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Banking

Government sets out plans to reform the structure of banking in the UK

The Government is today publishing its response to the report by the Independent Commission on Banking (ICB), which sets out plans to fundamentally reform the structure of banking in the UK.

This response agrees with the ICB’s recommendations and outlines how the Government will legislate to create a stable banking sector that supports lending to businesses and families, and removes the implicit taxpayer guarantee in the event of a bank failure.

The Government will implement the ICB’s advice in stages with the full package of reforms completed by 2019.  All necessary legislation will therefore be put in place by the end of this Parliament. The Government will publish a White Paper in spring 2012 setting out further detail on how the recommendations will be implemented; in advance of that, the Government is open to views on how to implement these plans.

The Chancellor of the Exchequer, the Rt Hon George Osborne, said:

“The Independent Commission on Banking was set up last year to look at what I have called the ‘British Dilemma’: how Britain can be home to one of the world’s leading financial centres without exposing British taxpayers to the massive costs of those banks failing.
The Government is preparing the most far reaching reforms of British banking in our modern history – our objective is to make sure what happened in Britain never happens again.”

The Secretary of State for Business, Innovation and Skills, the Rt Hon Dr Vince Cable, said:

“Sir John Vickers has produced a comprehensive plan to give the UK a more stable banking system that removes the implicit taxpayer subsidy.  We will take forward a full programme of reform with legislation in place to implement the ring-fence by 2015.

“The potential costs of an unsafe banking system are clear to everyone. Our reforms will protect taxpayers from the riskier aspects of banking and boost competition without harming the ability of UK banks to lend, to invest and to compete.”

Background
1. On 16 June 2010, the Chancellor of the Exchequer and the Secretary of State for Business announced the creation of the ICB, to be chaired by Sir John Vickers. The Commission was asked to consider structural and related non-structural reforms to the UK banking sector to promote financial stability and competition, and to make recommendations to the Government by the end of September 2011.
2. The ICB published its report on 12 September 2011, which can be found on the ICB website
3. In welcoming the report, the Government committed to responding by the end of 2011.  View the Government’s response.
4. Today’s response is open for comments until March 2012.

Executive Summary

In its final report the Independent Commission on Banking (ICB) made recommendations to promote financial stability and competition in UK banking. It recommended that its reforms be implemented no later than the start of 2019.

Financial stability

On financial stability, the ICB identified three key objectives:

  • make banks better able to absorb losses;
  • make it easier and less costly to sort out banks that still get into trouble; and
  • curb incentives for excessive risk-taking.

The ICB recommended a package of measures, consisting of ring-fencing vital banking services and increasing banks’ loss-absorbency, to achieve these objectives. The Government strongly supports these objectives and this dual approach.

Ring-fencing

On structural reform, the ICB recommended ring-fencing vital banking services on which households and SMEs depend, keeping them separate from wholesale and investment banking activities. This would more effectively insulate them from problems elsewhere in the (global) financial system and make banks easier to resolve without taxpayer support. It would also curtail implicit government guarantees, reducing the risk to the public finances and making it less likely that banks will run excessive risks in the first place.

Improving resolvability of banks through structural reform is in keeping with international initiatives to make it easier to deal with failing banks. Structural complexity has been identified by the Financial Stability Board (FSB) as one of the most important barriers to successful bank resolution.  And a consultation document on a possible EU framework for bank recovery and resolution, published by the European Commission earlier this year , contemplated changes being required to the structure of financial institutions, so as to reduce complexity in order to allow critical functions to be separated off in resolution.

The Government agrees with the ICB’s recommendation that vital banking services – in particular, the taking of retail deposits – should only be provided by ‘ring-fenced banks’, and that these banks should be prohibited from undertaking certain investment banking activities. The Government agrees that structural reform of the banking sector is needed and supports the proposal for the creation of a ring-fence around vital banking services.

The ICB set out a number of principles on which the ring-fence should be based. For example the fence should be flexible in location but of sufficient height to ensure effective legal, operational and economic separation between entities. The Government supports all these principles. Specifically, the Government intends that:

  • There be a set of mandated services within ring-fenced banks consisting of retail and SME deposits and overdrafts;
  • A set of wholesale and investment banking services should be prohibited from the ring-fenced bank in order to meet the objectives of the policy;
  • The ring-fenced bank should be allowed to conduct ancillary activities to support the provision of its core functions;
  • The ring-fenced bank should be legally and operationally independent from the rest of its corporate group; and
  • Economically the ring-fenced bank should not be dependent for its liquidity and solvency on the financial health of the rest of its group.

