My Lords, it is a great pleasure to open this debate on these two ring-fencing instruments because today marks the latest milestone in the long process of legislation to implement the ring-fence between retail and investment banking. These two orders define what must be inside the ring-fence and what must be outside. They are the final stage of legislation on the location of the ring-fence.
Ring-fencing will protect retail bank customers against the risks of investment banking. It will help to reduce the risk that a future Government are obliged to rescue a failing bank with taxpayers’ money. Ring-fencing will achieve this; first, by insulating vital retail deposit and payments services against shocks from elsewhere in the global financial system; and, secondly, it will make retail banks that provide these vital services simpler and more resolvable. This will mean that, if a bank gets into financial difficulties, the authorities will be better able to manage its failure in an orderly way, keeping those essential retail services running but without having to rescue the bank with public funds. Ring-fencing thus aims to get the taxpayer off the hook by making retail banks both less likely to fail and more safe to fail. The ICB recommended that all the legislation needed to implement the ring-fence be in place by the end of this Parliament. The Government have committed to that timetable and we are well on track to meeting our commitment.
Last year, we took the Financial Services (Banking Reform) Act 2013 through Parliament. It established in law the principles of ring-fencing, as well as implementing the recommendations of the ICB on bail-in and depositor preference. The Act also brought in wider reforms, including those proposed by the Parliamentary Commission on Banking Standards.
The Act created the concepts of a “ring-fenced body”; “core activities”, those that must be inside the ring-fence; and “excluded activities”, those that must be outside the ring-fence. It provided that the precise definitions of “core” and “excluded” activities be set in secondary legislation. This is the purpose of the two orders before us today. The ring-fenced bodies and
core activities order defines the scope of the ring-fence and the kinds of deposit that must be in the ring-fence. The excluded activities and prohibitions order defines the forms of trading in securities and commodities that must be outside the ring-fence, and imposes specific prohibitions on ring-fenced banks.
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The ring-fenced bodies and core activities order sets out which bodies will be subject to ring-fencing. The 2013 Act provides that any UK institution which accepts deposits, other than a building society, will be subject to ring-fencing, unless exempted by order. The order creates exemptions in two cases. First, it provides that only banks above a certain size will be required to be ring-fenced. The Government believe that the benefits of ring-fencing smaller banks are marginal and that the smaller banks would be likely to incur disproportionately high costs from having to ring-fence, which would reduce their competiveness. The order therefore creates an exemption, excluding banking groups with less than £25 billion of core deposits from the definition of “ring-fenced body”.
Secondly, the order exempts classes of institutions, such as insurers and credit unions, which are captured by the definition of “ring-fenced body” in the Act because they accept deposits. Ring-fencing is a policy developed to deal with the specific characteristics of banks and building societies. It was not designed as a solution to the regulatory challenges of other financial services firms. Therefore it is correct that they are exempted by this order. The order also provides that banks that cross the threshold due to a merger or acquisition, or resolution action taken by the Bank of England, will have a fixed four-year grace period before ring-fencing is applied to them.
The order also defines in detail the circumstances in which deposits can be held outside the ring-fence. The ICB recommended that large organisations and high net worth individuals should be able to deposit outside the ring-fence if they make an active choice to do so. This was because these depositors are sufficiently financially sophisticated to tolerate an interruption in access to a single bank, typically because they have multiple banking relationships. These sophisticated depositors therefore do not need the protection that is being mandated inside the ring-fence. They may, of course, choose to deposit in a ring-fenced bank if they wish.
The Government accepted this recommendation, and the order therefore provides that organisations above the Companies Act threshold for small companies—that is, organisations with turnover greater than £6.5 million, more than 50 employees, or an annual balance sheet total of more than £3.26 million— and individuals with greater than £250,000 in financial assets, can choose, as a one-off, to certify their deposits as non-core, allowing them to deposit with a non-ring-fenced bank.
The excluded activities and prohibitions order defines in detail the things that ring-fenced banks may not do. Under the Financial Services (Banking Reform) Act 2013, the regulated activity of,
“dealing in investments as principal”,
is an excluded activity. This means that ring-fenced banks may not engage in trading in financial investments on their own books. The Act, however, gives the Treasury power to make exceptions from this ban. The order before us creates exceptions, most importantly for ring-fenced banks’ own risk management and funding, for transactions with central banks, and for the provision of simple risk-management services to customers.
