Financial Services (Banking Reform) Bill

Lord Deighton Excerpts

Wednesday 23rd October 2013 Lords Chamber

[The Commercial Secretary to the Treasury (Lord Deighton) (Con)]

My Lords, these two amendments concern the role of auditing in banks. Many excellent points have been made about the historical challenges and weaknesses and to some of the problems they have created. However, not all of these have specifically addressed the amendments themselves.

Amendment 92 seeks to strengthen quality engagement between auditors and supervisors. We agree we want to accomplish that and the noble Lord, Lord Eatwell, made the same point. The question is about the most effective way to ensure it is consistently brought about and the difference between us is about how we accomplish that. It may appear attractive to require greater engagement in statute as a guard against complacency in the future, but the clause risks weakening the auditor dialogue and perpetuating the tick-box approach that was found wanting in the last financial crisis. That was one of the most important lessons about regulation we learnt from that crisis. The FSA was widely criticised for measuring adherence to its rules—like how many times you met the auditor—but not coming to an informed judgment about the risks in individual companies and the wider market. That is where the focus of our regulation needs to be.

I may have been in the private sector too long, but solving a major problem by legislating for a number of meetings has never been the best way to get quality outcomes to serious problems. The FSA was criticised, beforehand, for not engaging enough with the auditors of the banks they supervised. The then statutory requirement for regulators to meet with auditors at least once per year simply became another process and the wider purpose of the meetings was not properly developed. The whole point of the Financial Services Act 2012 was to make sure such failing was addressed and that the regulators follow a judgment-led approach to supervision. This means that all enforcement activities must enhance the regulators’ understanding of the business and the wider market to better enable them to detect risks before problems become serious.

FSMA now includes a new Section 339A—which deals with the powers to which my noble friend referred—requiring the PRA to have arrangements for sharing information and opinions with auditors of PRA-authorised persons, and to publish a code of practice setting out the way in which it will comply with this obligation. This code of practice, which we have talked about, sets out the principles governing the relationship between the regulators and bank auditors. The code has been laid before Parliament, so provision has already been made, both in and under FSMA, for a regular dialogue between the regulator and the auditor. These requirements mark a change in focus away from process—stipulating the number of meetings—to actual outcomes: getting them to do the job properly. This requires regulators to consider serious engagement with auditors and subjects their stated approach to scrutiny so we can see if they are complying with the code of conduct: it does not just fall away. This process is not only more rigorous in the short term, but gives the opportunity for parliamentary scrutiny when the codes of practice are laid before Parliament and provides a check on potential complacency in the future.

My noble friend Lord Lawson referred to the need to make sure the dialogue was at least quarterly: the PRA code says that it should be. Most noble Lords will not be familiar with the details of the code of practice, but for the major firms—the ones that are perceived to represent the greatest risk to the stability of the financial system—at least three or four meetings per year are encouraged. This is a risk-based approach and the meetings are: at least one routine bilateral meeting between the lead audit partner and the supervisor; one routine trilateral meeting between the lead audit partner, supervisor and the chair of the firm’s audit committee; and one bilateral meeting between the lead audit partner and supervisor in the lead-up to and during the annual audit of accounts.

Conversely, the amendment’s legal requirement for more regulator meetings with auditors would just follow in the footsteps of the tick-box policy from before the crisis. I am really talking about the smaller, much lower-risk firms, where the guidance is, generally speaking, for at least one meeting a year. Having two meetings a year would simply increase the workload of regulators and take them away from exercising judgment and away from prioritising the most concerning engagements. They would simply be setting up meetings, irrespective of individual circumstances, just because they needed to fulfil a rigid requirement. In our view, such rigidity would weaken engagement and impair the regulators’ ability to adapt their approach as circumstances change.

Because of all that, the Government remain unconvinced of the need to define the frequency of this dialogue in statute, as the PRA code already specifies this and invites scrutiny. My noble friend Lady Noakes put it very well when she spoke about how the world has moved on and how this now operates.

