Financial Services Bill

Lord Sharkey Excerpts

Monday 26th November 2012 Lords Chamber

Moved by

[Lord Sharkey]

92A: Clause 30, page 122, leave out lines 3 to 26 and insert—
“296A Additional power to direct UK clearing houses
(1) The Bank of England may direct a UK clearing house to take, or refrain from taking, specified action if the Bank is satisfied that it is desirable to give the direction, having regard to the public interest in—
(a) protecting and enhancing the stability of the UK financial system,(b) maintaining public confidence in the stability of the UK financial system,(c) maintaining the continuity of the central counterparty clearing services provided by the clearing house, and(d) maintaining and enhancing the financial resilience of the clearing house.(2) The direction may, in particular—
(a) specify the time for compliance with the direction,(b) require the rules of the clearing house to be amended, and (c) override such rules (whether generally or in their application to a particular case).(3) The direction is enforceable, on the application of the Bank, by an injunction or, in Scotland, by an order for specific performance under section 45 of the Court of Session Act 1988.
(4) The Bank may revoke a direction given under this section.
(5) In this section “central counterparty clearing services” has the same meaning as in section 155 of the Companies Act 1989 (see subsection (3A) of that section).
296B Additional power to direct UK clearing houses (No. 2)
(1) The Bank of England shall ensure that each authorised Clearing House draws up and maintains a recovery plan providing, through measures taken by the management of the clearing house or by a group entity, for the restoration of its financial situation following significant deterioration.
(2) The Bank of England shall ensure that the clearing houses update their recovery plans at least annually or after change to the legal or organisational structure of the clearing house, its business or its financial situation, which could have a material effect on, or necessitates a change to the recovery plan; and the Bank of England may require authorised clearing houses to update their recovery plans more frequently.
(3) Recovery plans shall not assume any access to or receipt of extraordinary public financial support but shall include, where applicable, an analysis of how and when a clearing house may apply for the use of central bank facilities in stressed conditions and available collateral.
(4) The Bank of England shall ensure that authorised clearing houses include in recovery plans appropriate conditions and procedures to ensure the timely implementation of recovery actions as well as a wide range of recovery options; and the Bank of England shall ensure that firms test their recovery plans against a range of scenarios of financial distress, varying in their severity including system wide events, legal-entity specific stress and group-wide stress.
296C Additional power to direct UK clearing houses (No. 3)
(1) The Bank of England shall require authorised clearing houses to submit recovery plans to it for review.
(2) The Bank of England shall review those plans and assess the extent to which each plan the following criteria—
(a) the implementation of the arrangements proposed in the plan would be likely to restore the viability and financial soundness of the clearing house, taking into account the preparatory measures that the clearing house has taken or has planned to take;(b) the plan or specific options could be implemented effectively in situations of financial stress and without causing any significant adverse effect on the financial system, including in the event that other clearing houses implemented recovery plans within the same time period.(3) Where the Bank of England assess that there are deficiencies in the recovery plan, or potential impediments to its implementation, they shall notify the clearing house of their assessment and require the clearing house to submit, within three months, a revised plan demonstrating how those deficiencies or impediments have been addressed.
(4) If the clearing house fails to submit a revised recovery plan, or if the Bank of England determines that the revised recovery plan does not adequately remedy the deficiencies or potential impediments identified in its original assessment, the Bank of England shall require the clearing house to take any measure it considers necessary to ensure that the deficiencies or impediments are removed; and the Bank of England may, in particular, require the clearing house to take actions to—
(a) facilitate the reduction of the risk profile of the clearing house;(b) enable timely recapitalisation measures;(c) make changes to the firm strategy;(d) make changes to the funding strategy so as to improve the resilience of the core business lines and critical operations;(e) make changes to the governance structure of the clearing house.”

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[Lord Sharkey]

My Lords, Amendment 92A would require the Bank of England to ensure that UK-authorised clearing houses have in place a recovery plan. The amendment sets out the features of a recovery plan and requires each clearing house to submit a recovery plan to the Bank for assessment. The amendment also gives the Bank the power to require changes to recovery plans that it finds deficient against well defined criteria. In the case of continued deficiency, it gives the Bank the power to require the clearing house to take any measure that it considers necessary to remedy these deficiencies. The overriding purpose of the amendment is to put in place statutory provisions to make catastrophic clearing house failure less likely.

