ICB Interim Report On UK Banking Reform - Capital Adequacy/BASEL

Background

The UK's Independent Commission on Banking (the "Commission") published its much anticipated interim report (the "Report") on 11 April 2011. The Commission was established by the UK government in June 2010 under the chairmanship of Sir John Vickers with the task of examining possible structural and related non-structural measures to promote stability and competition in UK banking. In September 2010 the Commission published an Issues Paper¹ which, on top of suggesting possible options for reform, was also a call for evidence. The Report sets out the Commission's provisional views on possible reform options and seeks further feedback and submissions in response to it. The Commission will make its final recommendations in September 2011 to the Cabinet Committee on Banking Reform.

We summarise below the principal features of the Report.

The Report focuses first on the effect of the global financial crisis on the UK's financial sector, which it notes is large, relative to the UK's GDP, and concentrated in a small number of institutions. For instance it estimates that Citigroup's assets constituted 16% of U.S. GDP at the time of its public bail-out, compared to a figure for RBS's assets of 99% of the UK's GDP at the time of its bail-out. In its view, this was a practical illustration of what had been understood for some time—that systemically important banks enjoy an implicit government guarantee because they are considered too big (or interconnected) to be allowed to fail. In the UK, the relative scale of the public bail-outs have served to emphasise, in the Commission's view, that the too-big-to-fail problem needs to be contained by introducing reforms that reduce the likelihood of failure of systemically important institutions and, if they do fail, reduce the impact of their failure. This could be achieved, in its view, by providing for the orderly resolution of failing institutions, as well as reducing levels of risk in the financial system as a whole, but it cautions that these reforms must be tailored so that they do not disproportionately affect the ability of the financial system to provide financial services that are critical for the "real economy".

As a separate topic, the Commission has also proposed initiatives to address its perceived weakening of competition in the UK retail banking industry as a result of the financial crisis. For instance, it estimates that following its acquisition of HBOS plc, the Lloyds Banking Group currently has around 30% of all current accounts in the UK.

The Commission asserts that structural and behavioural changes are necessary to improve conditions for competition in UK retail banking to counter the increased concentration and loss of challengers to the large incumbent banks as a result of the crisis. The Report considers three initiatives to help improve competition. The first consists of structural measures, such as imposing on the Lloyds Banking Group an even greater requirement to divest itself of assets and liabilities than it is already subject to pursuant to European Commission conditions for the approval of aid it has received from the UK Treasury. Second is to improve conditions for consumer choice in the banking sector by making it easier for customers to switch bank accounts. The aim of improving consumer choice in this way is to help reduce existing barriers to the entry of new competitors in the retail banking sector. The Commission considers that it should be possible to introduce such a system at a reasonable cost within a short timescale. Third is giving the Financial Conduct Authority a primary duty to promote competition as it will have regulatory tools not available to the general competition and consumer authorities, hence placing it in a strong position to play this role.

The remainder of this note focuses primarily on the financial stability proposals of the Commission.

Bank Stability

The Report states that measures to promote bank stability should be focused on making banks better able to absorb losses, making it easier and less costly to rescue banks that get into trouble and curbing incentives for excessive risk taking. The approach the Commission currently favours is a compromise between full structural separation of retail banking and investment banking and very high capital requirements, so as to balance the benefits of such measures with the associated costs. Its proposed measures include making bank debt more effective at absorbing losses, imposing high (but not excessive) capital requirements, and an internal ring-fencing of UK retail banking services within universal banks.

Increasing Loss-Absorbing Capacity

The Report divides loss-absorbing capacity into two categories, depending on whether it increases the ability of a bank to absorb losses before it fails and goes into resolution ("going concern" capacity), or only when the bank fails and enters resolution ("gone concern" capacity). Pre-resolution loss-absorbing capacity directly reduces the probability of bank failure by reinforcing the ability of a bank to take losses without failing. Post-resolution lossabsorbing capacity reduces the impact of bank failure by allowing losses to be absorbed by the shareholders and creditors of a bank rather than others (including taxpayers) being affected.

The Commission states that both going concern and gone concern loss-absorbing capacity can have an indirect effect on bank stability by exposing banks' owners and creditors to the risk of losing money, hence aligning their incentives with risk management so as to reduce the probability of failure. It therefore believes that increasing loss-absorbing capacity reduces the impact of failure on the rest of the financial system and the economy and therefore reduces taxpayer exposure. It believes that limiting the implicit government guarantee, which is especially relevant to systemically important financial institutions ("SIFIs"), can mitigate both the "too big to fail" problem (which gives rise to moral hazard concerns in encouraging banks with the benefit of an implicit state guarantee to take excessive risks and giving them a competitive advantage over other institutions) and the "too big to save" problem (where public finances are insufficient to bear the costs of bailing out a failing bank).

The Commission notes that the most straightforward and well-understood form of loss-absorbing capacity is equity and states that it has given substantial consideration to the appropriate minimum amount of equity it believes a SIFI should hold. It also observes that debt can be structured to absorb losses and in this regard it considers:

contingent capital – debt instruments that are written down or convert into equity at some point whilst the bank is still viable;
bail-inable debt – liabilities that are written down or convert into equity at the point of non-viability; and
depositor preference – ranking (at least some) depositors above other unsecured creditors in a bank insolvency.

