Following the publication of the Financial Services (Banking Reform) Bill (the Bill) on 4 February 2013, the Government published illustrative drafts of three statutory instruments in order to aid Parliamentary scrutiny of the Bill. Given that the Bill is primarily an enabling bill, the draft illustrative orders were intended to provide some detail on the policy underlying key areas of the Bill. The Government continued to develop these instruments in the interim and on 17 July published four statutory instruments for public consultation.
In addition to orders on ring-fenced bodies and core activities, excluded activities and prohibitions and fees and prescribed international organisations regulations, HMT and BIS also published an order on loss absorbency requirements. The consultation closes on 9 October and the Government intends to introduce the final versions of the statutory instruments into Parliament shortly after the Bill receives Royal Assent.
Ring-Fenced Bodies: core and excluded activities
The Ring-fenced Bodies and Core Activities Order (the RFB Order) defines the scope of the ring-fence, specifies which institutions will be exempt from ring-fencing and which deposits must be held within the ring-fence (‘core deposits’) and which can fall outside.
Who must ring-fence?
Article 6 of the RFB Order exempts small banks and non-bank institutions from the ring-fencing requirement. This means that the ring-fencing requirement will only apply to UK banks (or groups including UK banks) holding core deposits (as defined below) above a threshold of £25 billion. The government believes that this threshold will mean that 90% of UK retail deposits will be held in ring-fenced banks or building societies.
The following will be exempt:
credit unions; and
industrial and provident societies.
What activities (“core activities”) can only be undertaken from within the ring-fence?
The Bill states that all deposit-taking is a core activity unless exempted in secondary legislation.
What deposits can be taken inside or outside the ring-fence?
The following deposits are exempted under Article 3 of the RFB Order, and thus may be taken by a non-ring-fenced bank or a ring-fenced bank:
Large organisations: an organisation with turnover greater than £6.5 million per annum, more than 50 employees or an annual balance sheet total greater than £3.26 million. The Government has opted for a self-certification regime for large organisations that wish to bank outside the ring-fence (the original proposal in March suggested the obligation would be on the banks to certify the position). A declaration must be signed by the firm’s accountant or auditors and renewed annually. Failure to renew will result in deposits becoming “core” and being transferred into a ring-fenced bank.
High net worth individuals (HNWIs): an individual with “free and investible” total assets above £250,000. Individuals must make a signed declaration (countersigned by an accountant) stating that they wish to bank outside the ring-fence and that they have free and investible assets of £250,000. Customers must renew their statement of eligibility every two years. Failure to renew will result in deposits becoming “core” and being transferred into a ring-fenced bank.
Family members of HNWIs: a close relative (partners, parents, children or step children and, if under 18, then the partner's child or step child) of an HNWI. The eligible family member must sign and attach a signed statement from the HNWI. The family member will remain eligible as long as the HNWI’s statement of eligibility is valid.
Financial institutions: all financial institutions (including banks, investment firms, insurance companies, securitisation companies, funds, fund managers and financial holding companies) will be permitted (but not required) to deposit with non-ring-fenced banks.
My bank is under the £25 billion limit. Need I worry about core and non-core deposits?
Because the £25 billion threshold is defined by reference to core deposits, banks under the threshold will need to consider putting in place procedures to establish which of their deposits are core or non-core if they are to remain within the exemption once their aggregate deposit book exceeds £25 billion.
What can a ring-fenced bank not do?
The restrictions on ring-fenced banks’ activities appear in the Bill and in the draft FSMA 2000 (Excluded Activities and Prohibitions) Order. There are four categories of prohibited activities a ring-fenced bank cannot engage in:
dealing in investments as principal and dealing in commodities (subject to exceptions)
indirect access to inter-bank payment systems
having exposures to so-called ‘relevant financial institutions’ (RFIs)
having non-EEA branches (excepting Crown Dependency branches) and/or participating interests (shareholdings of 20% or more) in non-EEA undertakings.
The interaction between the various prohibitions, and exceptions to them, is unclear.
The prohibition captures dealing as principal in investments (as defined in the FSMA Regulated Activities Order, which itself is subject to a number of exclusions) and dealing in commodities. The exceptions are as follows:
Simple Derivatives: ring-fenced banks are permitted to sell simple derivative products to their customers. A simple derivative must:
relate to currencies, interest rates or commodities;
be structured so that the amount payable in relation to the derivative must move in direct proportion to the range in value of the risk factor it hedges;
be capable of fair valuation under IFRS 13 based on a level 1 or level 2 input.
To ensure that a ring-fenced bank does not take excessive market risk through their portfolios:
a net cap of 0.5 per cent of bank’s total own funds is proposed on the position risk that the ring-fenced bank is exposed to through the sale of derivatives; and
a ‘gross’ position risk requirement cap of 20% of the bank’s credit capital risk requirement is also proposed on the total volume of derivatives ring-fenced banks may provide to their customers. More complex risk management products would need to be sold through the non-ring-fenced bank.