In relation to the second amendment, the Government have been clear that the crisis highlighted deficiencies in accounting standards and the fact that there was room for improvement. We all agree with that, and that is what we said in our response to the final banking standards report. The regulators must have the information they need to do the job of safeguarding financial stability, and in some instances that may require disclosure of financial information on a basis different from that used by other audited bodies. In response to the noble Lord, Lord Hollick, the PRA will have access to management accounts, for example.

In response to the banking standards report, the Government asked the PRA, working with other authorities and the FPC, to undertake a broad-based review of this subject. That review will take account of the nature and scope of information required to create a separate set of accounts, the costs and benefits of the initiative, and international requirements. From 2014, the new Capital Requirements Directive IV will require banks to disclose supplementary information which goes beyond the international financial reporting standards. Therefore, it is not yet clear whether we need an additional, separate set of accounts in the light of the extensive prudential and other regulatory reporting requirements that are being imposed through the CRD IV framework.

However, I can assure noble Lords that, whatever the outcome of this review, the powers that have been given to the regulators under the Financial Services and Markets Act, as amended in 2012—this, again, goes back to my noble friend asking about the existing powers—are already sufficient to permit the regulators to do everything that this amendment gives them the power to do. Their current powers would permit the regulators to make rules requiring banks to prepare additional accounts, to the extent that this is permissible under EU law, to specify the principles that should govern the preparation of such information and to make it public. To the extent that the amendment merely gives the regulators the powers they already have and does not require anything else of them, it is unnecessary. I therefore ask the noble Lord to withdraw the amendment.

[Lord Lawson of Blaby]

My Lords, I have listened to what the Minister has said. On the second of his two points, I think that he is very close to the position that I and other noble Lords who have spoken are in concerning the IFRS accounts and their defects. He is very much closer than he is on the first one, and he is very close to what I was trying to say. He said that the Government are going to see whether they can get an improvement. He referred to CRD IV, which goes some of the way but is not entirely satisfactory. The only way that we will get accounts in a form that is satisfactory for the regulators and the supervisory requirements is if they ask for that. He is absolutely right that they can do that now. In practice, they could have done it before the 2008 crash, but they did not. That is the problem. Those of us who support the amendments are saying: once bitten, twice shy. It could have been done before; it can be done now. But it was not done before. Therefore there should be a statutory duty, which would make it more likely that it will be done. How can that be objectionable?

On the first issue the principle is the same: once bitten, twice shy. The idea that this is simply a bit of box-ticking is an insult to the intelligence of this House. As we say in the amendment, the meetings should take place more than once a year—and they will be nothing to do with box-ticking. They will be meetings of the kind that the supervisor and the regulator find most useful. Those people will use their discretion; there is no box to be ticked at all. That idea is—if I may say so, with great respect to my noble friend the Minister—a total absurdity.

It is perfectly true that under the code of practice and so on, such meetings could take place anyway. But that was also the case before: not only could such meetings have taken place, but the Banking Act 1987, which was then in force—that part was not repealed— encouraged them to do so. However, although meetings did take place to begin with, towards the end they did not happen. That is why it makes sense to make it a statutory duty for those meetings to happen. They will not take the form of box-ticking; they will take the form that the regulators and the supervisors find most useful. We leave that to their discretion, but we do not wish to leave to their discretion—this is, in effect, the Government’s position—whether the meetings take place at all. We may wish to discuss this further, but for the present I beg leave to withdraw the amendment.

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[Lord Brennan (Lab)]

My Lords, Mr Andrew Tyrie, the chairman of the Parliamentary Commission on Banking Standards, described leverage ratio as,

“the single most important tool to deliver a safer and more secure banking system”.

In their reply last July, the Government accepted this importance. Indeed at paragraph 5.50, they plainly stated that in the future the FPC should determine the ratio, provided that it was not allowed to fall below the international standards reflected in Basel III. However, at paragraph 5.51, that commitment having been repeated, it is then said that it is,

“subject to a review in 2017”.

The question therefore arises, if the Government are committed in principle to the FPC determining the ratio, what in this review in 2017 might affect that principle? Questions of amount or the approach to ratio in the light of Basel III go to the process rather than the principle of who determines the ratio. I presume that over the next four years, the Treasury will determine the leverage ratio and will place such requirements about it as it thinks fit on the banking industry.

