Financial Services and Markets Act 2000 (Excluded Activities and Prohibitions) Order 2014

Monday 21st July 2014 Grand Committee

Motion to Consider

17:12

Moved by

[Lord Newby]

That the Grand Committee do consider the Financial Services and Markets Act 2000 (Excluded Activities and Prohibitions) Order 2014

Relevant document: 4th Report from the Joint Committee on Statutory Instruments

[Lord Newby (LD)]

My Lords, it is a great pleasure to open this debate on these two ring-fencing instruments because today marks the latest milestone in the long process of legislation to implement the ring-fence between retail and investment banking. These two orders define what must be inside the ring-fence and what must be outside. They are the final stage of legislation on the location of the ring-fence.

Ring-fencing will protect retail bank customers against the risks of investment banking. It will help to reduce the risk that a future Government are obliged to rescue a failing bank with taxpayers’ money. Ring-fencing will achieve this; first, by insulating vital retail deposit and payments services against shocks from elsewhere in the global financial system; and, secondly, it will make retail banks that provide these vital services simpler and more resolvable. This will mean that, if a bank gets into financial difficulties, the authorities will be better able to manage its failure in an orderly way, keeping those essential retail services running but without having to rescue the bank with public funds. Ring-fencing thus aims to get the taxpayer off the hook by making retail banks both less likely to fail and more safe to fail. The ICB recommended that all the legislation needed to implement the ring-fence be in place by the end of this Parliament. The Government have committed to that timetable and we are well on track to meeting our commitment.

Last year, we took the Financial Services (Banking Reform) Act 2013 through Parliament. It established in law the principles of ring-fencing, as well as implementing the recommendations of the ICB on bail-in and depositor preference. The Act also brought in wider reforms, including those proposed by the Parliamentary Commission on Banking Standards.

The Act created the concepts of a “ring-fenced body”; “core activities”, those that must be inside the ring-fence; and “excluded activities”, those that must be outside the ring-fence. It provided that the precise definitions of “core” and “excluded” activities be set in secondary legislation. This is the purpose of the two orders before us today. The ring-fenced bodies and core activities order defines the scope of the ring-fence and the kinds of deposit that must be in the ring-fence. The excluded activities and prohibitions order defines the forms of trading in securities and commodities that must be outside the ring-fence, and imposes specific prohibitions on ring-fenced banks.

17:15

The ring-fenced bodies and core activities order sets out which bodies will be subject to ring-fencing. The 2013 Act provides that any UK institution which accepts deposits, other than a building society, will be subject to ring-fencing, unless exempted by order. The order creates exemptions in two cases. First, it provides that only banks above a certain size will be required to be ring-fenced. The Government believe that the benefits of ring-fencing smaller banks are marginal and that the smaller banks would be likely to incur disproportionately high costs from having to ring-fence, which would reduce their competiveness. The order therefore creates an exemption, excluding banking groups with less than £25 billion of core deposits from the definition of “ring-fenced body”.

Secondly, the order exempts classes of institutions, such as insurers and credit unions, which are captured by the definition of “ring-fenced body” in the Act because they accept deposits. Ring-fencing is a policy developed to deal with the specific characteristics of banks and building societies. It was not designed as a solution to the regulatory challenges of other financial services firms. Therefore it is correct that they are exempted by this order. The order also provides that banks that cross the threshold due to a merger or acquisition, or resolution action taken by the Bank of England, will have a fixed four-year grace period before ring-fencing is applied to them.

The order also defines in detail the circumstances in which deposits can be held outside the ring-fence. The ICB recommended that large organisations and high net worth individuals should be able to deposit outside the ring-fence if they make an active choice to do so. This was because these depositors are sufficiently financially sophisticated to tolerate an interruption in access to a single bank, typically because they have multiple banking relationships. These sophisticated depositors therefore do not need the protection that is being mandated inside the ring-fence. They may, of course, choose to deposit in a ring-fenced bank if they wish.

