Financial Services (Banking Reform) Bill

Lord Eatwell Excerpts

Wednesday 24th July 2013 Lords Chamber

[Lord Eatwell]

My Lords, I am most grateful to the noble Lord, Lord Deighton, for introducing the Bill. In his introduction he acknowledged the work of the Independent Commission on Banking and the Parliamentary Commission on Banking Standards in developing the thinking behind the policies that this Bill is intended to implement. The whole House is grateful to noble Lords who are members of the parliamentary commission for all the hard work they have done to formulate a new banking policy for this country. We look forward to hearing from three of them later today. The right reverend Prelate the Bishop of Birmingham is, I think, standing in for the most reverend Primate the Archbishop of Canterbury, from whom we hope to hear at a later stage. I hope also that we can hear at a later stage from the noble Lord, Lord Turnbull.

This Bill is the outcome of the Treasury’s intermediation, let us say, of the recommendations of the independent commission and, to a more limited extent, of the parliamentary commission. Less kindly observers might suggest that, instead of one of intermediation, the Treasury’s role might be described as watering down those recommendations. Every dilution by the Government increases the risk in the banking sector. It would assist the House enormously if, when the noble Lord, Lord Newby, sums up, he would list precisely those areas in which the Government have significantly toughened up on the recommendations that they have received.

Anyone who read this Bill without having studied the various documents issued by the independent commission, the parliamentary commission and the Treasury over the past two years would have absolutely no idea what the Bill is intended to achieve. The Bill essentially is an enabling Bill, which establishes the powers to do certain things—particularly with respect to the establishment of a ring-fence in the banking sector—without specifying exactly what is to be done. Noble Lords may search in vain for an indication of where the ring-fence might actually lie, how electrified or permeable the ring-fence might be, what would be the equity capital or primary loss-absorbing capital requirements and the leverage ratio—I prefer the British pronunciation—inside and outside the ring-fence, and so on. All those and many other matters are to be determined by order or handed over to the relevant regulator.

Yet those issues are central to any evaluation of the value of this legislation in the reform of one of Britain’s most important industries. The Government published last week a number of draft orders that illustrated how important aspects of the concept of a ring-fence will be made operational. That document illustrates just how fearfully complex those vital orders will be. To ensure that this crucial secondary legislation—and, indeed, what the parliamentary committee refers to as tertiary legislation—is suitably scrutinised, will the Government implement the parliamentary commission’s proposal that a small ad hoc joint committee of both Houses of Parliament be established on an ongoing basis to scrutinise secondary legislation and the proposed use of delegated powers?

It is clear that the Bill before your Lordships’ House today relates to but a fraction of the measures that either the parliamentary commission has recommended be included in it, or the Government have stated they intend to include. By the way, those are not the same thing, given that the Government have already rejected some of the parliamentary commission’s proposals.

We know that from the second report of the parliamentary commission there were 25 draft amendments. Some of those have been accepted but many have not. What is to become of those amendments?

There are then the important proposals on banking standards and culture contained in the remarkably thorough final report of the parliamentary commission. In their reaction to that report, the Government suggested that 13 of the conclusions will require implementation by means of primary legislation. There is a wide range of other matters that might properly be discussed at this Second Reading. So what will be accepted, and what will not? What form will all these amendments take? We do not know because we do not have them before us today. This Second Reading is being conducted largely in the dark. We wait for the Government to reveal their hand. When will this happen? When the Government publish their raft of amendments, will they publish a commentary on their significance to facilitate debate on this vital but complicated matter?

The Government estimate that the private cost of the Bill for the banking industry will lie in the range between £3.5 billion and £8 billion. Much of this cost is the removal of the implicit guarantee enjoyed by financial institutions too big to fail and is thus an economically appropriate reallocation of costs. Risk is being properly priced. In so far as the extra cost falls on ring-fenced banks, we can be sure that under current circumstances it will be passed on to retail customers and SMEs, increasing what is already an unreasonably marked-up cost of credit.

There is a serious need for increased competition in the banking industry to mitigate the impact of these extra costs. Since the crisis, defensive amalgamations and forced mergers have reduced competition from what was already a seriously inadequate level. This legislation introduces no fundamental change to the competition regime in banking. Account portability is a valuable addition to consumer choice, of course, but it is not a game changer in terms of competitive challenge. In addition, prudential regulation in our sensitive post-crisis world is proving an almost impenetrable barrier to entry for those who wish to establish new banks. The PRA will have competition as an objective, but where will that objective come in the hierarchy of objectives when it is considering a particular application? What are the Government going to do to bring about a game-changing shift in competition in retail banking in this country?

