Banking reform – financial stability, depositor protection and the SRR

3rd September 2008

Nick Paul, Paul Edmondson and Ash Saluja

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Outline

Background - the credit crunch so far

Getting out of this crunch

Avoiding another crunch/Northern Rock

Helping the authorities deal with another Northern Rock – the SRR

Getting the financial sector to pay – FSCS reform

Depositor protection by other means – market-led solutions

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Timetable

July consultation papers

– Follow January consultation

– Tripartite authorities

– 15th September close

FSA consultation on FSCS still to come

– June paper on status quo

SRR legislation asap – BBA remains concerned

BBA responses and many others eg Financial Markets Law Committee

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Background - the credit crunch so far

US originated mortgage backed securities (sub-prime)

Problems in international asset backed securities markets (assets and SIV/CDO wrappers) and then inter-bank lending

Basel II and mark to market

Negative impacts on

– Bank liquidity, balance sheets and capital

– Securitisation

Central bank support was subject to disclosure and stigma and so counter-productive

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Getting out of this crunch

Northern Rock, Bear Stearns and the next?

Central bank provided liquidity

– Increased/improved facilities

– BoE Special Liquidity Scheme – swap of mortgage backed securities for treasury bills with haircut

– FSA paper on disclosure of liquidity support – No real solution?

Capital raising

– Short selling

Lots of FSA reporting

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Avoiding another crunch/Northern RockImproving

– The stability and resilience of the financial system (including liquidity support arrangements in light of experience)

– Bank regulation

International and domestic eg

– G7 and Financial Stability Forum (FSF)

– Basel

Macro-regulation – a new approach

– Payment systems

– BoE role re systemic issues

– But FSA under Payment Services Directive

– OTC derivative infra-structure etc

– International regulatory co-operation and crisis management

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Improved risk management and financial requirements for banks (1)

Lots of diverse ideas

Liquidity management (historic regime is too capital focused) – lessons from Northern Rock - FS DP 07/7

Strengthened capital requirements for securitisation and off balance sheet and risk management re exposures to these and to leveraged counterparties –

– Improved stress testing

– ?Internal gearing

Cyclicality issues re Basel II/Capital Requirements Directive

Asset valuations

Accounting, auditing and disclosures eg re off balance sheet entities

Securitisation – processes and transparency eg re structured credit products

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Improved risk management and financial requirements for banks (2)

Banker remuneration

Credit derivative markets

Credit rating and credit rating agencies (CRA)

– CRA regulation

– SEC, European and self regulatory codes

– Conflicts and poor rating practices

– Over-reliance on CRAs by regulators and their rules

– Independent ratings and improved rating process

And the broader question of acceptable risks for retail deposit takers – Glass-Steagall Act type issues

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Improved FSA regulation

Lessons from Northern Rock – FSA’s mea culpa

Liquidity - not a priority or easily understood

Supervisory enhancement programme

– Heightened supervision

– Using existing powers

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Helping the authorities deal with another Northern Rock – the SRR

Authorities and government deeply scarred by Northern Rock

– A muddle and a lack of powers

SRR (and all its new/draconian powers) provides the answer if, despite the other changes, a bank finds itself in difficulty

– Hope SRR will boost confidence (and reduce risk of it having to be used?)

Emergency legislation used for NR nationalisation had to be ‘sun-setted’

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SRR – the perfect outcome? (1)

Before Northern Rock customers aware or concerned

SRR is triggered

Northern Rock customer receives a letter saying you now have an account at [?] bank with

– The balance of your old Northern Rock account

– All standing orders/direct debits in and out

– No interruption or impact on transactions

– No run on the bank

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SRR – the perfect outcome? (2)

This requires

– Very broad legal powers

– Extensive system requirements for all banks –just in case.

BBA favours using

– Existing bank platform to achieve fast payouts from FSCS funds under SRR

– Rather than proposal for fast (eg 1 week) pay-outs by FSCS itself on bank closure to new bank accounts opened by each customer

Use industry money to fund/support/pay for the rescue (via FSCS)

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SRR (1)

Pre-insolvency stabilisation tools (PSTs)

– Including new bank administration process

New insolvency regime for banks

PSTs –

– Private sector purchaser tool

– Bridge bank tool

– Partial transfer tool – cherry picking and transferring some assets/liabilities to purchaser/bridge bank and leaving the rest behind with a ‘rump’ bank

– Temporary public ownership tool

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SRR (2)

Complex rules on roles of

– Each tripartite authority

– FSCS

– FSA triggers SRR, but BoE administers with HMT holding purse strings

UK incorporated banks and building societies (including overseas branches)

Existing EU directive - ?need for EU solution?

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SRR – why is everyone so worried?

Overrides legal rights of

– Shareholders and other stakeholders

– Contractual counterparties (eg on derivative and other financial transactions and commercial contracts)

Contractual protections overridden

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SRR – why is everyone so worried? Cherry picking

Secured creditors

– Protection will be qualified – eg floating charges but what else?

Financial Collateral Arrangements Directive cannot be overridden, but some security vulnerable

– Security outside UK implementation

– Super-equivalent areas

Master netting agreements

– Proposals for protection limited to ‘qualifying financial contracts’ (QFCs) – definition of QFCs

– Structured finance arrangements – unable to protect

Impact on legal opinions (required for regulatory capital purposes) on netting and security

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SRR – why is everyone so worried?

Effective priority for retail depositors?

Will it work in practice?

– Many issues remain

– Merger control, state aid, human rights, EU directives etc

– International groups/operations/foreign law etc

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SRR – why is everyone so worried?

SRR funding payable by FSCS ie levy payers pay for

– Cost of state guarantees given

– Financing costs (and losses?)

– Compensation payable to third parties

Unacceptable increase in levy payers exposure (even though limited to exposure on full insolvency)?

