More than a decade has now passed since the onset of the financial crisis, but while the existential threat posed by that crisis may have been averted, UK banks and their groups continue to operate in a challenging regulatory and business landscape.
Recent years have seen the introduction of a wide rage of legislation relating to capital adequacy, conduct and individual accountability, while the regulators established in the wake of the financial crisis (the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA)) have proved themselves both ready and able to enforce the new regime.
Ultimately, the UK's impending withdrawal from the European Union (Brexit) poses the most significant post-crisis challenge for the UK banking sector. Lingering uncertainty as to the final outcome of Brexit negotiations between the UK and remaining EU Member States (EU27) means that many banks have already completed contingency planning arrangements based on worst-case assumptions, notwithstanding any more palatable arrangement that may ultimately be reached with the EU. Much of the regulatory framework applicable to UK banks derives from EU legislation. While this will initially be incorporated into the UK domestic framework following Brexit, the direction of travel of UK and EU financial services legislation thereafter remains to be seen.
The top five UK banking groups by market capitalisation2 are HSBC Holdings plc, Lloyds Banking Group plc, Royal Bank of Scotland Group plc, Barclays plc and Standard Chartered plc. Other than Standard Chartered plc, these banks, together with Santander UK plc (the UK subsidiary of the Spanish banking group), dominate the UK personal and business banking markets, although the market share of smaller challenger banks continues to develop.
ii THE REGULATORY REGIME APPLICABLE TO BANKS
i The UK regulatory framework for banks
Regulatory and supervisory responsibility for UK banks is divided principally between the Bank of England (in its capacity as the PRA) and the FCA. The Bank of England exercises its role as the PRA through its Prudential Regulation Committee, while its Financial Policy Committee (FPC) has a macroprudential mandate to identify imbalances, risks and vulnerabilities in the UK financial system, and can direct the PRA and the FCA to take certain actions to mitigate those risks. The Bank of England also acts as the UK's resolution authority for banks, building societies and certain investment firms.
The authority of the PRA and the FCA derives from the Financial Services and Markets Act 2000 (as amended) (FSMA). The FSMA sets out objectives for each regulator and requires each regulator to exercise its powers in a manner that it considers will advance those objectives.
The PRA is the prudential regulator of all UK banks and building societies, insurance companies and certain investment firms. The conduct of business of PRA-authorised firms is regulated by the FCA, and these firms are therefore referred to as dual-regulated.
Under the FSMA, it is a criminal offence for a person to engage in regulated activities by way of business in the United Kingdom unless authorised (an authorised person) or exempt from the authorisation requirement. Regulated activities are prescribed in secondary legislation made under the FSMA.3 Accepting deposits is a regulated activity where such deposits are lent to third parties or where any other activity is financed wholly or to a material extent out of capital or interest on deposits. The regulated activity of accepting deposits is specified for the purposes of the Financial Services and Markets Act 2000 (PRA-Regulated Activities) Order 2013 (PRA Order); consequently, firms that wish to carry on deposit-taking activities (i.e., prospective banks and building societies) are required to seek authorisation to do so from the PRA.
An application to the PRA for authorisation must cover all regulated activities that the applicant wishes to carry on, regardless of whether those activities are specified in the PRA Order. The PRA is required to obtain consent from the FCA before granting any authorisation. The FCA is fully involved in the authorisation process for such firms, and may request information from, or ask questions of, the applicant.
Other regulated activities under the FSMA that may be relevant to banks include dealing in investments as principal, dealing in investments as agent, advising on investments, arranging deals in investments, managing investments, certain residential mortgage-lending activities, safeguarding and administering investments (i.e., custody activities) and certain consumer credit-related activities. The investments to which the investment-related activities noted above relate are set out in secondary legislation and include shares, debentures, public securities, warrants, futures, options, contracts for differences and units in collective investment schemes.
The PRA's general objective is to promote the safety and soundness of the firms it regulates. The PRA is required to advance this objective by seeking to ensure that the business of PRA-authorised firms is carried on in a way that avoids any adverse effect on the stability of the UK financial system, and by seeking to minimise the adverse effect that the failure of a PRA-authorised firm could be expected to have on the stability of the UK financial system. The second element of this objective reflects the principle that the PRA does not operate on a zero-failure basis: a core aspect of the PRA's approach to banking supervision is its focus on the establishment, maintenance and implementation of appropriate recovery and resolution arrangements. Since 1 January 2019, the PRA has had specific responsibilities relating to ring-fenced bodies and ring-fencing requirements when advancing its general objective. The PRA also has a specific insurance objective and a secondary competition objective.
The PRA has a general power under the FSMA to make rules that apply to the firms it regulates, and to issue related guidance, with respect to regulated activities and other unregulated business activities (e.g., certain business lending activities that fall outside the regulatory perimeter in the United Kingdom) that such firms carry on. The PRA may, however, only make such rules as it considers necessary or expedient for the purpose of advancing any of its objectives.
The PRA has adopted a set of Fundamental Rules, which are a series of high-level prudential principles that underpin the PRA's regulatory approach to the firms it regulates. These focus on certain matters relating to governance, integrity, resolvability and financial resources. The Fundamental Rules are drafted as clear statements of principle, and include statements that 'a firm must at all times maintain adequate financial resources' and 'a firm must deal with its regulators in an open and cooperative way and must disclose to the PRA appropriately anything relating to the firm of which the PRA would reasonably expect notice'.
Consistent with its judgment-led approach to supervision, the PRA's supervisory approach focuses on the most significant risks to its statutory objectives. The PRA draws on a broad set of information and data in forming supervisory judgments and relies on banks – and other firms that it regulates – to submit that information and data. Periodically, the PRA may validate data though on-site inspections conducted either by its own supervisory staff or by third parties. To support its information-gathering and analysis, the PRA requires firms to participate in meetings with supervisory staff at senior and working levels.
The FCA is responsible for the regulation of conduct of business at all authorised firms in the United Kingdom (including banks and other PRA-authorised firms) and the conduct of business in respect of wholesale and retail financial markets and market infrastructure. The FCA is also responsible for the prudential supervision of firms that are not subject to prudential regulation by the PRA, which may include banks' subsidiaries or other entities within banking groups, such as dedicated consumer credit lenders and investment firms. Firms subject to both prudential and conduct of business regulation by the FCA are not dual-regulated, and therefore only need to seek authorisation from the FCA to carry on regulated activities.