At page 68 of the response, the Minister will recall that under the heading “leverage ratio”, it is stated that the Treasury is presently reviewing with the FPC the balance between backstop and frontstop considerations. The intention is to publish the results before the end of the year. Given the six weeks or so of parliamentary time that we have left until Christmas and assuming that Report is, for example, in December, will the Minister undertake to ensure that that review is published before Report? It will affect the debate, should it recur on Report, on the question of who makes the decision. The key point, however, is: why 2017, if the principle is accepted now?

[Lord Deighton]

My Lords, I welcome the engagement of noble Lords on this critical issue of the leverage ratio and the FPC’s toolkit. Everybody agrees the importance of making sure that our financial institutions are appropriately capitalised. There is no dispute about that and the lessons we should have learnt from the financial crisis. The real question—and again my noble friend Lady Noakes hit the nail on the head—is about the journey we take to get there, how it integrates with what is going on in global standards, and what powers the FPC and the regulators already have to ensure that we are in the right place in the mean time. I think that also comes back to the points made by the noble Lord, Lord Brennan.

I shall try to give some context, particularly for those who are not so familiar with all the aspects. With each of these amendments, I ask myself what the point of substance is between the amendment and the Government’s position and whether I can reconcile the two with the existing actions we are taking. In this case I have been able to comfort myself that adequate protections are absolutely in place, given the objectives of this amendment.

The FPC has two main sets of powers at its disposal. The first is a power to make recommendations. This includes recommendations to both the PRA and the FCA. They can be made on a “comply or explain” basis. The second set of powers, which we are talking about here, is to give directions to regulators to adjust specific macroprudential tools. Amendment 93 proposes that the Government give the FPC direction powers to implement a minimum leverage ratio in the UK. Before explaining why the amendment is not necessary or desirable, let me explain the international and domestic context, beginning with the international.

In order to address recognised problems with the system of risk-weighted capital requirements—which we have all talked about and acknowledged—the Basel III accord recommends a complementary binding minimum leverage ratio. Again, we have all agreed that the right way ahead is for the two to work together, so there is no dispute about that. That standard comes into force in 2018, following a final calibration of the leverage ratio in the first half of 2017 so that we get it right. Separately, at the European level the European Banking Authority will undertake a review of the leverage ratio with a view to the European Commission introducing legislation in 2017. The Government agree, and have consistently argued, that banks must be subject to the binding minimum leverage ratio requirement, which supplements the risk-weighted capital requirements as set out by the Basel III accord. Therefore the Government fully anticipate the development of internationally agreed minimum standards of leverage.

The Government take the view—and we believe that the regulators agree—that the optimal approach to creating a lasting binding minimum standard is to work towards international agreement and its implementation through legislation. As Mark Carney wrote in the Financial Times on 9 September:

“Yielding to calls for unilateral action to protect domestic systems would risk fragmenting the global system, slowing global growth and job creation”.

Once that minimum is agreed domestically, the Government propose—and this directly addresses the point made by the noble Lord, Lord Eatwell—to furnish the FPC with a specific macroprudential tool to vary the leverage ratio, through time, obviously subject to it not falling below the minimum.

However, the question raised by the amendment is: what powers do the regulators have to take action on leverage between now and 2018 in advance of the introduction of that internationally agreed binding minimum requirement through European legislation? Let me reassure noble Lords that the regulators already have extensive powers to address the issues raised by this amendment. The FPC has broad powers to make recommendations to the regulators, on a “comply or explain” basis, including on leverage. The PRA has all the powers necessary—which we have talked about—under Section 55M of the Financial Services and Markets Act 2000 to require individual firms to take specified actions, including on leverage. Under Section 137G of FiSMA it may make rules in pursuance of its general functions, including rules on leverage ratios.

The killer fact, if I may call it that, is that on 20 June—interestingly, one day after the publication of the PCBS report containing this recommendation—the PRA announced that it would require eight major UK banks to meet a tougher leverage ratio than that prospectively required by Basel III. They have already done that. That action followed a March 2013 recommendation from the interim FPC to the PRA to consider applying higher capital requirements to any major UK bank or building society with concentrated exposures to vulnerable assets, or where banks were highly leveraged relating to trading activities. Put simply, the regulators already have the powers to do what the noble Lord appears to be suggesting in advance of international agreement.

