Outreach Blog

Thursday, September 15, 2011

UK Independent Commission on Banking Issues Recommendations


Author: David Schwartz J.D. CPA David Schwartz J.D. CPA

Following the financial crisis, the UK established the Independent Commission on Banking (ICB) to examine options for the reform of the country’s banking industry.  In June 2010, the ICB was asked to study a range of structural and non-structural reforms to the UK banking sector that would foster financial stability and competition.  The ICB issued their final report on September 12.  The ICB’s proposals, if ultimately implemented, will have consequences not only for UK banks but also for foreign banks conducting business in the UK, and for counterparties, creditors, and other market participants.

The report proposes several changes to the structure of the UK banking system that potentially may simplify identification and remediation of failing financial institutions and reduce the probability and impact of bank failures. The reforms proposed by the ICB have the stated goal of:

Creat[ing] a more stable and competitive basis for UK banking in the longer term. That means much more than greater resilience against future financial crises and removing risks from banks to the public finances. It also means a banking system that is effective and efficient at providing the basic banking services of safeguarding retail deposits, operating secure payments systems, efficiently channeling savings to productive investments, and managing financial risk. To those ends there should be vigorous competition among banks to deliver the services required by well-informed customers.

Retail Banking v. Wholesale/Investment Banking

While proposing some structural reforms, the ICB does not recommend a sharp separation between retail banking and wholesale/investment banking.  Rather than requiring retail banking and wholesale/investment banking to be in separate non-affiliated firms, the report recommends structural reform through internal ring-fencing within universal banks to insulate UK retail banking services from investment banking risk. 

The purpose of the retail ring-fence is to isolate those banking activities where continuous provision of service is vital to the economy and to a bank’s customers in order to ensure, first, that this provision is not threatened as a result of activities which are incidental to it and, second, that such provision can be maintained in the event of the bank’s failure without government solvency support.

The ICB recommends that the activities of ring-fenced entities be divided into three broad categories:

  1. Activities which must take place within the ring-fence, such as insured deposits since these are explicitly guaranteed under the terms of the Financial Services Compensation Scheme;
  2. Activities that may take place within the ring-fence, such as services typically required by individuals and small and medium-sized enterprises (SMEs);
  3. Activities that must not take place within the ring-fence, for example the provision of capital markets services, trading and hedging services.

Loss Absorbing Capacity

The ICB recommends a modest increase in the bank capital requirements as a method of increasing the bank's owners and creditors exposure to underlying risks of a bank's business.  Presumably this greater exposure would act as an incentive for better monitoring of risk and more active control, which in turn, may reduce the probability of a bank failure. 

Equity:
  • Ring-fenced banks with a ratio of risk -weighted assets (RWAs) to UK GDP of 3% or more should be required to have an equity-to-RWAs ratio of at least 10%.
  • Ring-fenced banks with a ratio of RWAs to UK GDP in between 1% and 3% should be required to have a minimum equity-to-RWAs ratio set by a sliding scale from 7% to 10%.

In addition, the ICB proposes a number of tools intended to address loss-absorbing capacity, including bail-inable debt and depositor preference. The report also recommends leverage ratios for ring-fenced banks, as well as augmented primary loss-absorbing capacity, supervisor discretion regarding additional loss-absorbing capacity, and preference for depositors in the event of insolvency or resolution of a subject bank. 

Bail in:
  • The resolution authorities should have a primary bail-in power allowing them to impose losses on long-term unsecured debt (bail-in bonds) in resolution before imposing losses on other non- capital, non-subordinated liabilities.
  • The resolution authorities should have a secondary bail-in power to enable them to impose losses on all other unsecured liabilities in resolution, if necessary
Depositor preference:
  • In insolvency (and so also in resolution), all insured depositors should rank ahead of other creditors to the extent that those creditors are either unsecured or only secured with a floating charge.
Leverage ratio:
  • All UK-headquartered banks and all ring-fenced banks should maintain a Tier 1 leverage ratio of at least 3%.
  • All ring-fenced banks with a RWAs-to-UK GDP ratio of 1% or more should have their minimum leverage ratio increased on a sliding scale (to a maximum of 4.06% at a RWAs-to-UK GDP ratio of 3%).
Primary loss-absorbing capacity:
  • UK-headquartered global systemically important banks (G-SIBs) with a 2.5% G-SIB surcharge, and ring-fenced banks with a ratio of RWAs to UK GDP of 3% or more, should be required to have capital and bail-in bonds (together, primary lossabsorbing capacity) equal to at least 17% of RWAs.
  • UK G-SIBs with a G-SIB surcharge below 2.5%, and ring-fenced banks with a ratio of RWAs to UK GDP of in between 1% and 3%, should be required to have primary loss-absorbing capacity set by a sliding scale from 10.5% to 17% of RWAs.
Resolution buffer:
  • The supervisor of any (i) G-SIB headquartered in the UK; or (ii) ring-fenced bank with a ratio of RWAs to UK GDP of 1% or more, should be able to require the bank to have additional primary loss-absorbing capacity of up to 3% of RWAs if, among other things, the supervisor has concerns about its ability to be resolved at minimum risk to the public purse.
  • The supervisor should determine how much additional primary loss-absorbing capacity (if any) is required, what form it should take, and which entities in a group the requirement should apply to, and whether on a (sub)consolidated or solo basis

Other Recommendations

In addition to structural recommendations, the ICB’s report makes numerous recommendations aimed at increasing the competitiveness of UK banks including recommendations on lowering barriers to entry into the UK financial sector, easing depositor transitions, and improve transparency across all retail banking products.

Contrast with Basel III

The capital requirements proposed by the ICB for the UK exceed those required by Basel III.   Basel III standards require banks to have equity capital of at least 7% of risk-weighted assets by 2019, with a corresponding tightening of risk weights.  Further, Basel III standards also include a proposal as a secondary measure to limit leverage to thirty-three times. 

The report makes plain that, while the ICB sees Basel III standards as a very positive proposed change, the ICB does not think Basel III standards go far enough.  The ICB explains its disagreement with Basel III while recognizing that having a divergent standard in the UK could be troublesome.

First, the analysis discussed in Chapter 4 below indicates that, if capital requirements could be increased across the board internationally, then the best way forward would be to have much higher equity requirements, in order greatly to increase confidence that banks can easily absorb losses while remaining going concerns. The Commission is however conscious that unilateral imposition of a sharply divergent requirement by the UK could trigger undesirable  regulatory arbitrage to the detriment of stability. Second, a leverage cap of thirty-three is too lax for systemically important banks, since it means that a loss of only 3% of such banks’ assets would wipe out their capital. Third, in contrast with the Basel process, the Commission’s focus is on banks with national systemic importance, as well as on ones with global importance. Fourth, the loss absorbency of debt is unfinished business in the international debate.

It remains to be seen how the UK will act to harmonize the ICB’s recommendations with Basel III. 

Implementation

The ICB recommends the structural and capital proposals of the report to be implemented by early 2019.  This implementation deadline coincides with the deadline for full implementation of the Basel III. The ICB recommends that its  proposal for redirection services proposal should be introduced immediately.

Conclusion

Although the ICB’s recommendations appear moderate on the surface, should they be implemented, they represent an ambitious endeavor having far reaching effects outside the UK as other countries will no doubt follow the lead. 

The full text of the ICB’s report is available via: http://bankingcommission.s3.amazonaws.com/wp-content/uploads/2010/07/ICB-Final-Report.pdf

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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