The Government accepted this recommendation, and the order therefore provides that organisations above the Companies Act threshold for small companies—that is, organisations with turnover greater than £6.5 million, more than 50 employees, or an annual balance sheet total of more than £3.26 million— and individuals with greater than £250,000 in financial assets, can choose, as a one-off, to certify their deposits as non-core, allowing them to deposit with a non-ring-fenced bank.

The excluded activities and prohibitions order defines in detail the things that ring-fenced banks may not do. Under the Financial Services (Banking Reform) Act 2013, the regulated activity of,

“dealing in investments as principal”,

is an excluded activity. This means that ring-fenced banks may not engage in trading in financial investments on their own books. The Act, however, gives the Treasury power to make exceptions from this ban. The order before us creates exceptions, most importantly for ring-fenced banks’ own risk management and funding, for transactions with central banks, and for the provision of simple risk-management services to customers.

The first exception is intended to permit ring-fenced banks prudently to manage their own risks; for example, the interest-rate risk that arises from their lending activities. The ICB recommended that ring-fenced banks should be permitted to use derivatives or similar instruments to hedge these risks. The exception in the order therefore permits dealing in investments, including derivatives, provided that the sole or main purpose of the transactions is to hedge the risks of the ring-fenced bank or its subsidiaries. Similarly, the ICB recommended that ring-fenced banks should be allowed to trade in liquid assets, such as UK gilts, to manage their liquidity: the order therefore permits ring-fenced banks to do this. The second exception permits ring-fenced banks to trade with central banks. This will allow ring-fenced banks to access central bank liquidity in times of stress.

Thirdly, the order permits ring-fenced banks to sell a narrow range of simple risk-management products to their customers. A great many businesses, including small businesses, use simple swaps, futures and options to limit their exposures to interest rates, commodity prices and exchange rates; for example, by fixing the interest rates they will pay on their loans or locking in the exchange rate for trade transactions. This gives businesses certainty over their costs and revenues, allowing them the confidence to invest, grow and create new jobs. The exception in the order permits ring-fenced banks to sell the simplest and most standard products used by businesses for these purposes. This will allow ring-fenced banks to meet all the needs of the vast majority of UK businesses, including small businesses, which typically have only a single bank, and might find it costly and difficult to deal with an investment bank for risk-management services. Complex derivatives will not be permitted inside the ring-fence. These are typically used only by larger and more sophisticated corporate customers, who are often already multi-banked, so would have little trouble in sourcing derivatives from a non-ring-fenced bank.

Finally, as well as defining what trading in financial securities must be outside the ring-fence, the order creates a further excluded activity: dealing in commodities. Ring-fenced banks will be banned from speculating in physical commodities, such as precious metals or oil, as well as trading in financial investments. As well as defining the scope of the ban on dealing in investments, the order imposes a series of specific prohibitions on ring-fenced banks. First, ring-fenced banks are prohibited from having exposures to certain financial institutions. The ICB recommended this prohibition, which is a key part of the insulation of the ring-fence. It protects ring-fenced banks against financial contagion from elsewhere in the financial system. In line with the ICB’s recommendation, the order prohibits ring-fenced banks from having exposures to non-ring-fenced banks, most investment firms, globally systemic insurance firms and investment funds. It permits exposures to other ring-fenced banks, building societies, credit unions, recognised clearing houses and central counterparties, investment firms which only offer advice, and banks subject to the same restrictions as ring-fenced banks, such as small retail banks.

In connection with this, I should tell the Committee that there is a small typo in Article 2(3)(g) of this order. The words “is not permitted” in the second line of that sub-paragraph should come at the end of the first line, as I am sure all noble Lords will have spotted. This will be corrected in the order before it is made.

Exposures to non-systemic insurers are also permitted, as these firms, which engage only in traditional insurance business, do not pose contagion risks comparable to those from non-ring-fenced banks or investment banks. The ICB recommended some exceptions to the prohibition on relevant financial institutions. This order creates those exceptions. First, ring-fenced banks may have financial institution exposures for the purpose of managing their own risks. Secondly, ring-fenced banks may provide payments services to other financial institutions; for example, acting as clearing banks for small banks. The exposures involved are permitted, subject to controls imposed by the PRA to address any prudential risks. To ensure that ring-fenced banks are themselves always able to access the payments systems whose use is critical to their business, the order separately imposes restrictions on the extent to which they may use the services provided by interbank payment systems except as direct members the payments systems.