[Lord Eatwell]

I am intrigued by that argument. The noble Lord started off with a powerful argument for the necessity of a leverage ratio that is allied with risk-weighted assets and other measures. He is now saying that we do not need it because it is all there already. Why, then, are we even bothering to think about introducing it in 2017 or 2018? As he said, we have all the powers already. He is absolutely contradicting himself in a single speech. Will he also address the fact that the Bank of England’s response today to the banking commission’s final report states that the FPC will publish its assessment of the appropriate level of the leverage ratio by the end of this year? When the FPC publishes that assessment, what will the regulators and the Treasury do about it?

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[Lord Deighton]

There was nothing contradictory in what I said, but I will clarify it. For the longer term, we absolutely agree that we need an internationally consistent standard that will work with a minimum leverage ratio. In the mean time, before we are able to employ that in a way that is consistent with how those rules work out, we have the powers individually to make sure that leverage ratios exist which protect the system. I do not think that there is anything contradictory about that. It simply shows that in the short term we have the capacity to protect the financial system, and that is exactly what the regulators have done. There is nothing contradictory in that at all. The regulators have the powers to do what they need to do and will continue to have those powers after international agreement has been reached, at which point we will integrate them through the power that we will give the FPC to set the varying leverage ratio through time.

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[Lord Deighton]

I apologise to the noble Lord. I was so excited about the first question that I forgot about the second one. It is consistent with what I have already said that the FPC intends to address this recommendation in that timescale, but a full assessment will depend on the definition of leverage agreed internationally, so it all rather depends. In terms of who is going to implement it, as I said, the regulators already have the power to do so. In June this year, they changed the ratios on our key eight institutions to protect them in the mean time, so they have these powers and they have exercised them. I think that is a killer fact.

[Lord Lawson of Blaby]

My Lords, in some ways this has been a rather puzzling debate. I warmly endorse what the noble Lord, Lord Eatwell, said. This is one of the most important—if not the most important—issue that we have to discuss in the course of this extremely long Bill. For that reason alone, I think it likely that we will wish to come back to it at Report. Meanwhile, I am encouraged to some extent by what my noble friend the Minister said. However, he seemed to be saying at least two completely different things, if not three. One was that we would have to have the leverage ratio—we are all in agreement that we have to have a leverage ratio—that was internationally agreed. Then he said that we would also have discretion, with the FPC, to decide the leverage ratio, and therefore that there was no need for the amendment because the provision was already there.

First, I am not convinced that it is already there. I shall read very carefully what the Minister said. When my right honourable friend the Chancellor responded to the recommendation of the Parliamentary Commission on Banking Standards, he said nothing of the sort. Nor did he say whether he disagreed with it. He said the first part of what my noble friend said: namely, that we have to accept the international standard.

There are only two major global financial centres: New York and London. It is important that we do what is right for our financial centre—and the United States takes the same view. We should not rely on international agreements. Too often it is the lowest common dominator that is agreed. The United States is going its own way, particularly with large banks. It realises that it is a major global financial centre and that New York is so important to the American economy that they have to get it right.

In the United Kingdom, the banking and financial sector is even more important to the British economy. In relative terms, it is five times as important to our economy as the American banking and financial sector is to theirs. Therefore, it is all the more important, if we are to have a strong and successful financial centre and a strong and successful economy in this country, to do what is right.

It is quite clear that that means that we should have a leverage ratio that may be the same as what is agreed internationally—if it is agreed internationally—but may well be a more prudent one. It certainly would not be a less prudent one, but it may be in the interests of the City of London and the British economy that it should be more prudent.

The amendment states that the decision should be taken by the Financial Policy Committee of the Bank of England. In a sense, my noble friend agreed with that when he said that the duty was already there and that we had given it to the committee. If that is so, it is good news. However, I suspect that it is not entirely the case. Therefore, it is very likely—in fact, more than likely—that we will come back to this very important issue on Report. In the mean time, I beg leave to withdraw the amendment.