Under the FSMA, the FCA has a strategic objective to ensure that markets for financial services in the United Kingdom function well. This is supported by three operational objectives: consumer protection, enhancing the integrity of the market and promoting competition.
When pursuing its consumer protection objective, the FCA must have regard to consumers' need for timely information and advice that is accurate and fit for purpose, and whether firms are providing an appropriate level of care to consumers, among other factors. The FCA has various powers to further its consumer protection objectives, including powers to introduce product intervention rules (pursuant to which it can ban the sale or distribution of certain products), to require the withdrawal of misleading financial promotions, and to publicise the issue of a warning notice (a stage in an FCA regulatory investigation prior to any finding of guilt or wrongdoing).
The FCA uses its supervisory and enforcement work, thematic reviews and market studies to further its objectives. The FCA also has competition powers relating to the financial services sector that are concurrent with those of the Competition and Markets Authority (CMA). The FCA's competition powers permit it to investigate the performance of any market for financial services under the Enterprise Act 2002, and investigate and enforce against any breach of the Competition Act 1998 in financial services. In addition to the specific competition objective described above, the FCA is also subject to a general duty to promote effective competition in the interests of consumers, and may use its general powers under the FSMA to do so.
The FCA has the power under the FSMA to make rules that apply to all regulated firms, and to issue related guidance with respect to the carrying on of regulated activities and other unregulated business activities carried on by regulated firms. The FCA may, however, only make such rules as it considers necessary or expedient for the purpose of advancing one or more of its operational objectives. Like the PRA's Fundamental Rules, the FCA's Principles for Businesses set out high-level requirements that apply to the firms it regulates. One key principle is that a firm must pay due regard to the interests of its customers and treat them fairly.
The Bank of England
Alongside its roles as a microprudential regulator (exercised in its capacity as the PRA) and as the central bank of the UK, the Bank of England has specific regulatory functions relating to financial stability. In particular, it is the body responsible for the enforcement of the special resolution regime introduced by the Banking Act 2009 (see further Section III.vii) and, acting through the FPC, has the macroprudential objective of protecting and enhancing financial stability and the resilience of the UK financial system. The FPC does this by monitoring threats and taking action where necessary to address any perceived or identified vulnerabilities and imbalances in the UK financial system. The FPC has the power to issue macroprudential recommendations and directions to the PRA and the FCA. It does not, however, have the power to exert control over, or issue directions to, individual firms.
ii Management of banks
The Financial Services (Banking Reform) Act 2013 (Banking Reform Act) introduced amendments to the FSMA that have established an enhanced regulatory framework for individuals performing certain functions at UK banks or, in certain circumstances, UK branches of foreign banks. These reforms were primarily intended to enhance individual accountability in the banking sector and to address concerns that continuing responsibilities of senior bankers were inadequately defined. This section provides an overview of this framework, which includes a senior managers regime (which replaced the approved persons regime for banks), a certification regime (applying to other bank staff in positions where they could pose a risk of significant harm to the firm or its customers) and a set of conduct rules (which replaced the previous Statements of Principle and Code of Practice for Approved Persons) enforceable by either the PRA or the FCA. This framework, which originally only applied to UK banks and PRA-designated investment firms, was extended to cover insurers with effect from 10 December 2018, and will be extended to apply to FCA-authorised firms with effect from 9 December 2019 (subject to certain transitional measures).
Senior managers regime
Individuals intending to carry on certain specified senior management functions at UK banks require prior approval by the PRA or the FCA (the regulator granting the approval depends on the nature of the role). These specified senior management functions broadly cover roles in which persons are responsible for managing one or more aspects of the bank's affairs relating to a regulated activity, where the relevant function involves, or might involve, a risk of serious consequences for the firm or for business or other interests in the United Kingdom. Senior management functions are specified by either the PRA or the FCA, a distinction that reflects the difference in scope of each regulator's objectives.
There are currently 30 specified senior management functions (SMFs), each of which is labelled with an SMF number. Some of these functions relate to insurance undertakings only, and not all SMFs will therefore be relevant to banks and their groups. Banks are required to allocate overall responsibility for each of their activities, business areas and management functions to a person approved to perform a senior management function. If a person responsible for an activity, business area or management function that does not have a designated SMF number is not already approved to perform another senior management function, that person must be approved to perform the 'other overall responsibility' function.
Certain non-executive directors (NEDs) also require pre-approval as senior managers, including the chair, senior independent director and chairs of the risk, audit, remuneration and nominations committees. Other NEDs (termed notified or standard NEDs) fall outside the scope of the senior managers and certification regime, but are subject to certain FCA conduct rules (see below). The regulators also retain the ability to prohibit notified NEDs from carrying out their roles.
For senior management functions specified as PRA functions, individuals are pre-approved by the PRA with the FCA's consent. For senior management functions specified as FCA functions, individuals require pre-approval by the FCA only.
The PRA and FCA also specify certain prescribed responsibilities, which banks must allocate to individuals holding senior management functions. This is designed to ensure that there is individual accountability for the fundamental responsibility inherent in a particular function. Certain prescribed responsibilities are designed to be assigned to executives, while others reflect non-executive roles. Not all of the prescribed responsibilities will be relevant to all firms – for example, certain prescribed responsibilities apply only in specific circumstances (such as where a bank carries out proprietary trading or where a bank is ring-fenced). In general, each prescribed responsibility should be allocated to one individual, although the regulators have recognised that the sharing of responsibilities may be necessary in limited circumstances (e.g., where departing and incoming senior managers work together temporarily as part of a handover).
All applications for individuals to perform a senior management function must be accompanied by a statement of responsibilities, a document that sets out the areas of business for which the individual will be responsible. Banks are also required to produce a responsibilities map, a single document that describes the firm's management and governance arrangements.
Qualifications for approval: fitness and propriety
The regulators will approve an individual only if satisfied that the candidate is a fit and proper person to perform the senior management function for which approval is sought. The PRA and the FCA both apply a fit and proper test, which is concerned largely with the candidate's honesty, integrity and reputation, competence and capability, and financial soundness.
