Financial Services and Markets Bill

Baroness Kramer Excerpts

Committee stage
Tuesday 21st March 2023 Grand Committee

Moved by

[Baroness Kramer]

216: After Clause 71, insert the following new Clause—
“Limitation on the powers of the PRA
The PRA may not accept an application from any insurance undertaking, reinsurance undertaking or third-country insurance undertaking for the application of a matching adjustment to a risk-free interest rate term structure for a portfolio of assets with a rating of less than BBB by Standard and Poors Global Ratings or its equivalent.”Member’s explanatory statement
This amendment seeks to prevent a matching adjustment being applied to a portfolio of high-risk and/or illiquid assets.

[Baroness Kramer (LD)]

My Lords, I start by thanking your Lordships for your patience in putting up with me being gone over the past few weeks following surgery. Noble Lords from all sides of the House have been so kind; I have appreciated it very much. It is lovely to be back in this company today. Special thanks go to my colleagues who have carried the burden that I should have been here to carry.

In a way, it is almost ironic that the three amendments in this group are all in my name. Amendment 216 deals with insurance and matching adjustments; Amendment 241C deals with the ring-fencing brought in following the 2008 financial crash; and Amendment 241D deals with the senior managers and certification regime, which is also a feature of the remedies proposed after the financial crash. When I tabled these amendments, a number of people pointed out to me that they did not seem particularly pertinent to the time—what a difference two weeks make. We have had three mid-sized banks fail in the United States and HSBC has had to step in and take over Silicon Valley Bank’s UK arm. Of course, we have also had the debacle of Credit Suisse, now part of UBS.

All that underpins the consistent jeopardy and risk that exists in the financial services industry and, to my mind, underlines the importance of having proper regulatory mechanisms in place to remove that risk in the first place, deter risky behaviour and provide a resolution mechanism for when things go wrong, as they always will. I regard the three amendments in my name in this group as rather crucial.

Earlier in Committee, we discussed the concern that the new secondary objective of international competitiveness could compromise the primary objective of financial stability. However, in many ways, that was an abstract discussion. These amendments in these three crucial areas of the financial services sector—all are areas where the Government have clearly signalled both their intention to allow, indeed incentivise, a significant increase in risk and their determination to use the law to prevent regulators limiting that risk—provide us with something much closer to real-life examples.

I start with Amendment 216, which addresses the insurance industry. Of course, this also encompasses many people’s pensions; in a sense, that was clarified in the Budget by the Chancellor, who talked about, in essence, opening up defined benefit pension plans to holding illiquid high-risk assets, in the same way as he anticipates Solvency UK opening up insurance companies to holding a far greater portfolio of illiquid high-risk assets. Under the EU regime, Solvency II, insurance companies are required to build a capital buffer based on the risks in their investments—their asset portfolio. The provision is designed to provide a safeguard if an insurance company fails, protecting both policyholders and the taxpayer. Solvency II allows an insurer to reduce its buffer where the insurance company is holding long-term assets that match the cash flows of its life and annuity insurance and its reinsurance obligations. That relief is called the matching adjustment. It allows adjustment to the discount rate that the firm is required to use to value its cash flows in order to determine the size of the buffer.

With Brexit, Solvency II is being replaced by Solvency UK. No one, including me, denies that Solvency II is probably overly restrictive and requires a degree of reform. I have not objected that Solvency UK is reducing the level of capital—the sort of raw capital buffer—by 65% for life insurers and 35% for general insurers. But the Government are now choosing to go much further. At present, the matching adjustment, which, as I said, has the effect of reducing the buffer even further, applies only to long-term assets held by the insurance company that qualify as investment grade. The change now proposed allows long-term, high-risk, illiquid, sub-investment grade assets—subprime is another word that is often used—to get the benefit of the matching adjustment. There is nothing that the regulator can do about it.

Why would the Government take such a risk? I think the answer is sheer desperation. They are hoping that the insurance companies and the defined benefit pension funds, to which we now know that this will extend, if they do not need to hold much of a buffer, will invest much more in the scale-up of innovative businesses, because scale-up money is hard to find in the UK. Unfortunately, scale-up is the phase at which many companies fail. The standard rule of thumb is that 40% of companies scaling up fail.