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[Lord Turnbull]

I reassure the noble Lord, Lord Higgins, that it is certainly not intended, while this activity might remain within a banking group, that it should be done, under the plan, by a ring-fenced bank. One of the reasons why we took the view that we should wait and see is that the dividing line between a proprietary trade and a trade on behalf of a customer is not straightforward, which is why it is very difficult in the US. For example, if I lend the noble Lord money he may seek some kind of hedge which I would provide. That might mean that my position as the bank is no longer what I really want it to be. As a bank, I would look around to see what my colleagues have done during the course of the day, and we would then add up all the positions that we have taken. We may well find that that position is not where we really want to be, so on the following day the bank goes out and undertakes a trade which gets it back to the degree of hedged position that it wants. Was that a proprietary trade or was it a trade that was a consequence of serving a customer? That is why this is actually very difficult and why we are wise to wait and see whether workable definitions could be found of what constitutes real proprietary trading and of what constitutes trading in response to a customer. This measured amendment enables us to do precisely that.

[Lord Deighton]

My Lords, the ICB considered in detail the case for a ban on proprietary trading in the UK, but decided in favour of ring-fencing. The PCBS heard evidence from a wide range of sources that prop trading does not appear to play a large role in the UK at the moment—as my noble friend Lord Lawson pointed out—nor did it play a significant role in the financial crisis. The noble Lord, Lord Turnbull, has already addressed the question of my noble friend Lord Higgins, but it should of course be noted that the ring-fenced banks will be banned from proprietary trading as well as from market-making and other forms of trading activity that would expose them to risks from global financial markets. Therefore, from a prudential perspective, much of the risk posed by prop trading can be addressed by a suitably robust ring-fence which is, of course, the thrust of our legislation. This was the point made by the PRA in response to questions from the PCBS.

It is also worth noting that the evidence heard by the PCBS also suggests that prop trading is not necessarily the sole avenue for the cultural contamination of banks. For example, the PCBS highlighted in its excellent report the serious failings in culture and standards at HBOS, a bank which did not engage in any prop trading at all. Indeed, it is perfectly possible to run an integrated securities business with full integrity in a way that manages any potential conflicts of interest quite satisfactorily, so they do not necessarily follow. It is far from clear, therefore, that prop trading is the real problem facing the UK financial system, or that structural solutions address cultural problems. In light of that, and of observations about the practical difficulties of a ban on prop trading, as it is being attempted in the US through the Volcker rule, the PCBS did not recommend a ban on prop trading.

It is not wholly clear what further evidence would support a different conclusion to that reached by the PCBS in its own assessment, so it is unclear what a further review into proprietary trading within such a short period of the PCBS’s own report would add. Still less is there a need for such a review to be followed immediately by an independent review of the same question. Of course, we have no issue with reviews as a matter of principle: we are just not sure that, in this case, legislating for one in advance really does much for us.

As the findings of the PCBS do not suggest that prop trading presents a serious prudential risk at this time, I do not think we need to legislate for the regulator to carry out a further review. The absolutely valid point made by my noble friend Lord Lawson was that this could change in the future. That is what we are trying to address. Should that happen, the PRA has made it clear that it already has the powers it needs to bear down on prop trading where it endangers the safety and soundness of a firm or where the risk incurred is not consistent with the publicly stated risk appetite of a bank.

Moreover, monitoring and reviewing all risks to a bank constitutes an essential part of the PRA’s work. The PRA’s approach is to insist that firms adopt and follow a risk appetite that is consistent with the PRA’s statutory objective to promote the safety and soundness of firms that it regulates. This will include regular monitoring and review of all risks, not limited just to those associated with prop trading. Therefore, to require the PRA by legislation to undertake such a review seems unnecessary. Should we legislate for a review of how reference rates are set, for example? Should we legislate for a review of mis-selling practices? Why, therefore, should we do it for prop trading? It is not apparent to me what problem a review would solve. While I think that reviews can play a useful role, in this case we are not sure that it is justified in advance.