There are two major issues that do not seem to me to have been closely examined either by the independent commission or the parliamentary commission: regulatory arbitrage and the impact of banking structures on the performance of the real economy. In the run-up to the crisis, the activity of European banks raising deposits in the US and recycling them into the US shadow banking sector undermined the impact of US leverage regulations. The ICB refers tangentially to the importance of regulatory arbitrage, but I do not find its assertions convincing. Could the same recycling arbitrage happen to the UK’s ring-fence? Surely branches of EEA banks operating in the UK could undermine ring-fencing by providing the universal and potentially cheaper banking services that UK and EEA subsidiaries are no longer able to provide. What steps will the Government take to protect the UK ring-fence against such regulatory arbitrage?

Understandably, the thinking behind this Bill concentrated on the problems of the stability of the banking sector and, in particular, on ensuring that essential banking services are maintained during a crisis. This legislation also provides the opportunity to address a wider question: what structure of banking industry would best serve the needs of British industry as a whole, including manufacturing, the creative industries and internationally traded services aiding them to grow and compete in the global economy? Is the current structure that we are shoring up in this legislation really appropriate to the needs of the rest of UK plc? Is there a need for a British investment bank to supplement the Green Investment Bank and the infrastructure bank? Is there a case for regional banks? If the answer to both these questions is yes, will the Minister tell us how such institutions would fit into the ring-fenced structure proposed in the Bill?

An unfortunate aspect of the Treasury’s analysis has been the continued reliance on risk-weighted assets as the reference point for equity capital and potentially loss-absorbing capital and for the gradation of prospective measures with size. This reliance must be abandoned. As currently formulated, risk-weighted assets are a flawed and discredited measure. Consider, for example, the recent assessment by BaFin, the German banking regulator, on the capital requirements of German banks, as reported in the Financial Times on 28 May.

“Germany’s largest banks were €14bn short of the capital needed to meet incoming Basel III banking rules at the end of last year … BaFin’s estimates suggest that banks have mainly improved their capital ratios by … recalculating the risk weightings attached to some assets … Reducing the quantity of risk-weighted assets on the balance sheet means a bank can report a better capital ratio even if the amount of capital has not changed”.

If you do not like the numbers, just change them.

Three weeks ago, the Basel committee announced a major reconsideration of the role of risk-weighted assets, given that the measure is now so widely discredited. However, the Government’s response to the parliamentary commission’s final report states:

“The Government shares the concerns raised by the Commission and many other experts that flawed risk-weightings played a major role in the last crisis”.

That is all well and good, but after turning a single page, we read:

“Risk-weighted capital requirements should remain the primary measure of prudential capital regulation”.

This Government are deeply confused. A fundamental problem of risk-weighted assets is that they are excessively complex. As everyone knows, complexity is the friend of evasion, whether in taxation or regulation. However, a simpler measure is available: the leverage ratio. The parliamentary commission has recommended a leverage ratio of 4%. The United States has announced that it will be 6% in the US. The Treasury insists on sticking to 3%—why?

A higher leverage ratio of course reduces the return on bank equity—hence, by the way, bank bonuses—but it also significantly reduces risk. Why are the Government postponing handing determination of the leverage ratio to the Financial Policy Committee until 2018, despite the Bank of England repeatedly asking for this power now?

The vagueness of the ring-fence is exacerbated by the need to define various terms. What is an SME? If non-ring-fenced banks can inject capital into ring-fenced banks in times of need—a benefit claimed by the independent commission—cannot capital flow out when needed elsewhere, increasing the possibility of damaging contagion? If banks are also allowed to sell derivatives within the ring-fence, rather than act as agents, does this not reintroduce the fee-based culture that has already done so much damage in retail banking, whether in the form of PPI or selling to SMEs derivative protection that was anything but?

Surely it is not enough to claim that mandated activities do not pose a threat today, since activities that are safe today may prove very dangerous tomorrow. These dangers may even be part of systemic phenomena that are no fault of the individual firm. These and many more issues raise the core question of the permanence and permeability of the ring-fence. It is central to the attainment of the objectives of this Bill that the fence is impermeable; and it is vital for future confidence and investment in the banking industry that the fence’s location is clear, well-known and reasonably permanent.

The PCBS’s proposals on the electrification of the ring-fence are vital to the credibility. The Government have accepted the “first reserve power”, whereby a group containing a ring-fenced bank that is deemed to actively undermine the ring-fence could be forced to divest itself of the ring-fenced bank or the non ring-fenced bank—in other words, splitting them up. However, as we heard from the noble Lord today, the Government have rejected the inclusion of the second reserve power, whereby the ring-fence would be abandoned and full separation of all domestic and commercial banking strictly enforced.