The ICB set out some further details to support these principles. For example ring-fenced banks should be regulated for capital and liquidity purposes on a solo basis, should not be over-reliant on the rest of the corporate group for funding and should undertake transactions with the rest of the group on a third party basis. There is further detailed work to be done to translate the principles into practice. More details on the ICB’s recommendations on structural reform, and the Government’s plans for taking them forward, are set out in Chapter 2. The ICB recognised that the case for de minimis exemptions to the ring-fence restrictions was finely balanced, but was not persuaded at the time. The Government’s view is that there is a case for reviewing whether a de minimis exemption should apply.

Loss-absorbency

On increased loss-absorbency, the ICB recommended higher equity requirements for large ring-fenced banks, a minimum leverage ratio, loss-absorbing debt, insured depositor preference and higher levels of loss-absorbing capacity for banks that are difficult to resolve.

Many of these recommendations also fall within the range of measures contemplated by internationally agreed reforms. The Basel III rules clearly set minimum, not maximum, standards for equity and leverage ratios. The FSB’s standards on resolution regimes require national jurisdictions to make debt loss-absorbing in resolution (‘bail-in’). And the European
Commission’s consultation document on a framework for bank recovery and resolution contemplates both bail-in and requiring institutions that are hard to resolve to hold more loss-absorbing debt.

The Government supports the ICB’s recommendations on loss-absorbency and sees these non-structural reforms as an important complement to ring-fencing in making banks better able to absorb losses, easier to resolve if they do fail, and in curbing excessive risk-taking. In particular:

  • the Government intends to introduce higher equity requirements for large ring-fenced banks, and will seek sufficient flexibility in forthcoming European legislation to do so in the interests of UK and European financial stability;
  • the Government strongly supports a mandatory, minimum leverage ratio for all banks, as recommended by the ICB, and believes there may be a case for applying a higher minimum leverage ratio to some larger banks;
  • the Government agrees that the resolution authorities should have a statutory bail-in power to assist in bank resolution. The Government will seek to ensure agreement on including a robust bail-in power in the European crisis management framework;
  • the Government supports the principle that systemically important banks hold a minimum amount of loss-absorbing capacity on a group-wide basis. However, if a bank can show that its non-UK operations do not pose a risk to UK financial stability and thus to the UK taxpayer, this requirement should not apply to those operations;
  • on balance, the Government supports depositor preference, but believes that further analysis and consultation is needed on the scope of its application; andthe Government is of the view that supervisors should be able to require firms that are difficult to resolve to have additional loss-absorbing capacity.

More details on the ICB’s recommendations on loss-absorbency, and the Government’s response, are set out in Chapter 3 below.

The ICB’s financial stability recommendations have a clear focus on preserving the continuous provision of vital banking services located in the ring-fenced banks. However, it is important to draw a distinction between protecting the provision of critical services by ring-fenced banks, and protecting investors. Requiring ring-fenced banks to have more loss-absorbing capacity will ensure that the continuous provision of banking activities can be maintained, if necessary by imposing losses on investors – including creditors – not by guaranteeing them. The Government’s view is that all banks should be subject to normal competitive market forces, which means they must be able to fail safely without relying on a government guarantee and without putting the provision of critical services at risk.

The ICB’s proposals – by curbing incentives for excessive risk-taking, reducing the exposure of ring-fenced banks to the financial system and requiring non-ring-fenced banks to hold higher levels of loss-absorbing capacity – will also increase the resilience, and resolvability, of non-ringfenced banks. This is crucial. But in order to be effective, this will require the introduction of a resolution regime for all non-ring-fenced banks, including any that may not be covered by the Special Resolution Regime. The Government believes that all banks – including non-ring-fenced banks – need to be resolvable without the use of state resources, and believes the ICB’s proposals are an important step forward. But they should be complemented by the introduction of a resolution regime that covers investment firms and financial holding companies. This is discussed in Box 1.A.

Competition

On competition, the ICB made recommendations:

  • to improve prospects for a strong and effective challenger to come out of the Lloyds divestiture;
  • to mitigate barriers to entry and anti-competitive prudential requirements;
  • to improve switching;
  • to enhance transparency;
  • to secure pro-competitive financial regulation; and
  • on a possible future market investigation reference to the competition authorities.

The Government strongly supports all these objectives. A competitive banking sector is vital to ensure that the UK economy can benefit from banking products and services at efficient prices. Effective competition is also a spur to innovation and economic growth, and can lead to better quality and service for consumers. The emergence of a strong and effective challenger bank from the Lloyds divestiture – that would exert real, competitive pressure on the big banks – would be good for competition. A regulatory focus on improving competition is also consistent with strengthening the European single market – indeed the European Banking Authority and other European supervisory authorities are required to contribute to promoting “equal conditions of competition”.

