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

Lord Newby Excerpts

Monday 21st July 2014 Grand Committee

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.

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[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?

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[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.