I know that the Government are entirely alive to the possible failure of clearing houses, and I am grateful for the discussions that I have had with the Ministers’ officials on the subject. I think that it is almost universally acknowledged that when the G20 proposals for putting almost all derivatives trading through clearing houses are in place, these greatly enlarged clearing houses will be the focus of greatly enlarged risk.

One of the immediate consequences of the huge enlargement of business through the clearing houses will be a huge increase in the demand for high-quality collateral. The IMF believes that this shift will boost demand for high-grade assets by between $2 trillion and $4 trillion. The question is, of course, where will these high-grade assets be found? It is entirely possible that there will not be enough of them to backstop the $700 trillion derivatives market. In fact, in the US at least seven banks plan to let customers swap lower-rated securities that do not meet clearing house standards in return for a loan of treasuries that do—a process which is known, rather alarmingly, as “collateral transformation”. We saw what happened with the collateral transformation of sub-prime bonds, and we can see where this new collateral transformation might lead.

On 7 November, in his evidence to the Banking Standards Commission, in response to a question from my noble friend Lady Kramer, Andy Haldane of the Bank of England said that,

“many people are fearful that the next crisis may be in the infrastructure and particularly in the central counterparty space. For all the reasons you say, these will be entities that are too big to fail, on steroids”.

He was talking about clearing houses.

The Bill already contains a partial response to the fear that the failure of a clearing house would produce an even worse financial crisis than the one we are enduring. The Government have introduced in the Bill powers of resolution to deal in an orderly way with the failure of a clearing house. However, there is a stage before failure that is vital to consider if the chances of avoiding collapse are to be as high as possible—the stage that deals with recovery.

I am certain that all clearing houses already have in place detailed recovery plans aimed at preventing outright failure, allowing some continuation of trading and preventing infection spreading pervasively throughout the financial system. I am certain that these plans will have been discussed with the Bank. The Government may think that these discussions are sufficient. After all, there are only five recognised UK clearing houses and seven recognised overseas clearing houses under supervision.

The Government may also feel that the Bill already gives the Bank power to do pretty much as it sees fit, in the widest possible sense, if it sees a crisis developing. However, this assumes that it can see a crisis developing, which was obviously not true in the recent past. It also assumes that informal discussions are better than a clear, well defined statutory obligation. It places a higher value on informal contact than on an open, clear, regular and disciplined system of review. That attitude did not work too well with LIBOR. The Government’s Statement this afternoon about the new Governor of the Bank of England rather bizarrely stated:

“The role the Bank of England plays in our economy cannot be underestimated”.

It does not seem satisfactory essentially to say that because there are only 12 recognised clearing houses, the Bank can and will keep a very close eye on them. I am sure that the Bank already keeps a close eye on them, and its gaze will be even keener when the clearing houses’ risk to the entire financial system is enormously magnified. However, an eye, no matter how closely applied, is no substitute for a formal, disciplined, well defined and transparent supervisory process.

In a very real sense, the whole Bill is based on the premise that formal, disciplined, well defined and transparent supervisory processes are critical to the proper functioning and stability of the financial system. The EU also takes this point of view. An EU draft directive on recovery and resolution was published earlier this year. It requires a specific, formal and disciplined process for clearing houses to draw up recovery plans, maintain them and have them assessed and gives the appropriate regulator power to assess and to intervene. The language of the amendment comes almost directly from the draft directive. However, at the moment, the draft directive is not making much progress. It is still waiting for First Reading in the European Parliament.

The Government had anticipated that it may take time for European legislation to emerge. In their response to the consultation opened by the document, Financial Sector Resolution: Broadening the Regime, which covers central counterparties as a key group and closed on 24 September, the Government stated:

“In due course, the Government would therefore expect to see European legislation brought forward. However, the timing of any European legislation is uncertain at this stage. Even the Recovery and Resolution Directive, which is more advanced than other proposals, does not have a date that is certain for its adoption. The Government is therefore minded to develop the UK’s domestic regime in advance of the European process”.