Both regulators are interested in the qualifications of prospective directors of banks, and expect banks to carry out extensive referencing and due diligence before appointing new directors and other individuals performing senior management functions, including assessing suitability for the role, conducting criminal record checks and obtaining references from previous employers. The PRA and the FCA have, and frequently exercise, the power to interview prospective directors and other individuals performing senior management functions at banks.
Duty of responsibility
The senior managers regime is designed to increase individual accountability and is supported by a duty of responsibility, which allows the PRA or the FCA to bring a misconduct claim against the accountable senior manager if the authorised firm has contravened a relevant requirement. Broadly, the PRA or the FCA, or both, must show in any misconduct claim against an individual that the senior manager with the relevant responsibility did not take such steps as a person in the senior manager's position could reasonably have been expected to take to avoid the contravention occurring. The burden of proof lies on the regulator. Both regulators have produced guidance on the factors they will consider when addressing the duty of responsibility. Where the FCA or the PRA finds that a senior manager is in breach, it may suspend or limit the senior manager's approval, impose a penalty, impose conditions on the individual's approval or publish a statement of misconduct.
The certification regime applies to individuals employed in positions where they could pose a risk of significant harm to a firm or its customers. Neither the PRA nor the FCA pre-approves these individuals, but banks are required to certify that the individuals are fit and proper for their roles, both at the point of recruitment and thereafter (at least annually). If it believes that an individual within the scope of the regime fails to meet the requisite standards, a bank must refuse to renew that individual's certificate of fitness and propriety.
The FCA and the PRA have each issued conduct rules that apply to those subject to the senior managers and certification regimes. The FCA's conduct rules apply to all individuals approved as senior managers or covered by the certification regimes, as well as notified NEDs and all other employees (other than certain ancillary staff who perform a role that is not specific to the financial service business of the firm). The PRA's conduct rules apply to individuals approved as senior managers or covered by the certification regime, and to notified NEDs.
The conduct rules are high level, and reflect core standards expected of those within their scope, including requirements relating to integrity, acting with due care, skill and diligence, observing proper standards of market conduct, and dealing openly and cooperatively with regulators.
Both the FCA's and the PRA's conduct rules are in two tiers: those that apply to all individuals within the scope of the conduct rules (individual conduct rules) and those that apply only to senior managers (senior management conduct rules). The latter include the requirement to disclose to the regulators any information of which they would reasonably expect notice and to take reasonable steps to delegate responsibilities and oversee the delegation of responsibilities to an appropriate individual. In addition to the individual conduct rules, notified NEDs are subject to the senior management conduct rule requiring them to disclose to the regulators any information of which the regulators would reasonably expect notice.
Relevant individuals who fail to comply with a conduct rule, or who are knowingly involved in a contravention by an authorised firm of any requirement imposed on it by or under the FSMA, or FCA or PRA rules, may be fined or publicly censured, or both. Both regulators have the power to discipline an approved senior manager who has breached a conduct rule that it has issued, irrespective of whether it has approved the individual. Both regulators also have the power to withdraw approval from individuals or to issue a general or specific prohibition order prohibiting an approved person from carrying on any senior management function, or both.
Reckless misconduct in the management of a bank
The Banking Reform Act introduced a new criminal offence that applies in respect of misconduct by a senior manager that leads to the failure of a bank, building society or PRA-authorised investment firm (financial institution). The offence is relevant where – upon the failure of a financial institution – it is established that an approved individual:
- made, or agreed to the making of, a decision by or on behalf of the bank or investment firm as to the way in which the business of the financial institution, or another financial institution in its group, was to be carried on, or that individual failed to take steps that he or she could take to prevent such a decision being taken;
- at the time of the decision, the individual was aware of a risk that the implementation of the decision could cause the failure of the relevant financial institution;
- in all the circumstances, the individual's conduct in relation to making the decision fell far below what could reasonably be expected of a person in that individual's position; and
- the implementation of the decision caused the failure of the relevant financial institution.
The offence has been in force since 7 March 2016, and applies to any decision made on or after that date that causes a financial institution to fail.
iii PRUDENTIAL REGULATION
i Regulatory capital
Many of the detailed rules regarding the application of prudential supervision by competent authorities and in relation to regulatory capital adequacy are contained within the EU Capital Requirements Regulation4 (CRR) and the Capital Requirements Directive5 (CRD), together referred to as CRD IV (for further information, see the European Union chapter). The CRR is, at present, directly applicable in the United Kingdom and, accordingly, the PRA has not made rules to implement its provisions, except in relation to certain discretions afforded. The CRD, as an EU directive, is not directly applicable and has been implemented by means of legislation and regulatory rules adopted in the UK. It should be noted that the European Parliament has adopted, and the Council of the EU is (at the time of writing) soon expected to adopt, a directive amending the CRD and a regulation amending the CRR, a package commonly referred to as CRD V, later in 2019. If adopted in its current form, CRD V would entail significant changes to the regulatory capital and liquidity requirements that apply to UK banks. For the reasons set out in subsection i of Section VIII of this chapter, it is anticipated that once adopted by both the European Parliament and the Council of the EU, CRD V will be adopted or implemented (as applicable) in the UK regardless of the outcome of Brexit.
Under the CRR, UK banks are required to hold capital in respect of credit risk, market risk and operational risk. Credit risk is, broadly, the risk that a debtor will not repay a loan at maturity or that a counterparty will not perform an obligation due to the bank. Market risk measures the risk of a bank suffering losses as a result of changes in market prices where it has invested in debt or equity securities, or in derivatives or physical commodities. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
The rules on market risk apply to trading activity where the bank's purpose is to make a profit, or avoid a loss, from short-term changes in market prices (i.e., proprietary trading). Such trading positions constitute the bank's trading book. A building block approach applies, whereby capital must be held against specific risks (e.g., position risk, counterparty risk, foreign exchange risk and commodities risk). Transactions giving rise to more than one risk category may trigger several different capital charges. Banks can (with PRA approval) use a market risk internal model to calculate their capital requirements for market risk.