We need to give the regulator the space to allocate its resources in a way that is appropriate and proportionate when considering all the different risks to the UK financial system, not only focusing on one particular risk. Our more widely framed reporting requirements allow for this. For all of these reasons, I do not think that a review on the particular issue of prop trading is necessary. The regulators are already subject to extensive reporting requirements. I expect the PRA to make the Treasury, and Parliament, aware of any emerging risks it identifies, whether through prop trading or anything else. The deputy governor for financial stability has already written to the chair of the Treasury Committee, offering to discuss arrangements for reporting. I therefore ask the noble Lord to withdraw his amendment.

[Lord Higgins]

My Lords, the Minister says that we do not want to have the regulator wasting resources. However, if we ban an activity, it would not waste resources. I am also not absolutely clear—I thought I was—that we are going to say that proprietary trading by a ring-fenced bank is absolutely banned. If that is so, ought we not to make it absolutely clear in the Bill?

On the point made by the noble Lord, Lord Turnbull, we have to distinguish between proprietary trading and other activities such as hedging as there may be a case for the bank operating on behalf of its clients by hedging for a foreign exchange risk or whatever. However, that is not at all the same as what is normally meant, certainly by Paul Volcker, whereby banks use a client’s money to take on particularly risky investments which have nothing to do with the client.

[Lord Deighton]

I was trying to be clear but I shall reinforce my comments. I think this issue was covered on the first day in Committee when we dealt with the details of ring-fencing. It is clear that proprietary trading for ring-fenced banks is not allowed; it is an excluded activity, as defined. As my noble friend implies, there are some exceptions to that which are predominantly related to a bank’s own hedging activities to deal with its own surplus liquidity. My noble friend’s phrasing was accurate and the issue is included in the Bill.

[Lord Lawson of Blaby]

My Lords, I think that there has been a slight misunderstanding. My noble friend the Minister said that we have gone down the ring-fencing route instead. That is a different matter altogether. The idea of ring-fencing is to put a sharp barrier between the commercial banking operations of a universal bank—the lending to individuals and to small businesses and, indeed, medium-sized businesses—and the investment banking activities. There should be a line between them. There is also the great question, which we debated earlier, as to whether there should be a total separation. This is about whether a universal bank—I agree with my noble friend that it would not be done in the ring-fenced part—should be permitted to engage in proprietary trading at all.

It is all very well to say that there may be cultural contamination as a result of proprietary trading but that, as there are other forms of cultural contamination as well, we should not bother about this one. I do not buy that. If we can significantly reduce the amount of cultural contamination by making proprietary trading by banks illegal, that is a plus. There may still be other problems with the banking culture, but at least we would have solved an important part of it.

My noble friend the Minister also seemed to say that there was no need to review this issue. There is a need to review it for the very reason that the noble Lord, Lord Turnbull, pointed out. The overwhelming weight of evidence received by the commission in conducting its inquiry was that it would be a very good idea for banks not to engage in proprietary trading for some of the reasons that I and other noble Lords have given in this short debate. However, as the noble Lord, Lord Turnbull, identified, the problem was how precisely you define proprietary trading and distinguish between it and market-making and some of the other activities referred to.

I have known Paul Volcker for 30 years. He is a very wise old bird. I am not suggesting that my noble friend the Minister is not wise, but of all the people I have known in the financial sector Paul Volcker is among the wisest, if not the wisest. If he thinks that this measure is desirable and workable, that carries a great deal of weight with me. He said that if a chief executive of a bank did not know whether or not he was engaging in proprietary trading he ought to be fired. At one level that is a perfectly good answer. Nevertheless, there is a complicated issue of definition. That is why we have said that we should see how things develop over the next three years and see whether there is a workable system in the United States or whether those who say that it is completely impossible to have a satisfactory definition because it will not work are right. We will find that out and then we will take action accordingly.

It is nice to hear mention of the notion that the PRA can bear down on proprietary trading as it implies an acceptance that there is, or could be, a problem. However, that is not the same thing as saying very clearly that no bank should be doing this, even if it is not a ring-fenced bank. At present, the Bill does not go far enough in that regard. This is something to which we will almost certainly wish to return on Report. I beg leave to withdraw the amendment.