The Banking Reform Bill: Secondary Legislation Hints at the Data Challenge Facing Banks

On 8 March 2013, three draft statutory instruments to be made under the Financial Services (Banking Reform) Bill 2012-13 (the “Banking Reform Bill”) were published by HM Treasury:

These statutory instruments are starting to put flesh on the bones of the Banking Reform Bill, a piece of framework legislation which was published last month.  For more detail on the Banking Reform Bill in general, please see our previous blog post.

The draft statutory instruments deal with four main issues:

  • The class of institutions which are exempt from the definition of “ring-fenced body” (“Exempt Institutions”);
  • The types of deposit that do not need to be held within a ring-fenced body (“Exempt Deposits”);
  • The types of activities that will not be regarded as “excluded” and therefore can be conducted by a ring-fenced body (“Exempt Activities”); and
  • The amount of exposure a ring-fenced entity is permitted to incur to a “financial institution” (“Permitted Exposure”).

A more detailed summary of the draft statutory instruments is provided in the Schedule below.  As more information becomes known we will provide additional updates.  However, even at this stage of the legislative process, what becomes immediately apparent is the huge data challenge firms will face in monitoring the height and location of the ring-fence, particularly with respect to the process surrounding Exempt Deposits and when incurring exposure to financial institutions.

Schedule

The Ring-fenced Bodies Order

In general, the Ring-fenced Bodies Order defines:

  • The class of Exempt Institutions; and
  • The class of Exempt Deposits.

EXEMPT INSTITUTIONS

The following institutions do not qualify as ring-fenced bodies and are therefore not subject to the ring-fencing rules:

  • broadly, any deposit taking institution which has held, on average, GBP 25 billion or less in deposits (calculated by reference to all UK deposit taking institutions in the group);
  • insurance companies; and
  • credit unions or industrial and provident societies.

EXEMPT DEPOSITS

Deposits are Exempt Deposits if they are held on behalf of:

  • high net worth individuals (“HNWI”) (i.e. individuals who have, on average over the previous year, held free and investible assets worth GBP 250,000 or more); and
  • small and medium sized enterprises (“SME”) which are also financial institutions and have been certified as such within the preceding 18 months.

An SME is:

  • an enterprise which
    • employs fewer than 50 staff; and
    • has a turnover of GBP 6.5 million or less, or an annual balance sheet total of GBP 3.26 million or less; or
  • a charity which has gross income (calculated on a group-wide basis) of GBP 6.5 million or less.

Note, however, that the following do not qualify as “financial institutions” and so deposits held for these institutions cannot qualify as Exempt Deposits irrespective of whether the institutions would qualify as SMEs:

  • ring-fenced bodies;
  • building societies;
  • credit unions; or
  • investment firms authorised to deal in investments as principal or agent.

In addition, if a statement regarding HNW or SME status is not refreshed every 12 months, or if a firm is notified that an account holder no longer benefits from HNW or SME status, and the deposit is held by a firm which is not already:

  • a ring-fenced body;
  • an Exempt Institution; or
  • a building society

then the firm in question must notify the account holder that the deposit will become a “core deposit” (and therefore subject to the ring-fencing requirements) if the HNW or SME status is not refreshed within 18 months of its original date.  The notification must also request that the account holder respond to the firm within six months:

  • providing an updated HNW or SME certificate;
  • nominating a ring-fenced body to which the deposit can be transferred if it becomes a “core deposit”; or
  • acknowledging that the account holder will accept repayment of the deposit, together with details necessary to effect such repayment.

The account holder must also be warned that a failure to respond will result in the transfer of the deposit to an identified ring-fenced body.  If the firm has a group member which is also a ring-fenced body, then the transfer of the deposit should be made to that group member.

The Excluded Activities Order

EXEMPT ACTIVITIES

Under the Banking Reform Bill, ring-fenced bodies are not allowed to partake in “excluded activities” (i.e. dealing in investments as principal).  However, under the Excluded Activities Order, a ring-fenced body will not be regarded as carrying on an excluded activity by:

  • entering into a transaction if the sole or main reason for doing so is to hedge interest rate, currency, default or liquidity risk;
  • buying, selling or acquiring investments for the purposes of maintaining liquid resources as required by BIPRU 12 (provided that this does not result in a breach of the “Financial Institutions Exposure Limits” detailed below); or
  • entering into derivatives transactions with its accounts holders, provided that such transactions comply with the “Derivative Transactions” requirements detailed below.