The credit risk capital charge will depend on the bank's risk-weighted assets, calculated using either the standardised approach or an internal ratings-based approach. The standardised approach sets capital charges for exposure to particular classes of counterparty (e.g., corporates, interbank, retail, residential mortgages), generally based on external credit ratings. Internal ratings-based (IRB) approaches, which are based on internal models for credit risk, can be used only if approval is given by the PRA. The PRA recognises two IRB approaches: the foundation IRB and the advanced IRB. Under the foundation IRB, banks are required to determine the probability of default of exposures; the other risk factors are determined based on supervisory estimates, which are then fed into a formula to determine the capital charge for such exposures. Under the advanced IRB, the bank determines all the risk factors based on its own internal estimates.
The PRA would typically require a new bank to use the standardised approach and, if the bank can demonstrate to the PRA that it has sufficiently sophisticated risk-modelling methods, the PRA may grant permission to apply an IRB approach (although, under the CRR, this is not allowed within the first three years of the bank's existence).
The PRA imposes restrictions on large exposures incurred by banks, and requires capital deductions for funding arrangements (including loans and guarantees) entered into with connected parties where those arrangements are of a capital nature.
ii Types of capital
Under the CRR, bank regulatory capital is classified according to the scheme promulgated by the Basel Committee on Banking Supervision. In summary:
- UK banks are required under the CRR to hold base regulatory capital of at least 8 per cent of the total risk exposure amount (which takes account of exposures arising in respect of credit risk, market risk and operational risk) plus additional capital in respect of various regulatory capital buffers. The capital buffers include the CRD IV combined capital buffer (which is formed of a capital conservation buffer of 2.5 per cent of a bank's total risk exposure amount, plus a countercyclical buffer that the Bank of England calibrates on advice from the FPC), certain sector-specific capital buffers calibrated by the FPC, Pillar 2 capital buffers (which the PRA has split into Pillar 2A, a capital buffer to address risks that are not adequately captured by the CRR capital requirements, and Pillar 2B, an additional capital buffer to address risks to which the bank may become exposed over a forward-looking planning horizon) and systemic capital buffers (reflecting the global or domestic systemic importance of a bank). Ultimately, the effect of the buffers is that UK banks are required to hold regulatory capital of an amount that is significantly in excess of 10.5 per cent of the applicable total risk exposure amount (being the 8 per cent base requirement plus the 2.5 per cent capital conservation buffer).
- The base capital requirement relating to the highest quality of capital (Common Equity Tier 1 (CET1) capital, which is broadly ordinary share capital and reserves) is at least 4.5 per cent of the total risk exposure amount. Banks are required to satisfy the regulatory capital buffers referred to in (a) using CET1 capital and will, accordingly, need to maintain a CET1 capital ratio significantly in excess of 4.5 per cent of the total risk exposure amount. The PRA has the power to restrict the payment of distributions (in the form of dividends or staff bonuses) by UK banks unless this and certain other capital buffers are satisfied (further details of these measures are set out in the European Union and International Initiatives chapters).
- Subject to specified limits on eligibility, banks are permitted to hold other types of capital instrument to satisfy their total capital requirement, with these instruments categorised as Additional Tier 1 (broadly, perpetual subordinated debt instruments or preference shares with no incentive to redeem and that will automatically be written down or converted into CET1 upon the bank's CET1 ratio falling below a specified level, which the PRA expects to be at least 7 per cent) and Tier 2 (broadly, subordinated debt instruments with an original maturity of at least five years).
- In addition to the regulatory capital requirements under CRD IV, the Banking Reform Act introduced a framework for regulators to impose non-capital primary loss-absorbing capacity requirements on ring-fenced banks and banks that are systemically important. This requirement to hold additional loss-absorbing capacity, the amount of which is calibrated according to the minimum requirement for own funds and eligible liabilities (MREL) framework under the EU Bank Recovery and Resolution Directive6 (BRRD) and, for UK global systemically important banks (G-SIBs), the Financial Stability Board's total loss-absorbing capacity requirement (see subsection vii), will be fully implemented by 1 January 2022.
iii Group supervision
Regulatory capital requirements apply to individual banks on a stand-alone (solo) basis and to their groups on a consolidated basis. The PRA also supervises banking groups on a consolidated basis. The relevant requirements can be complex, but the basic principle is that banking groups must hold prescribed minimum amounts of capital, on a group-wide basis, to cover the risk-weighted assets and off-balance sheet liabilities of members of the group, whether they are regulated or not.
Under the CRR, consolidated supervision generally applies at the level of the highest parent undertaking incorporated in the European Economic Area (EEA) with its subsidiary undertakings that are banks or investment firms or that carry on broadly defined financial activities.7 Subsidiary undertakings are required to be consolidated in full, although proportionate consolidation for non-wholly owned subsidiaries is permitted in certain circumstances, subject to supervisory permission. Banking groups are permitted, subject to the satisfaction of certain prescribed conditions and haircuts, to recognise on a consolidated basis the minority interest that arises in respect of non-wholly owned subsidiaries that are fully included within the consolidation. Participations are also included within the scope of consolidated supervision on a proportionate basis. A participation is presumed to be held where there is a holding of 20 per cent or more of the share capital in another undertaking.
The PRA's liquidity regime broadly requires UK banks to be self-sufficient for liquidity purposes: banks may only rely on other members of their group if they obtain a rule modification from the PRA and comply with stringent requirements. The PRA is unlikely to grant this modification to a UK bank that is seeking to rely on liquidity from non-UK subsidiaries. The liquidity standards require banks to have adequate liquidity resources in certain specified stressed scenarios.
The CRR introduced a binding liquidity coverage ratio (LCR) and also contemplates the introduction of a net stable funding ratio (NSFR) requirement, measuring liquidity over a longer period of time than the LCR. The CRD V proposals include the implementation of a binding NSFR requirement which, if CRD V is adopted in its current form, would take effect during 2021.
v Leverage ratio
Given the number of systemically important banks in the UK and the relative size of the UK banking system, the FPC directed the PRA in 2015 to introduce a leverage ratio in the UK ahead of any internationally agreed standard. The PRA has implemented the FPC's proposals in relation to UK banks and building societies that have retail deposits equal to or greater than £50 billion, which include a minimum leverage ratio requirement of 3.25 per cent; a countercyclical leverage ratio buffer set at 35 per cent of the firm's countercyclical buffer; and for UK G-SIBs (and, from 2019, domestic systemically important banks (D-SIBs)), an institution-specific supplementary leverage ratio buffer.