Securitisation of own assets: a ring-fenced bank may transfer assets to, and buy debt instruments from, securitisation companies, provided that the securitisation vehicles concerned only hold assets acquired from the ring-fenced bank. The draft order also permits ring-fenced banks to have exposures to a conduit company (so as to avoid discrimination between different types of secured lending), provided that the conduit only exists in order to acquire assets from a single non-financial customer of the ring-fenced bank and they use these assets as security for a loan from the ring-fenced bank.
Security under loans: in connection with realising security under a loan (but not any other class of exposure), a ring-fenced bank may:
acquire common equity shares (but not other securities) from the borrower and subsequently sell those shares
deal in commodities.
Hedging (ancillary activities): a ring-fenced bank may deal in investments and/or commodities to hedge interest rates, exchange rates and commodity prices, default risk and liquidity risk. The PRA will continually monitor the way this exception is used.
Liquid assets buffer: a ring-fenced bank can deal in assets which are eligible for inclusion in the liquid assets buffer required under PRA regulation, provided the dealing does not result in an exposure to an RFI.
Inter-bank payment system
A ring-fenced bank must access inter-bank payment systems directly. Indirect access is allowed only where the bank is ineligible to participate directly or it is disproportionate for it to do so.
Exposures to RFIs
Exposures to (claims on) RFIs are prohibited subject to the following exceptions:
Hedging: a ring-fenced bank may transact with an RFI where its sole or main purpose is to hedge risk on interest rates, exchange rates, commodity prices or default risk (but not liquidity risk).
Intra-group transactions: a ring-fenced bank may have an RFI exposure (other than a short term exposure) within its group, subject to an arm's length requirement, where permitted by the PRA rules.
Short term exposures - payment services: a ring-fenced bank may offer payment services (and offer overdrafts supporting such services) to other RFIs provided the exposure to an individual RFI does not exceed 2% of the ring-fenced bank’s capital and the aggregate exposures to all financial institutions does not exceed 10% of the capital. Furthermore, no exposure can last more than five working days.
Trade finance: trade finance services (issue or confirmation of a documentary credit or a guarantee) are permitted where the following conditions are met;
the exposure is related to the supply of goods or services and the amount of the exposure is specified ex ante
exposures to any given RFI are limited to 5% of the ring-fenced bank’s capital
the transaction is documented under the UCP 600 or URDG 758
aggregate exposures are limited to 10%.
Liquidity management: A ring-fenced bank may buy, sell or hold securities eligible for the liquid asset buffer. Banks can repo securities out and reverse repo liquid assets in to manage the liquidity buffer.
Nostro and vostro accounts: a ring-fenced bank may hold nostro and vostro accounts with RFIs to enable it to undertake transactions permitted under the rig-fencing regime.
Branches and subsidiaries outside the EEA
A ring-fenced bank is prohibited from having
a subsidiary carrying out financial activities (which would be regulated in the UK) outside the EEA
branches outside the EEA and Jersey, Guernsey and the Isle of Man.
What’s still missing from the legislation?
Statutory instruments are also due on pensions and tax:
Pensions: The government intends to make regulations requiring banks to ensure that ring-fenced banks are not and cannot become liable for the pension schemes of bodies that are not ring-fenced. This is to prevent pension debts of other group members falling on the ring-fenced bank in the event that those other members fail, which could constitute a channel of a financial contagion across the ring-fence. The Government have confirmed that draft regulations will be published for consultation, following further discussions with the regulators, at a later stage during the Bill's progress through Parliament.
Tax: The Government is still looking into the question of how joint tax liability can be ‘switched off’ to avoid contamination across the ring-fence.
Where does this leave the ring-fenced bank?
A number of legal and practical issues will need to be ironed out before the legislation is finalised if the concept of a viable ring-fenced bank can realised.
A couple of examples in relation to the Ring-Fenced Bodies and Core Activities Order arise as a result of the actions that need to be taken when deposits become core deposits. It is unclear from the draft how a non-ring-fenced body will deal with an account-holder that fails to respond to the institution once the relevant time for submitting a revised statement of eligibility has expired. If there is no ring-fenced body within the group, should the institution simply treat the account as dormant? If a ring-fenced body exists within the same group, will it legally be required to accept the funds? The draft order also prescribes the format of the statement of eligibility within the schedule. The terms used within the mandated text are unlikely to be understood by a retail customer – how can the relevant institution be confident that it is treating its customers fairly?
The various prohibitions on the ring-fenced bank are narrow and leave substantial uncertainties as to the ability of ring-fenced banks to undertake ordinary course treasury management. Significant work needs to be done.
