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:
- 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;
- Activities that may take place within the ring-fence, such as services typically required by individuals and small and medium-sized enterprises (SMEs);
- 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