The Government are also hoping that the money will go into infrastructure. I should explain that many infrastructure projects are investment grade. TfL bonds, for example, are investment grade, as are the bonds for the M6 toll road; they qualify for the matching adjustment. But many infrastructure projects are high-risk and the bonds they issue are very illiquid. Just look at the pattern for most major infrastructure projects, and small ones as well. There have been delays and overruns in Crossrail, HS2 and pretty much every nuclear power project anywhere in the world. The worst part with infrastructure is that you rarely know that it is in trouble until it is very close to its official completion date. The matching adjustment would apply a far more extensive range of sub-investment grade investments. I know from talking to many companies that they see this as their way to get back into subprime mortgages and subprime property arrangements.

I am very old-fashioned. I believe that the primary purpose of an insurance company is to pay its policyholders on time and in full, and the primary purpose of a defined benefit plan is to pay its pensioners on time and in full. As I said at Second Reading, many people point out that these are pools of money and that the equivalent pension funds in Canada invest heavily in global infrastructure. I point out yet again that, if anyone reads the comments of the rating agencies on those Canadian pension funds, they will become very aware that the Canadian Government are regarded as a backstop should those funds collapse.

That is very different from the situation that we have in the UK, unless the Minister is about to tell me that the UK taxpayer is now willing to become a backstop for pension funds and insurance companies in the UK. The only example that I know about is one that we discussed earlier—Equitable Life. We know that nearly a million policyholders lost more than three-quarters of their investments when Equitable Life failed and that the Government did not bring them back to full recovery, even though the financial ombudsman found serial maladministration by both the Treasury and the regulator. I would very much like to know from the Minister, as we look at Solvency UK, which is enabled by the Bill, whether the Government now propose to give an equivalent backstop to that provided by the Canadian Government.

My amendment basically says that:

“The PRA may not accept an application from any insurance undertaking”—


I will not give you the rest of the details—

“of a matching adjustment to a risk-free interest rate term structure for a portfolio of assets with a rating of less than BBB by Standard and Poors … or its equivalent.”

This is my attempt to stop that reduction in the capital buffer for illiquid, high-risk investments.

I will try to be briefer in dealing with the other two amendments in this group. I shall take Amendments 241C and 241D together. These amendments sprang from the Chancellor’s speech on the Edinburgh reforms. I have referenced before my concerns, which are shared by many who, like me, sat on the Parliamentary Commission on Banking Standards, that we are seeing the rollback of the safeguards that followed our commission’s report Changing Banking for Good. Let me quote from it:

“An important lesson of history is that bankers, regulators and politicians alike fail to learn the lessons of history … measures that are implemented while memories are fresh will be at risk of being weakened once the economic outlook improves, memories fade, and new, innovative and lucrative approaches to global finance emerge.”


That is exactly what we are seeing today, and the past two weeks have illustrated it in spades. The failure of three significant mid-sized banks in the United States was enabled by the rollback of regulation, a rollback that had been sought by the siren voices of the industry. Those same siren voices are currently extremely influential in the Treasury, and I am hoping that we will hear from the Minister that she will go back and look at the decisions to weaken that regulation in the light of the reality that we have seen over the past two weeks and the experience in the United States. Many of these regimes, particularly the senior managers regime, are now to be carried over into the shadow banking world. I am sure that is a good thing, but it is very concerning if those projects are watered down before they are carried over.

I am very concerned about the watering down of ring-fencing. Today, I asked some questions in the Economic Affairs Committee, and it is clear that the Chancellor intends to make changes to the ring-fencing regime. I accept that there are times when one could claim that ring-fencing has been overzealous with small and medium-sized banks and there are some arguments for the need to change MREL, but it is shocking to see that the Government are backing the recommendation of the Ring-fencing and Proprietary Trading Independent Review that if a bank is deemed “resolvable” its ring-fencing features can be removed.