Surely the Government have got the matter the wrong way round.The decision to split up a single group would have severe financial and competitive consequences and would undoubtedly entail a lengthy and expensive legal and political battle. It is such a nuclear deterrent that there will be a high expectation that it will never be used. It is not a credible threat. However, if banking as a whole might be split, there is a powerful incentive for mutual monitoring. Accordingly, the incentives motivating the sharpest minds in the industry, ensuring that their colleagues do not undermine the interests of the banking industry as a whole, would be aligned with the statutory objective. What could be better than that?

There are many more complex issues in this legislation which we will debate in Committee. I totally understand the Government’s desire to have this legislation on the statute book as soon as possible, and we on this side will do everything we reasonably can in support of that endeavour. However, this is the most significant reform of the structure of UK financial services in the past 40 years, and we must get it right. That is why we will scrutinise the legislation line by line and demand the early and comprehensive publication of secondary legislation to better judge the true implications of the Bill.

It is vital that this legislation succeeds. If it is watered down, or if it is too complex and does not succeed, it may well do more harm than good. As the parliamentary commission commented in its final report:

“The banking industry can better serve both its customers and the needs of the real economy, in a way which will also further strengthen the position of the UK as the world's leading financial centre. To enable this to happen, the recommendations of this Commission must be fully implemented in a coherent manner”.

Sadly, the Government’s response to the independent commission and the parliamentary commission has been anything but coherent. This incoherence has grave implications for Britain’s financial services industry. On this side, it is our intention in Committee to restore coherence to the Bill.

--- Later in debate ---

[Baroness Kramer]

I thank the Minister for giving way. The commission recommended some form of ad hoc committee to try to look at secondary legislation. The problem with secondary legislation is that you vote it up or down, so you cannot actually amend it. Given that it carries so much of the weight of the purpose of this Bill, is there a way in which there could be a more constructive discussion of its contents so that it could come finally and formally in an amended form after that discussion has taken place?

[Lord Eatwell]

Before the Minister stands up, can I firmly second what the noble Baroness, Lady Kramer, has said? It would be enormously valuable if there were an ad hoc committee which could consider the secondary legislation, write a suitable report and thus inform the House’s debate.

[Lord Newby]

My Lords, there is an issue about the timing of an ad hoc committee which produces a report to inform your Lordships’ debate. Agreement has been reached with the usual channels that we start Committee stage very soon after we come back and I am not sure that such an ad hoc committee would help. I will talk to colleagues in the Treasury and in another place to see how best we can facilitate proper discussion of secondary legislation, because, obviously, as everybody agrees, much of the meat is in the secondary legislation.

Can I reassure the noble Lord, Lord Barnett, that the banks had no part to play in drafting the Bill? It was produced by parliamentary counsel in the normal way. I should have said that draft secondary legislation was published on 17 July.

There was much discussion about standards and culture. The right reverend Prelate the Bishop of Birmingham talked about banks discussing doing what is right and about personal virtue. I agree with him that a wind of change is blowing through the banks and I am not as gloomy as a number of noble Lords have been about the extent to which the culture within banks may change. I would not put it any higher than that. I think there has been a big change in Barclays, and that is not a legislative change, it is because of the change of leadership and a change in culture.

In response to the commission, the Government propose to bring forward a number of amendments which specifically deal with standards and culture. These include a new senior persons regime for senior bank staff; introducing a new criminal offence of reckless misconduct; reversing the burden of proof, so that bank bosses are held accountable for breaches of regulatory requirements within their areas of responsibility; and giving the regulators new powers to make rules to provide enforceable standards of conduct for all bank staff.

Virtually every noble Lord who spoke has talked about the need to increase the degree of competition in the banking sector. I absolutely agree with the noble Lord, Lord Flight, that this is, if anything, the fundamental issue now facing the sector. I congratulate him and Metro Bank on its third birthday, and I congratulate him on the work that he is doing to increase competition in a very practical way.

Clearly, there is no simple way of getting to the state that most noble Lords would like, which is having a plethora of new banks providing effective competition to the existing big banks. What we have done, however, is to make it a lot easier for new banks to enter the market. In July last year, the Chancellor commissioned an FSA review of barriers to entry and expansion in the banking sector and the result of that review, in answer to the noble Lord, Lord Northbrook, is that for new banks we could see capital requirements fall by up to 80% over what was previously required. This is a big change and one of the many components that will be needed to transform the competitive landscape.

The noble Lord, Lord Eatwell, said that he was concerned about whether branches of EEA banks in the UK could arbitrage the ring-fence. EU passporting law makes branches subject to regulation and supervision in the home state, so UK branches of EU banks would not be subject to UK regulation or to ring-fencing, as the noble Lord said. The presence of EEA banks in the UK market at the moment is very small and we believe that domestic banks enjoy a strong home advantage, so there is not likely to be significant arbitrage. However, EU law has within it provisions to ensure that institutions cannot simply move to avoid regulation. We and the regulators will of course be keeping that issue very much under review.