If implemented in its current form, CRD V will introduce a binding leverage ratio requirement of 3 per cent of Tier 1 capital that firms must meet in addition to their risk-based requirements. This would apply from the date on which the regulation amending the CRR enters into force.
The Banking Reform Act introduced the legal framework for the ring-fencing of core banking services that are critical to retail and small amd medium-sized enterprise (SME) clients. Affected banks were required to organise themselves to comply with the requirements by 1 January 2019. As a result, the core deposit-taking business of affected banks is now carried out through entities that are legally and financially independent of other group entities that carry on various wholesale or investment banking activities. Key details on the scope of the ring-fencing requirements and the restrictions applying to ring-fenced entities are set out in a combination of relevant secondary legislation8 and regulatory rules.
Broadly speaking, the ring-fencing requirements apply to banks that carry out the activity of accepting core deposits. For these purposes, core deposits include all deposits except those:
- made by large organisations (undertakings that are not SMEs) and their group members;
- made by relevant financial institutions;
- made by certified, consenting high-net-worth individuals and closely related persons; and
- taken by branches of an affected UK bank outside the EEA.
Banks whose core deposits do not exceed £25 billion are exempt from the ring-fencing requirements. This threshold is calculated taking into account all UK banks in a group. Building societies, insurance firms, credit unions, cooperative societies, community benefit societies, and Northern Ireland industrial and provident societies are also exempt.
Ring-fenced banks are subject to significant restrictions on their banking activities, including a prohibition (subject to exceptions) on incurring exposures to relevant financial institutions (e.g., non-ring-fenced banks, global systemically important insurers and investment firms) and limitations on the types of financial products and services that ring-fenced banks may provide. Ring-fenced banks are also prohibited from having branches outside the EEA and, subject to exceptions, participating interests (presumed to exist at a holding of 20 per cent or more of issued share capital) in undertakings incorporated or formed under the law of a jurisdiction outside the EEA. The scope of application of this requirement following Brexit is not yet clear.
A fundamental principle of the regime is that ring-fenced banks may not deal in investments as principal, except where narrowly drawn exceptions apply relating to matters including risk management, debt-for-equity swaps, securitisation of assets originated by the ring-fenced bank, certain simple derivative products, security over shares or other investments and entering into transactions with central banks.
The role of the PRA
The Banking Reform Act amended the PRA's general objective under the FSMA with effect from 1 January 2019 to provide that it must discharge its general functions in relation to ring-fenced bodies and ring-fencing requirements to ensure the continuity of the provision of core services in the UK. These core services are broader than the core activity of accepting deposits and extend to facilities for making payments from, and overdrafts in connection with, deposit accounts.
The PRA rules on ring-fenced banks are designed to ensure that:
- core activities of ring-fenced banks are not adversely affected by other group members;
- ring-fenced banks make commercially independent decisions;
- ring-fenced banks are not unduly reliant on resources from other group members that would not be available if those members failed; and
- ring-fenced banks are sufficiently resilient, including upon failure of a group member.
The Banking Reform Act also provides the PRA with powers to require the restructuring or break-up of a group that, in the PRA's view, is failing to meet the ring-fencing objectives.
vii Recovery and resolution regime
The PRA requires UK banks to produce and maintain a recovery plan, describing actions that could be taken by the bank to ensure the continuity of all or part of its (or of a group member's) business in prescribed stress scenarios; and a resolution pack containing information and analysis that would assist the regulator with any action it needs to take in the event that the bank is likely to, or does in fact, fail. The PRA has issued supervisory statements prescribing the information and analysis that must be set out in recovery plans and resolution packs, which take into account the requirements of the BRRD.
The Banking Act 2009 introduced a special resolution regime for UK banks, which is intended to facilitate the orderly resolution of banks in financial difficulties. The Banking Act 2009 also established two new insolvency proceedings for banks that are available in respect of failed banks or residual parts of banks that are in wind-down (referred to as the modified insolvency processes). Failure for these purposes includes insolvency, bankruptcy or administration of the bank concerned or the exercise of resolution powers under Part I of the Banking Act 2009 (the latter are referred to as the stabilisation options) in relation to that bank. The stabilisation options comprise methods for addressing the situation if a bank has encountered or is likely to encounter financial difficulties and can be summarised as the transfer of all or part of the business of the bank to a private sector purchaser, a bridge bank wholly owned by the Bank of England or an asset management vehicle; the bail-in option (see below); and taking the bank into temporary public ownership.
Exercise of the stabilisation options is subject to certain strict conditions prescribed under the Banking Act 2009. The PRA (having consulted with the Bank of England) must be satisfied that the relevant bank is failing, or is likely to fail, and the Bank of England (having consulted with HM Treasury, the PRA and the FCA) must be satisfied that, having regard to timing and other relevant circumstances, it is not reasonably likely that (aside from the stabilisation options) actions will be taken by or in respect of the bank that will enable the bank to cease to be failing or likely to fail. The Bank of England must have regard to certain special resolution objectives, and must be satisfied that the stabilisation option is necessary having regard to the public interest in the advancement of one or more of these objectives; and that one or more of the objectives would not be met to the same extent by the winding up of the bank. Each stabilisation option is subject to additional specific controls to ensure it is used only where the relevant authority considers it necessary having regard to relevant circumstances, such as the public interest in the stability of the UK financial system.
The Banking Reform Act amended the Banking Act 2009 to introduce bail-in as a stabilisation option. This came into effect on 1 January 2015. Broadly speaking, the bail-in tool enables the Bank of England, during the stabilisation period of a failing bank, to impose losses on shareholders and, subject to limited exceptions, unsecured creditors of a bank as if that bank were insolvent, through write-down or conversion into different forms of liability (e.g., equity). The bail-in tool, as implemented, is intended to reflect the powers required under the BRRD, and its use would be subject to the no creditor worse off principle (i.e., affected creditors must not be left worse off under bail-in than they would otherwise have been under ordinary insolvency proceedings).
Certain liabilities (such as deposits protected under the Financial Services Compensation Scheme (FSCS), the UK deposit guarantee scheme) are excluded from the scope of the bail-in tool.