The third exception permits ring-fenced banks to offer trade finance services to their customers. The ICB recommended that ring-fenced banks be permitted to offer trade finance services to customers. Such transactions often involve exposures to other financial institutions on behalf of their customers. The order also permits ring-fenced banks to have exposures to their own covered bond or securitisation vehicles and to engage in conduit lending and repo transactions. This is necessary to ensure that ring-fenced banks are not excluded from an important source of funding. Provision is also made to ensure that exposures to financial institutions which arise in the course of ordinary banking business, such as allowing retail customers to draw cash from the ATMs of foreign banks, do not breach the prohibition.

The final prohibition that the order imposes is on ring-fenced banks establishing branches or subsidiaries outside the EEA. The ICB recommended that ring-fenced banks should not offer services outside the EEA, to protect them against risks arising from elsewhere in the global financial system. Non-EEA branches or subsidiaries, which would be outside the recently agreed common European resolution framework, could also compromise the resolution of a ring-fenced bank in the event of failure. The order, therefore, prevents ring-fenced banks having such branches or subsidiaries, other than service companies that undertake no regulated financial activities.

These orders thus complete the process of defining the location of the ring-fence. It is central to the Government’s radical programme of financial reform to ensure that there is no repeat of the crisis and bailouts of 2007-09. Making these orders is an important milestone towards meeting our commitment to have the ring-fence legislated in this Parliament. It is a big step towards finishing the job of financial reform, to give Britain a world-beating financial sector, while protecting consumers and taxpayers. I commend the orders to the Committee.

[Lord Tunnicliffe (Lab)]

My Lords, I thank the Minister for his presentation of these orders. The Opposition will not object to them. Indeed, in some ways they are unsurprising to the extent to which I sat through them with colleagues, facing the noble Lord, Lord Newby, through many hours of the parent Bills. As far as I can tell, most of the features appearing in these orders have already been mentioned in debates, notes and so on. They seem to do the job. I have just a couple of direct questions about the orders, and one or two wider questions that I hope the Minister will be able to respond to.

It is very interesting in terms of political process the extent to which we depend on the supporting material. It is conceivable to put in the 30-odd hours that are necessary to work from the Act through to the orders, through to whether the Explanatory Memorandum properly explains the legislation. I trust the Minister.

[Noble Lords]

Oh!

[Lord Tunnicliffe]

Well, I trust the Minister in this case then, on the Explanatory Memorandum. Let us not get carried away, although I do have a small point even on that. I am saying essentially that the Minister’s presentation and the Explanatory Memorandum, which I have studied in some depth, and the orders in as much as I was able to relate them to the Explanatory Memorandum, leave me with only a couple of direct questions.

First, the Minister spoke about the firms that are in the core. That was unexceptionable and exactly how the commission was talking. All the stuff I remember from the Explanatory Memorandum seems to fit with that. I found no surprises and the Minister has not pointed out any surprises to me. Therefore, my attention has concentrated on the Financial Services and Markets Act 2000 (Excluded Activities and Prohibitions) Order 2014.

Looking at the Explanatory Memorandum for that order, as a result of the Minister’s speech, I first lighted on paragraph 7.4, which states:

“This Order provides that dealing in commodities (e.g. precious metals, oil, agricultural products) is an excluded activity”.

The Explanatory Memorandum refers to “agricultural products”, and I am sure that if I went into it in enough depth, I could find whether or not agricultural products are excluded. The Explanatory Memorandum says that they are, but the Minister’s speech did not. I ask that as a small technical question.

It is interesting that in the rest of the order virtually everything seems to be fairly black and white. This is in; this is not. This is excluded; this is not excluded. Paragraph 7.5 of the Explanatory Memorandum caught my eye, where it lists the key things that the order does. It states:

“Third, the Order creates an exception to permit ring-fenced bodies to sell a narrow range of simple derivatives to their customers”.