Ability to launch rescue knowing it will be financed by the industry may encourage FSA to trigger SRR too soon?

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Getting the financial sector to pay –FSCS reform

Making the fund bigger ie increasing the limits on the liabilities of levy payers and the cross subsidy from other sectors for deposit protection

Pre-funding those contingent liabilities

Increasing the compensation payable from the fund

Elephants in the room

– How big does the absolute capacity of the fund/levy payer liabilities need to be?

– Which banks are ‘too big to be allowed to fail’ and so would be nationalised, like Northern Rock, without substantial FSCS payments?

Current regime and recent changes not well understood

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Increasing the fund

Small ‘in perpetuity’ limit (0.3% of protected deposits –giving capacity of £2.4 billion) recently removed

Replaced by annual limit

– (Impact of increased borrowings by FSCS?)

Separate schemes had been replaced by cross-funding within single FSCS and revised limits

– Deposit takers levy – limit/capacity of about £1.8 billion

– Then rest of the general retail pool – brings total limit/capacity to slightly over £4 billion

– So all FSCS levy payers concerned and insurance sector, for example, became liable with similar contribution limit to banking/deposit takers

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Pre-funding contingent liabilities

Major claims on banks via FSCS during a credit crunch/banking crisis would potentially deepen the crisis

Pre-funding by banks is therefore attractive to government but cannot do it now

Legislation will give power to introduce later (although industry has seen this off for the time being)

How much would be required? £15 billion mentioned. Northern Rock has involved funding of 2 or 3 times that figure but net cost to taxpayer may be 10% of that figure?

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Increasing the compensation and liabilities payable from the fund (1)

‘Co-insurance’ and moral hazard policy already abandoned –

– FSCS now pays 100% of loss

– Not 90% (above £2,000) as previously

Paid net of most debts to bank – mortgage, overdraft etc

Excluded – large companies, authorised firms etc

Limit of £35,000 (97% of bank accounts)

– Per person (2 claims on a joint account ie £70,000)

– Per authorised bank ( not per brand or division –so accounts at Saga, AA, Birmingham Midshires, Halifax and Intelligent Finance and BoS are all aggregated for purposes of one £35k limit)

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Increasing the compensation and liabilities payable from the fund (2)

Depositors above limit get £35,000 and retain right to further recoveries from bank liquidator until total equals the entire deposit

Clients/beneficiaries of client accounts can claim £35,000 each providing they have identifiable balance/share

International

– Covers deposits at EEA branches of UK banks

– Covers UK branches of non-EEA banks authorised by FSA

– EEA banks – home scheme (may be higher or lower subject to directive minimum) and possible FSCS top-up (if higher)

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Increasing the compensation and liabilities payable from the fund (3)

Increase limit to £50,000

Move to gross basis from current net basis

Per person per bank basis

– Possible alternative of ‘per bank brand’ (would help some banks in relation to systems requirements)

– Per account (as in US) seems unlikely

Changing eligibility criteria?

Loss allocation rules?

– FSA’s June paper

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Depositor protection

Unprotected deposits - outside FSCS altogether

– Depositor not an eligible claimant

– Excluded deposit

– Bank not covered by FSCS

Deposits above FSCS limits

– Assuming no per account FSCS coverage

– Common personal transactions – house purchase, inheritance etc

– Larger deposits of wealthier people

– In own name

– SIPP/pension capital

– Larger balances in client accounts

Depends on final decision on FSCS coverage

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Potential market-led solutions (1)

?Will there be a demand

– In future FSA may warn of the dangers of deposits beyond FSCS coverage – they have suggested flagging of accounts according to FSCS coverage

– All depositors are/will be more aware of risks

– IFAs are highlighting dangers and suggesting spreading to maximise protection

– Trustees and firms with client accounts etc are obliged to consider and spread risk under existing rules but will be more concerned in new environment

FSA interested in commercial products

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Potential market-led solutions (2)

Insurance solution?

Secured deposits?

Multi-bank/sweeper products?

– IFAs and intermediaries

– Own initiative

– Linked banks?

– Getting the higher rates for larger deposits

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US position – deposit insurance

Similar to FSCS but pre-funded. Protects up to $100,000. Administered by FDIC

Considered wide-spread private deposit insurance in late 1980s and early 1990s

Most schemes now terminated

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Current US environment

Customers demand dropped when banking industry stabilised

Banks offer alternative solutions to customers

Lack of interest and capacity from (re)insurers

(Re)insurers concerned about existing exposure to banking industry and fear extreme events

Private solution would be more expensive

However, small number of insurers do still provide excess deposit insurance

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Lessons for the UK

Customer demand might drop as banking sector recovers

UK banks could meet customer needs by other means – eg spreading deposits

Might be difficult to attract insurance capacity

However, further consultation between banks and insurers worthwhile?

Is there a “real” risk for insurers – or will the government still prevent banks from failing?

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Possible insurance products?

Broad insolvency risk may be too great for insurers

– Given aggregation risk including as FSCS levy payer

Specialist products

– For individual depositors (eg as add-on to house insurance or conveyance service)

– Attached to particular accounts by bank

– Purchased by firms with client accounts for their client’s protection

– IFA services

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Consultation responses

CMS response

Key issues to think about for your response on SRR

– Costs in terms of bank systems

– Balance too much in favour of a perfect SRR (which may never/rarely be used) at expense of immediate and continuing adverse impact on all UK banks

– Adverse impact on financial counterparties of in-scope banks – secured creditors, derivatives (QFC definition), structured finance

– Legal opinions and avoidance

– Adverse effect on UK banks competitiveness (cost of funding?)

– Resist exposure to SRR via FSCS levy

– Cross-subsidy and pre-funding of FSCS