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

Lord Tunnicliffe Excerpts

Monday 21st July 2014 Grand Committee

These orders thus complete the process of defining the location of the ring-fence. It is central to the Government’s radical programme of financial reform to ensure that there is no repeat of the crisis and bailouts of 2007-09. Making these orders is an important milestone towards meeting our commitment to have the ring-fence legislated in this Parliament. It is a big step towards finishing the job of financial reform, to give Britain a world-beating financial sector, while protecting consumers and taxpayers. I commend the orders to the Committee.

[Lord Tunnicliffe (Lab)]

My Lords, I thank the Minister for his presentation of these orders. The Opposition will not object to them. Indeed, in some ways they are unsurprising to the extent to which I sat through them with colleagues, facing the noble Lord, Lord Newby, through many hours of the parent Bills. As far as I can tell, most of the features appearing in these orders have already been mentioned in debates, notes and so on. They seem to do the job. I have just a couple of direct questions about the orders, and one or two wider questions that I hope the Minister will be able to respond to.

It is very interesting in terms of political process the extent to which we depend on the supporting material. It is conceivable to put in the 30-odd hours that are necessary to work from the Act through to the orders, through to whether the Explanatory Memorandum properly explains the legislation. I trust the Minister.

[Noble Lords]

Oh!

[Lord Tunnicliffe]

Well, I trust the Minister in this case then, on the Explanatory Memorandum. Let us not get carried away, although I do have a small point even on that. I am saying essentially that the Minister’s presentation and the Explanatory Memorandum, which I have studied in some depth, and the orders in as much as I was able to relate them to the Explanatory Memorandum, leave me with only a couple of direct questions.

First, the Minister spoke about the firms that are in the core. That was unexceptionable and exactly how the commission was talking. All the stuff I remember from the Explanatory Memorandum seems to fit with that. I found no surprises and the Minister has not pointed out any surprises to me. Therefore, my attention has concentrated on the Financial Services and Markets Act 2000 (Excluded Activities and Prohibitions) Order 2014.

Looking at the Explanatory Memorandum for that order, as a result of the Minister’s speech, I first lighted on paragraph 7.4, which states:

“This Order provides that dealing in commodities (e.g. precious metals, oil, agricultural products) is an excluded activity”.

The Explanatory Memorandum refers to “agricultural products”, and I am sure that if I went into it in enough depth, I could find whether or not agricultural products are excluded. The Explanatory Memorandum says that they are, but the Minister’s speech did not. I ask that as a small technical question.

It is interesting that in the rest of the order virtually everything seems to be fairly black and white. This is in; this is not. This is excluded; this is not excluded. Paragraph 7.5 of the Explanatory Memorandum caught my eye, where it lists the key things that the order does. It states:

“Third, the Order creates an exception to permit ring-fenced bodies to sell a narrow range of simple derivatives to their customers”.

The Minister gave a perfectly satisfactory explanation of why that was useful. What was less clear to me—I have to admit that it may be deep in the order—is how one defines “simple”. Listening to the Minister, “simple” seems to be defined as small and what small businesses want, while “complex” is big and what complex businesses want. That did not seem to me a fundamentally correct definition of “simple”; it should have more depth in it if it is to be a serious limitation on what is inside and outside the ring-fence. I would value further explanation of what “simple” means.

--- Later in debate ---

[Lord Newby]

My Lords, I am grateful to the noble Lord, Lord Tunnicliffe, for those questions, because they enable me to clear up, I hope, the points that he raised. He asked whether agricultural products were included in the definition of “commodity”. The answer is that, just like a metal, agricultural products —such as pork belly, or whatever, futures—are an excluded entity, along with all other commodities.

The noble Lord asked me about how to define “simple”. I am slightly inclined to say that of course it is not easy to define “simple” simply. However, the simple instruments that ring-fenced banks will be permitted to sell to their customers are defined in articles 10 and 11 of the excluded activities and prohibitions order, so there is quite a long list there. The definition or underlying concept of “simple”, is that we are primarily talking about derivatives that do not complicate the resolution of a failing bank. Why do we try to keep to simple products? We want to make it possible, relatively easily, to resolve a failing bank. Therefore simple derivatives are primarily ones that are straightforward to value; that is what makes them simple, or relatively simple.