Equity and the SIFI Surcharge

The Commission, in considering the amount of equity that should be held by banks, has had regard to the minimum regulatory capital requirements set out by the Basel Committee for Banking Supervision ("BCBS") in its recent Basel III papers, in particular the amount of common equity tier 1 capital ("CET1") (comprising ordinary shares, share premium and reserves) to be held by banks against their risk-weighted assets ("RWAs"). It notes that although risk weights have in recent history done a poor job of assessing how much capital should be held against assets, they are the "backbone" of the Basel Capital Accord and so should be used in finding a ratio for the amount of equity to be held by banks. The Report notes the minimum requirement under Basel III that banks hold at least a 7% ratio of CET1 to RWA (consisting of a 4.5% minimum common equity requirement and a 2.5% capital conservation buffer). The Commission states that recent studies of appropriate levels of CET1 as a percentage of RWA provide a recommended minimum ranging from between 7% to 20%. The Commission concludes that a 7% ratio is an important step in increasing a bank's loss-absorbing capacity but is clearly insufficient for SIFIs. The Commission states that it believes the minimum credible "SIFI surcharge" over the Basel III 7% minimum is 3%, which should take the form of an increased equity buffer, rather than an increase to the hard minimum requirement, so that a SIFI's minimum ratio of CET1 to RWAs should be 10%. The Commission believes that this will makes SIFIs safer and incentivise them to reduce their systemic importance to avoid or reduce the cost of having to hold extra capital.

The Commission acknowledges the ongoing work in the international community, including by the Financial Stability Board ("FSB") and BCBS, in relation to SIFIs and their minimum capital requirements. It believes that UK banks (including SIFIs) active in international markets should not be required by regulation to hold more equity than that ultimately agreed at an international level, provided that such banks have credible resolution plans, including effective loss-absorbing debt. Regardless of international consensus in relation to the SIFI surcharge, the Commission believes, however, that large retail banking operations in the UK should be backed by an equity ratio of at least 10% (so a minimum SIFI surcharge of 3%).

The Commission also believes there may need to be a distinction between different SIFIs and some may need a CET1 ratio above 10% or be subject to additional requirements, (such as having to issue additional loss-absorbing debt compared with other SIFIs). The Commission also stresses that its conclusion on the appropriate minimum level of equity for SIFIs is based on the assumption that bank debt can also be made loss-absorbing (as set out below). If this cannot be achieved, it believes minimum equity levels would need to be significantly higher.

Contingent Capital

The Report describes contingent capital as debt that is designed to convert into equity or be written-down on the occurrence of some trigger event while a bank is still viable. The aim of contingent capital is therefore to recapitalise a bank under stress to leave it able to continue as a going concern. The Report notes that there are various advantages of contingent capital compared with equity, including that it is cheaper than equity, both because it is senior and (assuming interest payments are tax deductible) is more tax efficient. Another perceived advantage is that contingent capital mitigates the "debt overhang" problem at times of stress (where shareholders have weak incentives to raise additional equity at times of crisis as debt holders reap more of the benefit) as a conversion (or write-down) that effectively recapitalises the bank without requiring the shareholders to provide additional funds. Furthermore, the Commission notes that the prospect of any conversion diluting existing shareholders provides an incentive to those shareholders to raise more equity to ensure a bank remains wellcapitalised to steer well clear of the trigger.

The Commission acknowledges that there remain a number of uncertainties in relation to the effectiveness of contingent capital as a loss-absorbing instrument. These uncertainties include the appetite and ability for investors such as insurance companies and pension funds to hold large quantities of contingent capital instruments; and the importance of holders of contingent capital instruments being able to bear the risks associated. If they are not able to bear the potential losses, a conversion or write-down could act as a channel for contagion from the failing bank to another section of the financial system. The Commission also notes the "death spiral" concern associated with contingent capital. This concern is that when the market senses that a bank is nearing the trigger point in relation to its contingent capital, this could have a negative impact on the bank (including encouraging existing shareholders to sell their shares to avoid dilution causing a rapid decline in its share price), speeding up its decline and increasing the chance of conversion or write-down and thus actually weakening financial stability.

Bail-in

The Report describes bail-inable debt as acting in the same way as contingent capital except that the write down or conversion into common equity occurs at the point of non-viability and requires intervention by the regulator. The Commission states that, although such debt may allow some of a bank's operations to continue as a going concern, it may just enable the solvent bank to be resolved in a solvent manner. In identifying which of a bank's liabilities should be bail-inable the Commission notes that although it would be possible to identify certain types of debt that would be subject to bail-in (the recent EU consultation papers suggest all senior debt could be subject to bail-in subject to certain exceptions), this would incentivise banks to avoid issuing such debt. It suggests, as an alternative, that banks could be required to hold a minimum amount of bail-inable debt (which is also suggested as a possibility in the EU consultation papers).² The Report states that bail-in may be particularly valuable as a resolution tool for investment banking businesses where there are particular challenges in view of the fundamental differences in the insolvency regimes around the world. A degree of international agreement as to the mechanics of bail-in would therefore be helpful in overcoming this problem and allowing global banking businesses to fail more safely.

Depositor Preference

The Commission proposes that all or some depositors should be ranked above senior unsecured creditors on a bank's insolvency for two principal reasons. Firstly, retail depositors are not as well-placed as other senior unsecured creditors to monitor and discipline banks' risk taking, and therefore the subordination of the senior unsecured creditors would better align the incentive of such creditors to discipline banks with the ability to do so. Secondly, although retail deposits are guaranteed (up to a limit (currently £85,000)) by the Financial Services Compensation Scheme (the "FSCS"), the FSCS guarantee transfers some of the risk relating to a bank's activities away from that bank and its creditors to the banking system as a whole (with an effective back-up from the taxpayer). The depositor preference would create a buffer that would absorb losses prior to depositors (and therefore potentially taxpayers) suffering a loss. The Commission believes this could make failing banks easier to resolve, especially where there is a political motive for avoiding losses for retail depositors. The Commission also states there may be grounds for extending depositor preferences to deposits beyond those that are FSCS-insured, as in the U.S.

To read this article in full please click here.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

United States: ICB Interim Report On UK Banking Reform