As the UK resolution authority under the BRRD, the Bank of England is also required to set MREL requirements for UK banks, building societies and investment firms within the scope of the BRRD. MREL supports the bail-in tool and is intended to ensure that firms within the scope of the BRRD have sufficient own funds and other eligible liabilities to facilitate the effective application of bail-in on resolution. The Bank of England sets MREL requirements on an institution-specific basis and according to the preferred resolution strategy applicable to that institution and its group. For UK G-SIBs, the Bank of England also sets MREL as necessary to implement the Financial Stability Board's total loss-absorbing capacity (TLAC) standard.
Different requirements apply in relation to external MREL (which applies to resolution entities, i.e., the entity or entities in respect of which a group's preferred resolution strategy envisages that resolution action would be taken) and internal MREL (which applies to legal entities within a group that are not themselves resolution entities).
For resolution entities in respect of which bail-in or partial transfer is the preferred resolution strategy, the MREL requirements are to be phased in as follows:
- since 1 January 2016, all resolution entities in respect of which bail-in or partial transfer is the preferred resolution strategy have been required to maintain MREL resources at least equal to their capital requirements;
- since 1 January 2019, G-SIBs with a resolution entity incorporated in the UK have been required to meet an MREL requirement equal to the TLAC standard, being the higher of 16 per cent of risk-weighted assets or 6 per cent of leverage exposures;
- from 1 January 2020, G-SIBs and D-SIBs with a resolution entity incorporated in the UK will be required to meet an MREL requirement equal to the higher of two times their Pillar 1 capital requirement plus their Pillar 2A capital requirement, or two times the leverage requirement (to the extent applicable). Other institutions in respect of which bail-in or partial transfer is the preferred resolution strategy will be required to meet an MREL requirement of 18 per cent of their risk-weighted assets; and
- from 1 January 2022, all resolution entities in respect of which bail-in or partial transfer is the preferred resolution strategy will be subject to an MREL requirement equivalent to the higher of two times their regulatory capital requirement (plus any relevant buffers), two times the leverage requirement (to the extent applicable) or, in the case of G-SIBs only, 6.75 per cent of leverage exposures.
The Bank of England generally expects to set internal MREL requirements as equal to an institution's capital requirements for those institutions that are not material in a group context. Material subsidiaries, however, are subject to an internal MREL requirement that is calibrated at 75 to 90 per cent of the external MREL requirement that would apply to that entity if it were itself a UK resolution entity. Material subsidiaries for these purposes are those that have more than five per cent of the consolidated risk-weighted assets of a group, generate more than five per cent of the total operating income of the group, have a leverage exposure measure larger than five per cent of the group's consolidated leverage exposure measure, or are otherwise material to the delivery of a group's critical functions.
The Bank of England intends to review its calibration of MREL by the end of 2020 before setting the end-state MRELs that will apply to institutions from 1 January 2022. Institutions that have adopted a modified insolvency process (rather than bail-in) as their preferred resolution strategy will be required to meet an MREL equal to their regulatory capital requirements; no separate requirement will apply.
If CRD V is adopted in its current form, it would introduce further requirements relating to internal MREL for G-SIBs, as well as detailed requirements relating to the eligibility of liabilities as MREL resources. These are expected to apply from the date that CRD V enters into force.
Certain deposits held at UK-authorised banks are covered by the FSCS. The FSCS is managed and administered by the Financial Services Compensation Scheme Limited, a limited company established under the FSMA. This body is accountable to the PRA and the FCA for the effective operation of the FSCS, but is independent from those regulators. Pursuant to the FSMA, the PRA and the FCA are jointly responsible for ensuring that the FSCS is capable of discharging its functions.
The FSCS, which is funded by levies on regulated firms imposed on different sectors (and is therefore free to consumers), protects certain retail deposits (primarily those of private individuals and small businesses), and claims relating to certain investment products and certain types of insurance policies. The maximum current level of protection for bank deposits is £85,000 per depositor in respect of all the depositor's accounts held at a bank.
Deposits protected by the FSCS are regarded as preferential debts in the event of a UK bank's insolvency, and therefore rank ahead of the claims of most other unsecured creditors.
iv CONDUCT OF BUSINESS
The FCA is responsible for the supervision and regulation of the conduct of business of banks in the United Kingdom. There are certain overarching legal and regulatory principles that UK banks must consider in the conduct of their business, such as the FCA's Principles for Businesses, which include a principle that firms must treat their customers fairly (TCF principle). The TCF principle applies to services provided to retail and professional clients, although it is recognised that these client types require different levels of protection, and extends beyond the direct treatment of those customers to all the activities of regulated firms that affect customer outcomes.
UK banks should also be aware that UK consumer protection legislation will render certain unfair or unreasonable terms in consumer and certain other contracts as void or unenforceable. There are also restrictions in the FCA's rules that effectively prevent regulated firms from seeking to exclude or restrict, or to rely on any exclusion or restriction of, certain duties or liabilities that they may otherwise have to customers.
Further, the FCA's Banking Conduct of Business Sourcebook contains a set of reasonably high-level FCA rules that apply in relation to deposit-taking activities, and relate to matters such as communications with customers, financial promotions, post-sale requirements and cancellation rights in relation to banking products.
The Financial Ombudsman Service operates an independent alternative dispute resolution service for certain customers of PRA and FCA authorised firms.
i Mortgage regulation
The Mortgage and Home Finance Conduct of Business Sourcebook (MCOB) contains FCA rules in respect of activities associated with regulated mortgage contracts. These rules apply to banks and other entities that carry on regulated activities associated with mortgages, including entering into regulated mortgage contracts as lender, and administering, arranging and advising on such contracts. A regulated mortgage contract is, broadly, a loan secured by a mortgage on land in the EEA where at least 40 per cent of that land is used, or intended to be used, as or in connection with a dwelling by the borrower where the borrower is an individual or a trustee. MCOB sets out regulatory requirements relating to (among other things) advising and selling standards, disclosure obligations (both at the pre-application and offer stages of the negotiation of a regulated mortgage contract), arrears and repossessions, and equity release products.