[Lord Tunnicliffe]

Can the noble Lord repeat what he just said? I think he said something quite profound, although he said it quickly: that, by definition, they must be instruments that would not complicate the resolution.

[Lord Newby]

Yes; they are derivatives that would not complicate the resolution of a failing bank. They would not complicate it because they are relatively straightforward to value. As the noble Lord can imagine, some derivatives are extremely difficult to value. If I can just slightly elaborate on that, the excluded activities and prohibitions order limits ring-fenced banks to selling forwards and futures, plus a small range of options. They may only sell derivatives to hedge against three types of common business risk, namely currency, interest rate and commodity risk. Those are the most common business risks in which the market for derivatives is most liquid and, because it is liquid in those areas, it is easier to value them. To ensure that derivatives do not have any of the features that make them hard to value, the order requires that options contracts entered into must specify the amounts that may be bought or sold under the option, be at a specified price, and exercisable on a single specified day; or, in the case of interest caps or floors, interest rates must be based on a specified principle sum for a specified period.

The order also requires that ring-fenced banks may only sell derivatives that can be valued on the basis of observable market data or of a type traded on exchanges, and whose fair values are based on level 1 or 2 inputs under international financial reporting standards. Such instruments are more liquid and could be more easily valued in resolution. Article 12 of the order creates those safeguards, as well as placing caps on the net market risks of the derivatives portfolio, the gross size of the derivatives portfolio and the proportion of the portfolio that can be made up of simple options. I hope that that has gone some way to satisfy the noble Lord on that front.

The noble Lord asked about consultation. Consultation was issued in July last year, and the summary of responses was released in December of last year. We also consulted widely with stakeholders, including the Association of Corporate Treasurers, the CBI, non-financial companies, law firms and, of course, the banking industry itself. As a result of that consultation, we have made some changes to the legislation that are largely technical, but which will ensure that ring-fencing is fully compatible with the needs of UK businesses. For example, we made some small changes to the definition of “simple derivatives”, made it permissible for ring-fenced banks to have exposures to non-systemic insurers, made a series of technical changes to ensure that exemptions for payments and trade finance are operable, and removed the caps on payments and trade finance exposures. We also prohibited ring-fencing banks from having branches in the Crown dependencies. Therefore that is relatively technical stuff, but it has improved the legislation and has been a good exercise.

The noble Lord asked how the supervisors would supervise. The PRA is the principal supervisory body. It is in day-to-day contact with the banks. If it feels that it is not getting adequate information from the banks, it has extensive powers to require further information from them if it has any specific concerns. If a generic problem were to arise, it would obviously be in a position to discuss with the Treasury whether any further changes were needed in terms of the secondary legislation or in any other respect.

As to the question of timing, as the noble Lord said, the end point for the final implementation of the ring-fence is 2019. The justification for that is so that we can get all the secondary legislation done by the end of this year, which we expect to be able to do. The PRA then has to produce very detailed rules to make sure that the system is clear and works in the way that we wish it to do. On the basis of both the primary and secondary legislation, we estimate that it could take up to two years for all those rules to be finally in place, and then a final two years for the banks to implement the rules. That does not mean that the banks will not do anything in the mean time, because making this change obviously involves them in a huge amount of effort, activity and cost, so they are beginning to think about how they are going to do it. We have always thought that this timetable is measured and proportionate. The very fact that the banks know that we are moving in this direction means that some activities that they might have undertaken in the past they will not undertake in the interim period because they know what the new rules will be and that they will abide by them.

[Lord Tunnicliffe]

I thank the Minister for giving way. Clearly, we would like to see this done more quickly, but I hear the Minister’s response. I presume that, alongside this, there will be a parallel activity by the banks to develop their own structure—the responsibility of directors and so on—and to be in a corporate shape for this structure. Are the Government, through the PRA, participating in or monitoring that development?