DERIVATIVE TRANSACTIONS

A ring-fenced body may enter into derivatives transactions with its account holders provided that those transactions:

  • have a linear pay-off (i.e. no options); and
  • the sole or main purpose of the transaction is to hedge:
    • interest rate risk;
    • currency risk; or
    • commodity price risk; and
  • there is evidence available to assess the “fair value” of the investment; and
  • the “position risk requirement” (i.e. the capital requirement applied to market risk positions under BIPRU 7) attributable to all such transactions remains less than TBD% of the ring-fenced body’s own funds; and
  • the sum of the position risk requirements attributable to each individual transaction is less than TBD% of the “credit risk capital requirement” of the ring-fenced body calculated in accordance with GENPRU 2.1.51.

FINANCIAL INSTITUTION EXPOSURE LIMITS

Ring-fenced bodies are prohibited from entering into any transaction under which it will incur exposure to a financial institution unless:

  • the sole or main reason for entering into the transaction is to hedge:
    • interest rate risk;
    • currency risk; or
    • default risk; and
  • where the transaction is concluded with a member of the ring-fenced body’s group, it is done so on arms’ length terms; and
  • where the financial institution in question is a “small credit institution” (judged by reference to the size of its balance sheet), the transaction does not increase the ring-fenced body’s exposure:
    • in aggregate to small credit institutions above TBD% of the ring-fenced body’s own funds; or
    • to its counterparty (i.e. to the small credit institution) above TBD% of the ring-fenced body’s own funds; and
  • the transaction does not:
    • increase the aggregate payment exposure of the ring-fenced body to an amount equal to or greater than:
      • TBD% of the ring-fenced body’s own funds in relation to overnight payment exposure[1], or
      • TBD% of the ring-fenced body’s own funds in relation to intra-day payment exposure; and
      • increase the ring-fenced body’s exposure to the financial institution to an amount which is TBD% or more of the ring-fenced body’s own funds; and
  • the transaction does not:
    • increase the aggregate settlement exposure of the ring-fenced body to an amount equal to or greater than:
      • TBD% of the ring-fenced body’s own funds in relation to settlement exposure with a maximum tenor of t+2, or
      • TBD% of the ring-fenced body’s own funds in relation to settlement exposure with a maximum tenor of t+5[2]; and
      • increase the ring-fenced body’s exposure to the financial institution to an amount which is TBD% or more of the ring-fenced body’s own funds; and
  • in relation to letters of credit issued to a financial institution on behalf of a customer of the ring-fenced body:
    • the customer is not a financial institution; and
    • the letter of credit:
      • is issued in connection with the supply of goods or services; and
      • specifies the transactions to which it relates; and
      • specifies the total credit available under it; and
      • is subject to the uniform customs and practices for documentary credits 2007 version[3]; and
      • the total exposure of the ring-fenced body in relation to letters of credit is less than TBD% of the ring-fenced body’s own funds.

Ring-fenced bodies will be required to disclose payments exposure, settlements exposure and exposure to letters of credit.

OTHER DEVELOPMENTS

Inter-bank Clearing and Settlement Services

Ring-fenced bodies will be required to access inter-bank clearing and settlement systems either directly, or indirectly via another ring-fenced body.

Non-EEA Branches and Subsidiaries

Without the approval of the Prudential Regulation Authority (“PRA”), a ring-fenced body may not:

  • maintain or establish a branch in any country or territory which is not an EEA member state; or
  • have a participating interest in any undertaking which is incorporated in or formed under the law of country which is not an EEA member state.

Moreover, although a ring-fenced body will be deemed to have provisional approval for its application, ultimately the PRA will only be able to approve an application if, at a minimum:

  • information sharing arrangements exist which will enable the PRA to obtain any required information;
  • any stabilisation powers exercised by the Bank of England or the Treasury would be recognised in the jurisdiction in question; and
  • approval of the application would not increase the risk that the failure of the ring-fenced body would have an adverse effect on the continuity of the provision within the UK of “core services”

The Fees Order

These regulations enable HM Treasury to charge certain expenses associated with the UK’s participation in the Financial Stability Board, to a defined class of market participants.


[1] The implication appears to be that incurring payment exposure which is greater than overnight is not permitted.

[2] The implication appears to be that incurring settlement exposure in excess of t+5 is not permitted

[3] As published by the International Chamber of Commerce

This piece is cross-posted from Recovery and Resolutions Plans with permission.