Monday, October 15, 2012

UK Government Submits to Parliament Sweeping Reform Legislation Ring-Fencing Commercial from Investment Banking

The UK Government has submitted to Parliament landmark and sweeping legislation to ring-fence retail commercial, deposit-taking banking from investment banking. The legislation would also introduce a resolution buffer to ensure that systemically important banks have sufficient loss absorbing capacity to mitigate the impact of any remaining barriers to their resolvability. The bill has been referred for review to the Parliamentary Commission on Banking Standards, which will report on the legislation by December 18, 2012.

In the main, the legislation is intended to implement the recommendations of the UK Independent Commission on Banking, the Vickers Commission, which proposed a sweeping structural change for organizations engaged in commercial banking. In essence, within a single organization the range of ordinary banking operations, such as deposit taking, lending, and payments, would be segregated in a retail bank, which would be overseen by its own independent board of directors and ring-fenced to greatly reduce relations with the rest of the organization. While proprietary trading and investments in hedge funds would not be prohibited, these activities would be outside the ring-fence and thus isolated from retail banking.

The Government believes that accepting deposits from individuals and small and medium-sized enterprises should be a core activity of ring-fenced banks. This means that, under the legislation, the only UK banks which will be able to undertake this activity will be ring-fenced banks, and banks which have been exempted from the definition of a ring-fenced bank, such as building societies.

The draft prohibits ring-fenced banks from undertaking certain excluded activities and will grant Treasury the power to designate an activity as an excluded activity. The Treasury has broad power to exclude activities, and most will be detailed in secondary legislation. However, the draft provides that dealing in investments as principal is an excluded activity, which would exclude most of the derivatives and trading activities currently undertaken by wholesale and investment banks.

There may be circumstances in which it may be necessary or desirable to permit a ring-fenced bank to undertake an excluded activity. So the draft gives the Treasury flexibility in this area. For example, ring-fenced banks could be permitted to provide some risk management products to customers provided that they did not require the bank to hold capital against market risk, give rise to trading book treatment, or did not threaten resolvability.

There is concern that a total ban on investment products would mean ring-fenced banks would not be able to provide clients with important hedging and risk management services. The Chancellor has specifically asked the Parliamentary Commission to look specifically at the question of whether ring-fenced banks should be able to offer simple derivatives to their customers and provide its views to Government in the December 18 report. Following receipt of the Commission’s advice, the Government, as with other matters, will consider the implications for subsequent secondary legislation.

The draft requires regulations ensuring that the ring-fenced bank is able to act independently of the rest of its group while carrying on its business. In relation to ring-fenced banks that are members of a group, it specifies the areas in which rules should be made, including holding shares in other corporate entities, entering into contracts with other members of the group, governance of the ring-fenced bank, restricting payments that a ring-fenced bank may make to other members of the group and disclosure. These provisions do not limit regulators’ power to, but rather are designed to ensure that a ring-fenced bank interacts with the rest of its group on a third party basis, and that it remains legally, economically and operationally independent.

The draft Bill provides for a continuity objective for regulators that will give them a duty, when dealing with matters related to ring-fencing, to protect the uninterrupted provision of vital and core banking services. The draft sets out how the regulators are required to advance this objective. The objective means that, for example, the new Prudential Regulatory Authority should take steps to ensure that ring-fenced banks are insulated from shocks that could cause a disruption to the continuity of core services, but also that, in the event of failure, either of a ring-fenced bank, or another part of its group, those core services can be maintained.

This does not mean that there should be a zero failure regime for ring-fenced banks, assured the Government. On the contrary, ring-fenced banks should be allowed to fail, but in an orderly way, with the use of special resolution tools by the authorities where necessary. Ring-fencing will make it easier for the authorities to let them fail, as it will ensure that the core services being provided can be separated and can continue to operate independently from the rest of the group. For example, said the Government, the best resolution approach for a failing banking group containing a ring-fenced bank may be a private sector sale of part or all of the core services, thereby maintaining continuity for depositors, while allowing the rest of the bank to go through an orderly administration process.

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