The Mortgage Credit Directive9 was implemented in the United Kingdom on 21 March 2016. This moved the regulation of second charge mortgages from the FCA's consumer credit regime to its regulated mortgage regime (bringing second charge mortgages within the scope of the provisions in MCOB) and granted the FCA additional supervisory powers in respect of certain categories of buy-to-let mortgages.
ii Consumer credit
The FCA has been responsible for the regulation of consumer credit activities since 1 April 2014, when it assumed this role from the (now defunct) Office of Fair Trading. The regulatory framework is complex, and is split between requirements under the Consumer Credit Act 1974 (as amended) (CCA) and the FCA's own consumer credit rules. As a result of the transfer of regulatory responsibility to the FCA, activities that were regulated under the CCA (which include consumer lending, credit brokerage and debt collection) are now regulated activities under the FSMA. Firms carrying out consumer credit activities are subject to various parts of the FCA Handbook (such as the FCA's Principles for Businesses).
iii Investment business
Investment business, in this context, includes activities such as dealing in investments (whether as principal or as agent), managing investments and providing investment advice. If a bank, or another entity within its group, intends to carry on these regulated activities in the UK, it must be appropriately authorised by the PRA or FCA (as applicable). These activities are subject to their own detailed conduct of business rules, including the rules in the Conduct of Business Sourcebook and the Principles for Businesses referred to above.
The provision of various investment services and activities in relation to certain financial instruments also falls under the ambit of the MiFID II regime,10 which came into force on 3 January 2018. The MiFID II regime has been implemented in the United Kingdom through various pieces of legislation and rules of the PRA and FCA. The regime imposes various additional organisational and conduct of business requirements on investment firms. (For more information about MiFID II, see the European Union chapter.)
iv Payment services
The revised Payment Services Directive11 (PSD2), which came into effect on 13 January 2018, has been implemented in the United Kingdom by the Payment Services Regulations 2017 (PSRs).
The PSRs set out an authorisation and prudential supervisory regime for payment service providers that are not banks, building societies or e-money issuers (each of which are required to be authorised under separate legislation); these businesses are known as authorised payment institutions. The FCA is the competent authority for the conduct of business aspects of the PSRs in relation to all payment service providers (including banks), and for the prudential aspects of the PSRs in relation to authorised payment institutions.
UK banks raise funding from a number of different sources. In addition to deposits, interbank lending and wholesale funding, receipts from securitisations are gradually becoming more important as the securitisation market continues to recover.
The ability of UK banks to rely on sources of funding from within their group to meet liquidity requirements is limited under the PRA's rules, as noted in Section III.
The Bank of England also makes available certain liquidity facilities to UK banks, in particular through its discount window facilities and open market operations.
vi change of CONTROL AND TRANSFERS OF BANKING BUSINESS
i Acquisitions of control: the FSMA regime
Outline of the UK regime
Under the UK change in control framework, which is set out under the FSMA and reflects requirements originally introduced through the Acquisitions Directive12 (and now set out in CRD and other sectoral directives), any person who decides to acquire or increase control of a UK-authorised person must first obtain the approval of the appropriate regulator (i.e., for banks, the PRA).
Where the PRA is the appropriate regulator, it is required to consult the FCA before finalising its determination in respect of the change of control, and the FCA is permitted to make representations to the PRA in respect of matters including the suitability of the proposed controller and the financial soundness of the acquisition; the likely influence that the proposed controller would have on the UK-authorised person; and whether there are reasonable grounds to suspect, or suspect an increased risk of, money laundering or terrorist financing in relation to the proposed change in control.
The PRA has an assessment period of 60 working days to make its determination, commencing on the date on which it acknowledges receipt of a complete change in control application. The PRA may, no later than the 50th working day of the assessment period, request further information to complete its assessment, and can interrupt the assessment period once for up to 20 working days while this information is provided (30 working days if the notice-giver is situated or regulated outside the EEA, or is not subject to supervision under certain EU financial services directives). The process can be completed well within the maximum time allowed, but it can never be assumed that this will be possible.
Completion of such an acquisition without prior approval from the appropriate regulator is a criminal offence, and may result in the acquirer's shareholding rights being restricted or a court ordering the sale of the shares.
An existing controller of a UK-authorised person that decides to reduce its control over that person is required to give notice of that intention to the appropriate regulator (although no formal consent is required for such a reduction).
Every UK bank is required to take reasonable steps to keep itself informed about the identity of its controllers, and to notify the PRA as soon as it becomes aware that any person has decided to acquire control or to increase or reduce control of the bank.
Meaning of control
The term control is broadly defined, such that a person (A) will have control over a UK bank (B) for the purposes of the regime if A holds 10 per cent or more of the shares or voting power in B or a parent undertaking (P) of B; or holds shares or voting power in B or P as a result of which A is able to exercise significant influence over the management of B.
A will be treated as increasing its control over B, and requiring further approval from the PRA (or the FCA, as appropriate), if the level of shareholding or voting power in B or P, as the case may be, increases through any threshold step. In addition to 10 per cent, threshold steps occur at 20, 30 and 50 per cent, and upon becoming a parent undertaking.13
For these purposes, a controller's (or proposed controller's) shareholdings or voting power are aggregated with those of any person with whom it is acting in concert. There is no statutory definition of acting in concert for these purposes, although the European Union and the United Kingdom have issued guidance indicating, broadly, that persons will be acting in concert when each of them decides to exercise his or her rights linked to shares acquired in accordance with an explicit or implicit agreement made between them.
The UK regulatory approach to change in control of a bank
The PRA's assessment of a change in control application must take into account the suitability of the acquirer and the financial soundness of the acquisition to ensure the sound and prudent management of the UK bank. The assessment should have regard to the likely influence that the acquirer will have on the UK bank, but must disregard the economic needs of the market.
The PRA may object to an acquisition of a bank only if there are reasonable grounds for doing so on the basis of prescribed assessment criteria or if the information provided by the applicant is incomplete.
Broadly speaking, the assessment criteria include:
- the reputation and experience of the acquirer and persons who effectively run the business of the acquirer;
- the financial soundness of the acquirer;
- the expected ability of the UK-authorised person to comply with prudential requirements following the acquisition of control;
- whether the acquisition could adversely affect the PRA's ability to perform effective supervision of the UK-authorised person; and
- whether there are reasonable grounds to suspect financial crime.
The PRA may impose conditions on its approval where it would otherwise object to the acquisition, but may not impose conditions requiring a particular level of holding to be acquired. The FCA can, where it has reasonable grounds to suspect financial crime, direct the PRA to object to an acquisition of control, or not to approve an application for the acquisition of control unless it does so subject to conditions that the FCA specified.
ii Transfers of banking business
It is possible to transfer banking business in the United Kingdom by way of a court-sanctioned banking business transfer scheme under Part VII of the FSMA (Part VII transfer). This does not, however, prevent the use of other mechanisms for the transfer or assumption of assets and liabilities relating to banking businesses by other means, such as assignments or novations.