The first exception is intended to permit ring-fenced banks prudently to manage their own risks; for example, the interest-rate risk that arises from their lending activities. The ICB recommended that ring-fenced banks should be permitted to use derivatives or similar instruments to hedge these risks. The exception in the order therefore permits dealing in investments, including derivatives, provided that the sole or main purpose of the transactions is to hedge the risks of the ring-fenced bank or its subsidiaries. Similarly, the ICB recommended that ring-fenced banks should be allowed to trade in liquid assets, such as UK gilts, to manage their liquidity: the order therefore permits ring-fenced banks to do this. The second exception permits ring-fenced banks to trade with central banks. This will allow ring-fenced banks to access central bank liquidity in times of stress.
Thirdly, the order permits ring-fenced banks to sell a narrow range of simple risk-management products to their customers. A great many businesses, including small businesses, use simple swaps, futures and options to limit their exposures to interest rates, commodity prices and exchange rates; for example, by fixing the interest rates they will pay on their loans or locking in the exchange rate for trade transactions. This gives businesses certainty over their costs and revenues, allowing them the confidence to invest, grow and create new jobs. The exception in the order permits ring-fenced banks to sell the simplest and most standard products used by businesses for these purposes. This will allow ring-fenced banks to meet all the needs of the vast majority of UK businesses, including small businesses, which typically have only a single bank, and might find it costly and difficult to deal with an investment bank for risk-management services. Complex derivatives will not be permitted inside the ring-fence. These are typically used only by larger and more sophisticated corporate customers, who are often already multi-banked, so would have little trouble in sourcing derivatives from a non-ring-fenced bank.
Finally, as well as defining what trading in financial securities must be outside the ring-fence, the order creates a further excluded activity: dealing in commodities. Ring-fenced banks will be banned from speculating in physical commodities, such as precious metals or oil, as well as trading in financial investments. As well as defining the scope of the ban on dealing in investments, the order imposes a series of specific prohibitions on ring-fenced banks. First, ring-fenced banks are prohibited from having exposures to certain financial institutions. The ICB recommended this prohibition, which is a key part of the insulation of the ring-fence. It protects ring-fenced banks against financial contagion from elsewhere in the financial system. In line with the ICB’s recommendation, the order prohibits ring-fenced banks from having exposures to non-ring-fenced banks, most investment firms, globally systemic insurance
firms and investment funds. It permits exposures to other ring-fenced banks, building societies, credit unions, recognised clearing houses and central counterparties, investment firms which only offer advice, and banks subject to the same restrictions as ring-fenced banks, such as small retail banks.
In connection with this, I should tell the Committee that there is a small typo in Article 2(3)(g) of this order. The words “is not permitted” in the second line of that sub-paragraph should come at the end of the first line, as I am sure all noble Lords will have spotted. This will be corrected in the order before it is made.
Exposures to non-systemic insurers are also permitted, as these firms, which engage only in traditional insurance business, do not pose contagion risks comparable to those from non-ring-fenced banks or investment banks. The ICB recommended some exceptions to the prohibition on relevant financial institutions. This order creates those exceptions. First, ring-fenced banks may have financial institution exposures for the purpose of managing their own risks. Secondly, ring-fenced banks may provide payments services to other financial institutions; for example, acting as clearing banks for small banks. The exposures involved are permitted, subject to controls imposed by the PRA to address any prudential risks. To ensure that ring-fenced banks are themselves always able to access the payments systems whose use is critical to their business, the order separately imposes restrictions on the extent to which they may use the services provided by interbank payment systems except as direct members the payments systems.
The third exception permits ring-fenced banks to offer trade finance services to their customers. The ICB recommended that ring-fenced banks be permitted to offer trade finance services to customers. Such transactions often involve exposures to other financial institutions on behalf of their customers. The order also permits ring-fenced banks to have exposures to their own covered bond or securitisation vehicles and to engage in conduit lending and repo transactions. This is necessary to ensure that ring-fenced banks are not excluded from an important source of funding. Provision is also made to ensure that exposures to financial institutions which arise in the course of ordinary banking business, such as allowing retail customers to draw cash from the ATMs of foreign banks, do not breach the prohibition.
The final prohibition that the order imposes is on ring-fenced banks establishing branches or subsidiaries outside the EEA. The ICB recommended that ring-fenced banks should not offer services outside the EEA, to protect them against risks arising from elsewhere in the global financial system. Non-EEA branches or subsidiaries, which would be outside the recently agreed common European resolution framework, could also compromise the resolution of a ring-fenced bank in the event of failure. The order, therefore, prevents ring-fenced banks having such branches or subsidiaries, other than service companies that undertake no regulated financial activities.
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.