The current drafts would prevent a ring-fenced bank from carrying out any of the following activities:
Securitising on market standards terms
Dealing with RFIs to manage liquidity risk (outside the liquid assets buffer)
Selling products on behalf of another financial institution (other than an affiliate)
Hedging inflation risk
Buying or holding any type of insurance
Undertaking trade finance on bespoke terms
Being the beneficiary of a guarantee from a RFI
Holding foreign currency in an account with a foreign bank.
These are only some of the consequences that the drafting throws up – it is unclear how many are intended policy outcomes and how many are simply the result of drafting in a vacuum.
Loss absorbency requirements
Following the ICB’s recommendations in relation to non-capital primary loss absorbing capacity (PLAC), the draft Banking Reform (Loss Absorbency Requirement) Order proposes a minimum requirement of 17% of risk weighted assets (RWA) for the largest banks – which can be scaled according to a firm’s systemic importance. The order also proposes that the PLAC level can be increased for particular banks, where the circumstances require it.
The PLAC requirements are intended to apply to the following ‘relevant bodies’:
UK corporate authorised persons that are members of a UK headquartered global systemically important bank (G-SIB)
Others UK-incorporated entities identified as domestic systemically important banks (D-SIB) by the regulator.
In setting the applicable PLAC requirement, the regulator will be required to take into account the degree of risk the failure of a ‘relevant body’ is perceived to pose to: (i) the continuity of the provision in the UK of core services; or (ii) the stability of the financial systems within the United Kingdom. The regulator will also be required to ensure that its decisions are consistent with the on-going responsibilities of the UK authorities in relation to the consolidated group supervision of UK-based cross-border banks.
The Government is of the view that PLAC should comprise the highest quality loss-absorbing instruments – capital (equity, Additional Tier 1 and Tier 2 capital) and long term unsecured debt. For a debt instrument to be eligible it must have a minimum remaining term of 12 months and meet any other requirements that may be required under the RRD. The Government queries whether there is an argument for requiring further criteria, for example, that eligible instruments must be issued from a holding company rather than an operational entity and state that they welcomes views on whether such criteria should be mandatory in all cases or whether authorities should have discretion on a case-by-case basis.
UK headquartered G-SIBs: The Government believes that the largest G-SIBs should be subject to a minimum PLAC requirement scaled according to the firm’s systemic importance. Under the draft order, the regulator would need to calibrate PLAC requirements on a sliding scale alongside the G-SIB equity surcharge proposed by the Basel Committee and Financial Stability Board. A G-SIB in the top 2.5 per cent equity surcharge ‘bucket’ would therefore be required to have PLAC of at least 17% of its RWA. The regulator will be required to include UK and EEA members of a banking group in their calculation of PLAC and, where the ‘resolution strategy’ recommends their inclusion, non-EEA subsidiaries. If the overseas subsidiaries’ resolution strategy envisages them being resolved locally, then the UK parent company will not be required to issue PLAC against them. This will not be the case where the resolution strategy envisages a ‘whole group’ solution.
Ring-fenced banks and other D-SIBs (including building societies): In relation to D-SIBs, the regulator will be required to set minimum requirements of at least 17% for those ring-fenced banks and other D-SIBs that it deems to be of great systemic importance to the UK (scaled according to such importance). The draft order also requires the regulator to take account of the quantum of core deposits and the aggregate amounts shown as assets on the balance sheet for the preceding financial year when determining the applicable PLAC requirements. The regulator will be entitled to impose the PLAC requirement on a parent undertaking of the relevant entity, provided the parent undertaking down-streams the relevant amount to the entity in an appropriate form.
Additional PLAC requirements
The draft order provides the regulator, in line with the ICB recommendation, with the power to set additional PLAC requirements where they are appropriate to ensure that firms can be made resolvable. This can be applied on a firm-by-firm basis taking into account the firm’s resolution strategy
The white paper accompanying the draft legislation acknowledges the developments that are on-going in the international context, and confirms that the PLAC requirement policy will need to sit within the context of the European Commissions’ forthcoming Recovery and Resolution Directive.
 RFIs include the following: banks, investment firms which deal as principal or agent, companies in the insurance sector, securitisation companies, funds, fund managers and financial holding companies. The following are (perhaps surprisingly) not RFIs: exchanges, CCPs, securities depositaries, MTFs, portfolio managers, family offices, some high frequency traders, non-UK SPVs.
 Assessed by calculating the position risk requirement on each individual transaction without netting countervailing positions.
 The draft Order refers to securitisation companies under the Corporation Tax Act.
 It is unclear how disproportionality is to be assessed here.
 As noted above it is unclear whether an RFI exposure which falls within the exceptions in (a), (b) and (d) is also prohibited. On its face it would appear so.
 The term ‘exposure’ is defined in the draft order. Note that the term does not match the regulatory capital definition of that term. It is unclear how/whether credit risk mitigation is intended to be taken into account.