This is exactly what the Government have done regarding the resolution half of the proposal. The question is why they have not done this for the recovery part of the proposal. Warding off collapse is every bit as important as dealing with collapse. The risks involved in the failure of a clearing house have the potential to make the current financial crisis look almost trivial. Why not take every precaution we can, and why not take them now?

The new Governor of the Bank of England is also of this mind. He said two weeks ago in a speech to the Canadian Club of Montreal that it was not yet clear that the “too big to fail” situation had been ended, and added, quite explicitly, that each global systemically important financial institution must have mandatory recovery resolution plans in place. I hope that the Minister will agree with Mr Carney and might reconsider the importance of having in place a rigorous recovery plan regime for clearing houses, rather than relying on informal supervision while we wait for the EU to regulate. I beg to move.

[Baroness Cohen of Pimlico]

My Lords, I draw attention to Amendments 92B and 92C in my name. I must declare my interest as a director of the London Stock Exchange and, for that matter, as vice president of the Borsa Italiana—and, as such, the owner of a clearing house in Italy. Subject to all the regulatory requirements, I have a 60% shareholding in LCH.Clearnet, a London-based clearing house.

London Stock Exchange Group supports recovery and resolution powers for the financial markets and believes that these will be best delivered in clear and consistent legislation. We expect to come under close scrutiny. The amendments in my name help with elements of proposed new Section 296A of the Financial Services and Markets Act, which gives the Bank of England additional powers to direct UK clearing houses that were introduced by the Government in Committee. That is why we have not heard quite so much about them until now.

I am grateful to the Minister for the assurance he provided to the House on 15 October that the Bank of England would not use these powers to require shareholders, members or clients of clearing houses to recapitalise or otherwise fund a failing clearing house. This is vital because owners of a clearing house need to know their maximum possible liabilities in order to manage and control their funding. Following helpful discussions with HM Treasury and the Bank of England, it is understood that the circumstances in which the power of direction would be exercised fall somewhere between the day-to-day powers and the other powers provided by the Banking Act. Again, I am grateful to HM Treasury and the Bank of England for their willingness to engage in dialogue on all this. I am sure that we all want effective regulation of clearing houses, but we need clarity and certainty around the scope of the powers and the circumstances of their use.

The amendment seeks to put in the Bill the government description of the circumstances in which the powers would be used, as is the case for the existing crisis powers, and when they are to be used. This should also include a requirement to consult the other regulators and the clearing house, as suggested in the amendment.

My amendments would bring clarity and would, to some extent, future-proof these powers in three key ways. First, Amendment 92B would clarify that the powers would be used only if “necessary”, rather than “desirable”, which is an objective and appropriate test.

Secondly, Amendment 92C seeks to characterise the new powers in proposed new Section 296A of the Financial Services and Markets Act more clearly as sitting between the day-to-day powers and the Bank of England’s crisis powers. My amendment seeks to introduce conditions on the Section 296A power, while stopping short of requirements provided for under the Banking Act powers, which have much stricter trigger conditions and consultation requirements. This would allow the Bank a clear ability to use the different sets of powers. If Government can improve on this wording to give greater clarity on exactly when the powers would be used, I would welcome that. I hope at this stage only to highlight the issue and seek closer definitions.

Thirdly, Amendment 92C would place a consultation requirement on the Bank before using the powers—and takes account of the changes being made to Section 298 of FiSMA—that would allow the Bank to waive consulting the clearing house, if necessary. This would ensure that the relevant authorities considered the wider market consequences of a proposed direction, while allowing flexibility for the Bank.

Taken together, these amendments would achieve the Government’s objectives and support the legitimate interest of clearing houses. The amendments would retain full flexibility of the Bill as drafted, while offering greater clarity and certainty for market infrastructure operators, which we all need.

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[Lord Sassoon]

My Lords, the Government note the concerns expressed about the additional powers of direction to be conferred on the Bank of England. Some of these concerns are reflected in Amendments 92B and 92C, tabled by the noble Baroness, Lady Cohen of Pimlico. These amendments seek to impose more stringent conditions on the Bank of England’s ability to exercise the Section 296A power. I will say at the outset that in response, the Government are minded to bring forward amendments at Third Reading to address some of the concerns raised by the industry.