The proposition behind ring-fencing was that retail banking is an entirely different animal from the casino banking of investment banking. It is essentially in many ways a utility, and it needs to be kept safe and separated by the virtues of the ring-fence. On the commission we also saw constant cross-contamination—in other words, risks being taken within the retail bank because of the impact in the universal banking model of their investment banking colleagues. Things such as PPI and various other forms of general abuse of customers clearly sprang from the internal pressures that were created by the overall culture of the combined firm. We could also see that many of the risks that the investment bankers tended to take were fuelled by their access to retail bank accounts that paid no or very little interest and were protected by insurance and which almost, in a sense, provided a honeypot that incentivised the taking of undue risks and played a very significant role in the kind of failures that led to the crash.

To quote Paul Volcker,

“it is the damage that it does to the culture of the whole institution … Trading operations and impersonal proprietary trading operations are simply different from a continual banking relationship.”

In other words—of which there were many—the linkage between retail banking and investment banking contributes fundamentally to all kinds of abuse of customers and small businesses, from PPI, the asset stripping of RBS GRG and the mis-selling of interest rate swaps. It also lay behind the complete collapse in credit standards and the short-term funding strategies that sank HBOS. Ring-fencing is a vital tool to provide for financial stability. With the plans to remove the cap on bankers’ bonuses, which the Government and industry treat as one of their highest priorities, it is even more important that this protection stays in place. My Amendment 241C would prevent any such destruction of the ring-fence without a decision by Parliament in primary legislation.

--- Later in debate ---

The legislation establishing the SMCR is contained within FSMA; amending that already requires primary legislation. However, Amendment 241D would also bind the hands of the regulators, restricting their ability to amend their respective regulatory handbooks. The Changing Banking for Good report was crucial. It paved the way for this important regime but regulation must be able to respond to changing circumstances. The proposed amendments would make the regime less flexible and leave the regulators less able to respond to emerging issues or risks.

[Baroness Kramer (LD)]

My Lords, I thank everyone who has spoken. When I originally drafted these amendments, they were genuinely probing amendments. I felt that I had stumbled on some issues that, if I was correct, would surely be of such significance that they would have been brought before the House and widely discussed. They changed two of the absolute pillars of our financial regulatory regime: ring-fencing and the senior managers regime. It is evident to me that this is a relatively new topic for most noble Lords here, who are the core of those in this House who engage on these issues. I am therefore very troubled that this has not been part of a broad, in-depth discussion between the Government and Parliament.

I very much agree with the noble Lord, Lord Eatwell. If we had a working accountability system, there would be a mechanism to help deal with all this, but we do not have one. Frankly, I do not want to wait until we do, unless we agree something on that in this Bill, because these fundamental changes have such a possibility of putting our financial stability in jeopardy that we cannot simply sit back and treat them as if they are fairly minor adjustments. They are fundamental to changing the guard-rails that have protected us for the past several years.

I very much agree with the noble Lord, Lord Eatwell. Stress testing is not a litmus test; it is simply a tool to try to expand one’s thinking and to try to identify potential possibilities. The Government have treated it as if it was some kind of litmus test: if it comes up red or blue, or whatever else it is, you have passed and everything is fine. That is not what it is about—in fact that is an abuse of the whole concept of stress testing.

I am extremely worried about the changes to Solvency II as it moves to become Solvency UK. I should say to the noble Baroness, Lady Bennett, that I do not have a quibble with the regulator—the regulator has been shut out of this process. This is a government decision that the matching adjustment will be allowed to apply to illiquid high-risk investments because those are the kind that the Government wish to see increased in our economy. I am happy to see them too but, frankly, I would like somebody in the financial capital market who understands the risk and is willing to take the risks to put money in, whether it is scale-up or infrastructure. The idea that this will now become the norm for pension funds, where basically the policyholders will have absolutely no say and I suspect very little understanding of the level of jeopardy in the fund to which they are contributing on a regular basis, bothers me hugely.

I will be very glad if someone else can come up with some mechanisms. The mechanisms that I used here of parliamentary accountability have been my attempt to deal with what seemed like a problem that was not being discussed. However, the excellent speeches that we have heard today, and indeed the Minister’s reply—it did not suggest that we have been exaggerating the situation, but confirmed the problems—mean that we will have to try to find some mechanism, and quickly, to deal with this range of issues. The last two weeks have made it clear that it is complacency to think that we have in place the kind of structure that genuinely protects us from financial risk, and complacency is exceedingly dangerous. I beg leave to withdraw the amendment.

Amendment 216 withdrawn.