible liabilities (MREL), December 2021)

2)     Nigel Terrington also suggested to us that if there was a movement to a pre-funded scheme for the FSCS, it would allow for a lower MREL threshold and, as a result, mid-tier banks would be able to lend more to SMEs. Would that be the case? We would welcome your thoughts on whether a pre-funded Financial Services Compensation Scheme (FSCS) scheme might allow a reduction in MREL thresholds. For example, would a pre-funded scheme reduce the risk to public funds presented by a mid-tier bank failure? [Q570-571, see also Q337-339 in previous oral evidence session]

The Bank of England, as resolution authority, recently published information about the FSCS funding model and the links to the MREL policy in its December 2021 Policy Statement ‘The Bank of England’s review of its approach to setting a minimum requirement for own funds and eligible liabilities (MREL)’.  Below I have set out the exact text that relates to this issue.  In short, the Bank of England, as resolution authority, does not believe that a movement to a pre-funded scheme will materially alter its judgement on the MREL threshold.  This is because such a move is unlikely to change the losses incurred by uncovered depositors or the continuity of banking and critical services. 

Would changing the FSCS funding model enable a change to MREL policy?

The FSCS is the UK’s deposit guarantee scheme. It is currently funded in the main by annual levies on the banking industry. Some respondents to the CP suggested the FSCS could be ‘pre-funded’, as a better way to protect public funds in the event of a bank or building society insolvency. That is, levy-payers would be required to make a contribution to a centrally managed fund that would be built up to a certain level over a number of years and then replenished as necessary. In this way, the potential demand from the FSCS for an unexpected high levy or a loan from the National Loans Fund could be reduced. The Bank has considered these suggestions in finalising its revised MREL policy.

Pre-funding the FSCS would require legal changes and, given HM Treasury is responsible for designing the statutory framework within which the FSCS operates, this would be a matter for HM Treasury to consider. However, the Bank considers that – taking account of all factors relevant to determining the resolution strategy of a firm, including its special resolution objectives it is unlikely that introduction of pre-funding for the FSCS would materially alter the Bank’s judgment on which firms need to have a stabilisation powers resolution strategy and, therefore, be set an MREL in excess of minimum capital requirements.

Pre-funding, whatever its size, would not change the exposure of uncovered or ineligible depositors to loss in the event of a bank or building society failure, or enable banking services and critical functions to continue through insolvency. Compared to a stabilisation power resolution strategy, it would also not provide enhanced mitigation against potential contagion and instability within the financial sector or guard against a potential loss in confidence in bank deposits resulting from a bank insolvency.

Pre-funding might reduce risks to public funds but, in practice, these risks would not be eliminated in the event of a bank insolvency. Any pre-fund of material size would take a considerable amount of time to build up, and may not – even once its target level is reached – be sufficient to fully cover the pay out of all of a mid-tier firm’s eligible deposits.

Importantly, the advance contributions to the pre-fund would reduce levy-payers’ retained earnings, and therefore capital (all else equal). This means that there would be less capital to support lending to the real economy and to absorb losses, potentially reducing banking sector resilience. Particularly in the years that the fund is being built up, there would be increased burden on levy-payers: depending on how the levies were allocated, this could be a barrier to entry or growth within the sector. The fund would also require professional management, which would come at a cost.

The Bank has not considered the pre-funding suggestion beyond its impact on the firms and issues considered in the MREL Review, and the drawbacks identified do not necessarily apply to alternative potential models of FSCS funding.” (Source: The Bank of England’s review of its approach to setting a minimum requirement for own funds and eligible liabilities (MREL), December 2021)

3)     Please can you set out what work the PRA has done in relation to the poverty premium for insurance products, including addressing any market failures, and what work you are planning to do.

The question is related to the position in favour of financial inclusion measures, broadly defined as aiming to ensure that the whole population across the country has access to affordable insurance or banking services such as cash.

However, these type of interventions relate mainly to conduct rather than to prudential requirements. A financial inclusion have regard would not broaden the PRA’s considerations, but rather encourage lower safety and soundness standards. This is because the calibration of efficient and proportionate prudential requirements must be based on risk considerations regardless of the background of the customers involved so as to ensure the PRA’s primary objectives of safety and soundness and policyholder protection to set lower corresponding requirements in order to induce firms to reduce premiums.

As a result of these considerations, the PRA hasn’t done work in relation to the poverty premium for insurance products.

4)     Please can you set out what work the PRA has done to address market failures in relation to access to cash, including the impact of bank branch closures, and what work you are planning to do.

As the sole issuer of banknotes in England and Wales, the Bank’s responsibility is to meet the public’s demand for banknotes. It has always met that demand and will continue to do so.

The Bank’s primary responsibilities in the cash system relate to the supply and wholesale distribution of banknotes. The Bank has therefore been working with relevant industry participants as part of the Wholesale Distribution Steering Group (WDSG) to ensure that wholesale cash infrastructure continues to support the effective retail provision of cash. The WDSG has agreed a set of industry-wide commitments to support continued access to cash. To underpin this the Bank has asked industry participants to bring forward by the end of Q1 2022 individual, measureable commitments with a set of key indicators and criteria that they are willing to be held accountable for. To help support this, HMT will provide the Bank with the powers that it needs to keep the wholesale infrastructure sustainable and resilient into the future.

The Bank and UK authorities are committed to cash and are taking action to protect it. The Bank is in regular contact with other authorities who have responsibility for retail cash access (HMT, FCA, PSR) as part of the Joint Authorities Cash Strategy Group, in order to help ensure that cash remains available and accessible for those who want to use it. This includes supporting HMT’s 2021 Consultation Paper on Access to Cash, which sought views on the government’s legislative proposals for protecting access to cash including: establishing geographic requirements for the provision of cash withdrawal and deposit facilities, the designation of firms for meeting these requirements, and establishing further regulatory oversight of cash service provision. Geographic requirements would be set on the basis of cash access facilities being available within maximum distances of a minimum percentage of the population. Designated firms will be able to use a range of facilities to provide access for the purpose of meeting the requirements. This includes using their branch networks, but also arrangements under the LINK ATM scheme and the Post Office Banking Framework for example.

At the same time, the PRA continues to monitor branch closures and discusses the evolution of branch networks and distribution channels in the context of bank and building society business models more generally. Its work has recognised the impact of changes in consumer behaviour during the pandemic and, as part of its analysis, it has gathered intelligence on planned closures by banks and building societies as part of updates to their strategic plans. The PRA liaises with the FCA on this topic, who require firms to set out how customer needs will be addressed before closures are announced.

I hope that the above information is of interest. Should you have any further questions, please do not hesitate to contact me.

Yours sincerely

Vicky Saporta

March 2022