A number of noble Lords talked about leverage—what an appropriate ratio should be, and where the power to set ratios should lie. There is a certain confusion about where powers lie at the moment. Although I am sure that we will discuss this at greater length later on, I would point out that the Government’s proposal, based on the Basel process, is that we would have a statutory minimum leverage level across the piece. However, the regulators already have the power to set a different leverage ratio for individual institutions, as we have already seen in the way that they have looked at Barclays and Nationwide—and completely without any political interference. That power will obviously continue.

The noble Lord, Lord Eatwell, drew a comparison between the 3% leverage ratio here and the 6% ratio in the US. We do not believe that these are even remotely comparable. Indeed, Mark Carney described comparing the two as being like comparing apples and oranges. I am sorry that I do not have time to explain in great detail why we believe that to be the case.

Electrification was possibly the issue that took most of your Lordships’ time. There are two issues here, given that we have agreed that in respect of an individual bank we will take powers in the Bill to enable that bank to be wholly separated. In respect of that, there has been considerable criticism of the provisions in the Bill on the basis that they provide too low a voltage, as the noble Lord, Lord Lawson, possibly said. We will be bringing forward amendments before Committee which seek to provide an appropriately increased level of voltage. I hope that they will commend themselves to your Lordships’ House.

In terms of total separation and a reversion to Glass-Steagall, our view is very straightforward. If ring-fencing were to prove ineffective, the only proper and democratic way to introduce full separation would be to return to Parliament with new primary legislation. However, given that it is a separate policy—not the same policy with a bit tacked on—we do not believe that the proposals in the Bill will be a failure. It would not be sensible to legislate for a failure that we do not think will happen; if we did that with every bit of legislation, the statute book would be many times its current length.

The noble Baroness, Lady Kramer, asked whether the Government had gone further than the PCBS on competition. It is a small thing, but we have recommended that the PRA and FCA review barriers to entry in a shorter time—the commission said two years; we have said 18 months—and that they publish annual statistics on the authorisation process so that we can see how things are going. The noble Baroness asked about game-changers in retail banking. The truth is that there will be no game-changer, but a series of small steps. The one step that will help is the seven-day switching service, which will be introduced in September and to which a number of noble Lords referred.

The noble Baroness also asked who will buy bail-in bonds. The Government have consulted on that; feedback suggested that there should be demand for bail-in debt instruments of the type that the ICB said banks should issue. Therefore we do not share her concern that there will be no effective demand for that.

The noble Lord, Lord Lawson, made a very eloquent argument for breaking up RBS into the good bank and bad bank. He knows that there will be a government response to that suggestion in the near future. He asked also about proprietary trading and believes that that is a bad idea. We believe that the ring-fencing method is superior to the Volcker-type rule in respect of prop trading and do not see a compelling case for a ban on prop trading in addition to the ring-fence. I can confirm that a difficulty in which an investment bank found itself would not threaten a high street bank. In terms of where funds can flow, it is a one-way valve: there would be no possibility of funding going from a ring-fenced bank back to an investment bank.

The noble Lord, Lord Flight, asked about the mis-selling of CDOs where that was being done, as I understand it, by foreign banks in this country. I can confirm that UK regulators could take action against any firm for mis-selling in the UK, including, obviously, foreign firms that were based here.

The noble Earl, Lord Caithness, talked about banks owning your money. He proposed what is essentially the same as full reserve banking and limited reserve banking, as it is known in the trade. The ICB has considered that issue and rejected the approach that he suggested.

The noble Lord, Lord Sharkey, asked whether the Government had gone soft on payday loan regulation: no, they have not. The FCA will be bringing forward proposals about how it intends to regulate the sector early in the autumn, which means that regulators are not waiting until next April to start to have impact. On central counter-parties, the noble Earl said that perhaps this is not the right Bill, and he is correct. The Financial Services Act 2012 extended the resolution powers in the Banking Act 2009 to systemically important investment firms, CCPs or group companies. Those powers will commence when secondary legislation has been laid in the autumn.

The noble Lord, Lord Northbrook, said that the SIs do not allow ring-fenced banks to provide export finance to SMEs. That is not the case. They can support UK businesses trading internationally. Obviously that is a very important issue for many small businesses.

I am extremely grateful to the noble Lord, Lord Tunnicliffe, for the constructive approach he took to the way we deal with this. I completely accept that we are asking noble Lords to work very hard over a relatively short space of time looking at a lot of new material. From the Government’s point of view, we will be making available all amendments and secondary legislation the moment we have them, and we are very keen that the House has the full opportunity to give all the proposals, not just those already in the Bill but those that will be coming forward, the maximum possible considered scrutiny.