The Minister gave a perfectly satisfactory explanation of why that was useful. What was less clear to me—I have to admit that it may be deep in the order—is how one defines “simple”. Listening to the Minister, “simple” seems to be defined as small and what small businesses want, while “complex” is big and what complex businesses want. That did not seem to me a fundamentally correct definition of “simple”; it should have more depth in it if it is to be a serious limitation on what is inside and outside the ring-fence. I would value further explanation of what “simple” means.

17:30

I was also interested in how policy and detail developed. As we know, there is subtle detail when orders are created to bring an Act into force. I noticed with some disappointment the rather short section in the Explanatory Memorandum on consultation. It states:

“In the light of consultation responses, the Government made a number of technical changes”.

I would have valued a little more information on how the consultation and the changes came about. Of course, I could have taken up the invitation in paragraph 8.2 to go to the link there given. I fear that, if I did, I would probably find myself facing a 200-page document and having to admit defeat by sheer volume. If the Minister could shed a little more light on the consultation, I would value it.

My mind then started to go away from where we had been together with the Bill to the reality of this becoming a ring-fence. I started to wonder who does what, which is when my thinking came back to this idea of “simple”. How does whoever is responsible for this—I assume that it is the PRA—ensure that the instruments inside the ring-fence are simple and that all other instruments are outside? Does it review every instrument that a bank is going to trade in, or does the bank have to self-certify with the PRA reviewing it afterwards? By what process does the detail in the orders come about? We can all pass rules, but, let us be honest, with this industry, a policeman—for want of a better word—has to be there making sure that the rules are obeyed and implemented. I am interested in who does what and how they do it.

Finally, we heard a number of lovely little phrases throughout the Minister’s speech referring to timetables. He talked about being in the final stages, and said that the instruments would be in place by the general election and that the Government were close to finishing the job. Can the Minister flesh that out a bit? Finishing the job means a ring-fence being in place that is properly policed. When we can we expect that? I seem to remember a dreadful date like 2019 being bandied about. If all the stuff is in place by 2015, why will it take that amount of time for it to be in place, giving the protection for the citizen that I know both the Minister and I want? Certainly, I want to see it in place as quickly as possible.

[Lord Newby]

My Lords, I am grateful to the noble Lord, Lord Tunnicliffe, for those questions, because they enable me to clear up, I hope, the points that he raised. He asked whether agricultural products were included in the definition of “commodity”. The answer is that, just like a metal, agricultural products —such as pork belly, or whatever, futures—are an excluded entity, along with all other commodities.

The noble Lord asked me about how to define “simple”. I am slightly inclined to say that of course it is not easy to define “simple” simply. However, the simple instruments that ring-fenced banks will be permitted to sell to their customers are defined in articles 10 and 11 of the excluded activities and prohibitions order, so there is quite a long list there. The definition or underlying concept of “simple”, is that we are primarily talking about derivatives that do not complicate the resolution of a failing bank. Why do we try to keep to simple products? We want to make it possible, relatively easily, to resolve a failing bank. Therefore simple derivatives are primarily ones that are straightforward to value; that is what makes them simple, or relatively simple.

[Lord Tunnicliffe]

Can the noble Lord repeat what he just said? I think he said something quite profound, although he said it quickly: that, by definition, they must be instruments that would not complicate the resolution.

[Lord Newby]

Yes; they are derivatives that would not complicate the resolution of a failing bank. They would not complicate it because they are relatively straightforward to value. As the noble Lord can imagine, some derivatives are extremely difficult to value. If I can just slightly elaborate on that, the excluded activities and prohibitions order limits ring-fenced banks to selling forwards and futures, plus a small range of options. They may only sell derivatives to hedge against three types of common business risk, namely currency, interest rate and commodity risk. Those are the most common business risks in which the market for derivatives is most liquid and, because it is liquid in those areas, it is easier to value them. To ensure that derivatives do not have any of the features that make them hard to value, the order requires that options contracts entered into must specify the amounts that may be bought or sold under the option, be at a specified price, and exercisable on a single specified day; or, in the case of interest caps or floors, interest rates must be based on a specified principle sum for a specified period.