Before bringing forward amendments at Third Reading, I will reflect further on the debate we have had today. However, I am happy to confirm that the Government are considering amendments to raise the threshold of the trigger for the power of direction to a “necessary” rather than a “desirable” test; to more clearly set out how the power is to be used, including specifying procedures with which the Bank should comply prior to issuing a direction, whether on a routine or an expedited basis; and, finally, to set out in statute the assurance that I have already given the House that the additional power of direction cannot be used to compel a clearing house to accept the business of a competitor.

I will now address the amendments in this group. Amendment 92A, tabled by my noble friend Lord Sharkey, seeks to introduce a requirement for clearing houses to draw up and maintain recovery plans. The appropriate place for a requirement for clearing houses to prepare recovery plans would be in Part III of the recognition requirement regulations made under Section 286 of FiSMA, not in primary legislation.

The Government have already outlined their intention to build on the positive developments around loss allocation arrangements that are being introduced by some clearing houses of their own volition, and will also consult on proposals to make changes to the recognition requirement regulations, which are the operating conditions under which clearing houses are licensed to operate in the UK. The changes would have the effect of requiring all UK clearing houses to have in place loss allocation rules. As part of the consultation exercise, the Government will also seek views on proposals to change the recognition requirement regulations to make mandatory the preparation and maintenance of recovery plans by clearing houses. We are on the case and certainly are not waiting for EU legislation. However, we believe that the recognition requirement regulations are the appropriate place for these conditions, and we will take action to that end.

Amendment 93A, tabled by my noble friend Lord Flight, would impose further preconditions on the exercise of the power, would limit the scope of any direction given under the power and would apply various provisions of the special resolution regime provided for in Part 1 of the Banking Act 2009 to any direction given. It would not be appropriate for the Bank of England to wait until the financial position of a clearing house had deteriorated to the extent that it posed a serious threat to financial stability or failed to meet its recognition requirements before exercising the additional power of direction. The additional power of direction is a supervisory power, not a resolution power. It will allow the Bank of England to manage the considerable risks that may be posed by the actions of a clearing house which do not constitute a breach of its recognition requirements or its obligations under FiSMA 2000. If Amendment 93A were agreed, the Bank of England might be unable to give a direction that would safeguard the solvency of a clearing house, forcing the use of resolution powers as a last resort in order to minimise the impact of the failure of the clearing house on wider financial stability.

It would also be inappropriate to limit the scope of any direction that the Bank of England might give in the way suggested by Amendment 93A. The additional power of direction is intentionally wide-ranging. The Government feel that this is essential in order to build in sufficient flexibility to enable the Bank to manage and respond to new and unusual risks that may require regulatory action that goes beyond the purposes specified in Amendment 93A. The Government also believe that requiring a court order to be obtained before any direction could be given by the Bank could undermine successful regulatory intervention in instances where there was a need to act with alacrity in the event of a crisis. The court may not necessarily be well placed to make judgments on whether action is necessary having regard to the relevant public interest criteria.

Finally, it would not be feasible to apply the provisions of the special resolution regime provided for in Part 1 of the Banking Act 2009 to this power of direction. The additional supervisory power of direction provided for by Section 296A is separate and distinct from the stabilisation powers, exercisable in respect of UK clearing houses, provided for by Amendment 193G. In contrast to the power of direction, which is a supervisory tool, the stabilisation powers are resolution tools that would be deployed to minimise the impact of the failure of a clearing house on wider financial stability. Given that alternative, specific resolution powers exist, it would be unreasonable for the Bank of England to use the power of direction to effect “partial property transfers”. Such an action would be contrary to the constraints under which the Bank operates as a public authority.

With those explanations and assurances about what we intend to come forward with at Third Reading, I hope that my noble friend will feel able to withdraw his amendment.

[Lord Sharkey]

My Lords, I seem to have put my amendment in the wrong place, but I think I heard the Minister say that recovery plans would be made mandatory in any case but by other means. Given the risks involved, it would be nice to have some sense of when that may actually happen, but in the mean time I beg leave to withdraw the amendment.

Amendment 92A withdrawn.