The ICB’s recommendations on financial stability will also help to address competition concerns in financial services, and complement the competition recommendations. As the ICB noted in its final report, financial stability recommendations that eliminate the implicit government guarantee are themselves pro-competitive. Where banks are regarded as ‘too big to fail’, market participants – in particular debt investors – will contract with them on more favourable terms than with smaller banks, distorting competition. Therefore measures to tackle the implicit government guarantee will help to remove distortions in the European single market.

Going beyond the ICB’s recommendations, the Treasury Select Committee has called for the Payments Council, a private sector body responsible for setting the strategy for retail payment systems in the UK, to be brought within the scope of regulation. The Government supports this, and will consult in the New Year on options for enhancing the regulatory framework for payment systems.

More details on the ICB’s recommendations on competition, and the Government’s response, are set out in Chapter 4 below.

Economic impact and competitiveness

The ICB estimated that its package of recommendations would cost the banks £4bn-£7bn a year. The ICB said this could have a knock-on cost to GDP of around £1bn-£3bn a year, but this should be set against the benefits of reducing the annualised cost of financial crises of up to £40bn a year.

The ICB noted that the impact on the Government’s fiscal position of the reform package would be complex but should be strongly positive. However, the ICB did not attempt to quantify this. On competitiveness, the ICB noted that its recommendations would only affect around 15% of the banking institutions in the City and would not affect insurance companies, fund management firms etc. By improving financial stability the recommendations would in fact be likely to increase the attractiveness of the UK as a place to do both financial and non-financial business.

The Government has conducted its own economic impact analysis, informed by modelling exercises carried out by the major UK banks. On the basis of this work, the Government has concluded that while the ICB’s estimates do not capture the full range of costs, the measures that the ICB recommended will deliver net benefits to the UK economy and the taxpayer.

The Government estimates the aggregate private costs to UK banks at £3.5bn-£8bn. These additional bank costs are estimated to produce a gross reduction in GDP of £0.8bn-£1.8bn, somewhat lower than the ICB’s estimate. Against these costs should be set the potentially much larger benefits to the economy from increased financial stability. Based on the ICB’s estimate of the annual cost to the economy of financial crises, even if other regulatory reforms reduced the probability of a financial crisis by 30%, and the ICB’s recommendations reduced the probability of a crisis by only a further 10%, and the output loss caused by a crisis by 25%, the ICB’s recommendations would yield an incremental economic benefit of £9.5bn per annum. The Government therefore believes that the economic benefits of implementing the ICB’s recommendations would significantly outweigh the costs and will deliver significant net benefits to the economy and the public finances.

On competitiveness, the Government is committed to ensuring that the UK continues to be at the heart of the international banking and finance sector. This is best achieved by establishing a stable financial system in the UK, not by providing implicit taxpayer subsidies to a small proportion of the financial institutions that constitute the City.

More detail on these issues, including the Government’s own preliminary analysis of the economic impact and competitive effects of the ICB’s recommendations, is set out in Chapter 5.

Implementation

The ICB said that its recommendations should be fully in force by no later than the start of 2019, consistent with the deadline for implementation of the Basel III reforms agreed by G20 leaders. The Government’s intention is that implementation should proceed in stages with the final, non structural, changes related to loss absorbency fully completed by the beginning of 2019. Primary and secondary legislation related to the ring fence will be completed by the end of this Parliament in May 2015 and banks will be expected to be compliant as soon as practically possible thereafter. The Government will work with the banks to develop a reasonable transition timetable.

This response sets out the Government’s initial views on the ICB’s principal recommendations. The Government will bring forward a White Paper in Spring 2012 which will set out detailed proposals on the ICB’s recommendations, and launch a consultation.

Implementation of the recommendations will strengthen the European single market, as one of the biggest distortions to this market is the perceived implicit government guarantees. The ICB’s recommendations represent the UK’s contribution to removing these distortions. The
Government will work to ensure that current EU legislation does not hinder the reforms necessary to ensure financial stability and a sound financial system.

More detail on the proposed timeline and mechanics for implementation – and their interaction with the development of relevant European legislation – is set out in Chapter 6.

This response contains a number of outstanding policy questions. The responses to these will be used to inform the detailed proposals and further consultation that will be set out in the White Paper. Details on how to respond to the policy questions are set out in Chapter 6.

Get the The UK Government response to the Independent Commission on Banking and other documents.

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