The order also requires that ring-fenced banks may only sell derivatives that can be valued on the basis of observable market data or of a type traded on exchanges, and whose fair values are based on level 1 or 2 inputs under international financial reporting standards. Such instruments are more liquid and could be more easily valued in resolution. Article 12 of the order creates those safeguards, as well as placing caps on the net market risks of the derivatives portfolio, the gross size of the derivatives portfolio and the proportion of the portfolio that can be made up of simple options. I hope that that has gone some way to satisfy the noble Lord on that front.

The noble Lord asked about consultation. Consultation was issued in July last year, and the summary of responses was released in December of last year. We also consulted widely with stakeholders, including the Association of Corporate Treasurers, the CBI, non-financial companies, law firms and, of course, the banking industry itself. As a result of that consultation, we have made some changes to the legislation that are largely technical, but which will ensure that ring-fencing is fully compatible with the needs of UK businesses. For example, we made some small changes to the definition of “simple derivatives”, made it permissible for ring-fenced banks to have exposures to non-systemic insurers, made a series of technical changes to ensure that exemptions for payments and trade finance are operable, and removed the caps on payments and trade finance exposures. We also prohibited ring-fencing banks from having branches in the Crown dependencies. Therefore that is relatively technical stuff, but it has improved the legislation and has been a good exercise.

The noble Lord asked how the supervisors would supervise. The PRA is the principal supervisory body. It is in day-to-day contact with the banks. If it feels that it is not getting adequate information from the banks, it has extensive powers to require further information from them if it has any specific concerns. If a generic problem were to arise, it would obviously be in a position to discuss with the Treasury whether any further changes were needed in terms of the secondary legislation or in any other respect.

As to the question of timing, as the noble Lord said, the end point for the final implementation of the ring-fence is 2019. The justification for that is so that we can get all the secondary legislation done by the end of this year, which we expect to be able to do. The PRA then has to produce very detailed rules to make sure that the system is clear and works in the way that we wish it to do. On the basis of both the primary and secondary legislation, we estimate that it could take up to two years for all those rules to be finally in place, and then a final two years for the banks to implement the rules. That does not mean that the banks will not do anything in the mean time, because making this change obviously involves them in a huge amount of effort, activity and cost, so they are beginning to think about how they are going to do it. We have always thought that this timetable is measured and proportionate. The very fact that the banks know that we are moving in this direction means that some activities that they might have undertaken in the past they will not undertake in the interim period because they know what the new rules will be and that they will abide by them.

[Lord Tunnicliffe]

I thank the Minister for giving way. Clearly, we would like to see this done more quickly, but I hear the Minister’s response. I presume that, alongside this, there will be a parallel activity by the banks to develop their own structure—the responsibility of directors and so on—and to be in a corporate shape for this structure. Are the Government, through the PRA, participating in or monitoring that development?

[Lord Newby]

Yes, they are. We are talking not about hundreds of institutions but about a small number of banks, which are very heavily regulated already. They are in daily touch with the PRA about one or other aspect of the regulations and that dialogue is ongoing. Indeed, some banks have already announced some of their broader strategic thinking. Others are keeping theirs close to their chest and, in some cases, are looking to make sure that these orders have indeed gone through before they decide what to do. In most cases, by the end of the two years before which the PRA detailed rules will not have come out, I expect the banks to become pretty clear about where they want to end up. They will do it, as I said, in consultation with the PRA because that is the way that the system operates already and will continue to operate in the future.

I hope that I have answered the noble Lord’s questions. I was involved, as was he, with the passage of the Financial Services (Banking Reform) Act, at the start of which there was a lot of scepticism about whether it would be possible to do what we have done today and define a ring-fence satisfactorily. I think that these orders indeed do so satisfactorily. It is a major step forward in a very important process to improve the safety and security of the banking sector. I commend the orders to the Committee.

Motion agreed.