Part VII transfers
A Part VII transfer of banking business, referred to in the FSMA as a banking business transfer scheme is, broadly speaking, a scheme whereby the whole or part of the business carried on by a UK bank is transferred to another entity and where the whole or part of the transferred business includes deposits.
In relation to the second condition, deposits must form an integral part of the business to be transferred under a banking business transfer scheme, but need not be the sole or predominant business carried on.
A banking business transfer scheme takes effect without the consent of the depositors or other counterparties, although any person who alleges that he or she would be adversely affected by the carrying out of the scheme may be heard in the court proceedings required to sanction the scheme. The court may require assurance that those persons have been fairly treated. Both the PRA and the FCA are entitled to be heard in the proceedings.
A prescribed procedure exists for the implementation of Part VII transfers. This can be summarised as follows:
- High Court application: an application to the Court can be made by the transferor, the transferee, or both. The court procedure involves two hearings (a preliminary hearing and a final hearing, each described in more detail below);
- preliminary hearing: the Court is requested to grant a preliminary order sanctioning the publication of notices (see below) and setting a date for the final hearing. Once this order is granted, notices (approved by the PRA) regarding the scheme must be published in the London, Edinburgh and Belfast Gazettes, as well as in two national newspapers in the United Kingdom;
- scheme document: the terms of the Part VII transfer are documented in a scheme document, which must be lodged in support of the application to the Court. The scheme document must include specific details of the transfer and provisions regarding particular categories of asset or liability being transferred;
- scheme statement: a statement explaining and setting out the terms of the scheme document must be prepared and be given free of charge to anyone who requests it. A copy of the court application and the statement must be provided to the PRA, which will share the documents with the FCA;
- regulatory approval: although not a legal requirement, the approval (or confirmation of no objection) of both the PRA and the FCA should be sought before the final hearing. As a practical matter, the PRA and FCA have the right to attend and make representations at the final hearing (see below), and the Court will attach great weight to their views. A banking business transfer scheme that has not been approved by the regulators is therefore unlikely to proceed; and
- final hearing: the Court is requested to sanction the scheme at the final hearing. Any person who alleges that he or she would be adversely affected by the carrying out of the scheme has the right to object. If the Court is so minded, the scheme will be sanctioned by a final court order. The PRA and the FCA have the right to attend the final hearing, and representatives from at least one of them would usually be expected to do so.
The Court may sanction the scheme if:
- the PRA certifies that the transferee possesses (or will possess before the Part VII transfer takes effect) adequate financial resources, taking the Part VII transfer into account;
- the transferee has the necessary authorisation to carry on the business being transferred in the United Kingdom;
- at least 21 days have elapsed since the PRA was given copies of the application and the statement; and
- the Court is satisfied that, in all the circumstances of the case, it is appropriate to sanction the Part VII transfer.
The Court has wide-ranging powers to make the scheme effective, including providing for the transfer to the transferee of the whole or any part of the undertaking concerned, and of any right, property or liability of the transferor (whether the transferor has the capacity to effect the transfer in question or not). If any property or liability included in the order is governed by the law of a country or territory outside the United Kingdom, the final court order may require the transferor, if the transferee so requires, to take all necessary steps for securing that the transfer of that property or liability is fully effective under the law of that country or territory. The Part VII transfer takes effect as provided in the scheme document, and this normally happens shortly after the final court order is made.
In the past year, a number of banking groups have made use of banking business transfer schemes to transfer EEA banking business from UK banks to entities authorised in the EEA as part of their Brexit contingency planning arrangements. The sheer number of such transfers (alongside ring-fencing transfer schemes and Brexit-related transfers of insurance business under Part VII of the FSMA) has placed significant pressure on the capacity of the regulators and the courts. This has in turn caused delays to the overall Part VII process, both for transfers motivated by Brexit contingency planning and for those with business-as-usual commercial drivers.
Ring-fencing transfer schemes
The Banking Reform Act amended the FSMA to introduce a modified version of the banking business transfer scheme specifically for ring-fencing purposes, referred to as a ring-fencing transfer scheme. Broadly, a scheme carried out by a UK banking group will be a ring-fencing transfer scheme where:
- the whole or part of the business to be transferred is carried on by a UK authorised person or by a qualifying body (a body incorporated in the United Kingdom that is in the group of a UK authorised person but that is not itself authorised); and
- the purpose of the scheme is either to enable the person transferring the business, or the person to whom it is transferred, to carry on core activities in compliance with the FSMA and the PRA's ring-fencing rules; or to assist in the corporate restructuring of a group, which includes the transferor or the transferee, to enable one or more members of the group to become ring-fenced banks, while one or more other members of the group remain as non-ring-fenced banks.
Ring-fencing transfer schemes do not require the transfer of deposit-taking business. Accordingly, a ring-fencing transfer scheme could be used, for example, to transfer activities that cannot legally be carried on by a ring-fenced bank (e.g., certain derivatives or traded commodities positions) to a third party.
Ring-fencing transfer schemes require additional administrative steps to banking business transfer schemes, including a requirement for a report from an independent expert whom the PRA must approve as having the necessary skills to provide a report on the scheme. The purpose of the report is to set out whether persons other than the transferor are likely to be adversely affected by the scheme, and if so, whether the adverse effect is likely to be greater than reasonably necessary to achieve the purpose of the scheme.
A court application relating to a ring-fencing transfer scheme may be made only with the consent of the PRA, and the PRA must have regard to the scheme report when deciding whether to give consent.
On 1 July 2015, the FCA and the PRA introduced five new remuneration codes primarily aimed at strengthening the alignment of long-term risk and reward. These remuneration codes apply to more than 3,000 banks, building societies and investment firms in the United Kingdom. Banks are subject to two of these codes, namely the PRA's CRR Remuneration Code and the FCA's Dual-Regulated Firms Remuneration Code. These are supplemented by guidance and opinions from the PRA and the FCA and, since 1 January 2017, guidelines issued by the European Banking Authority (EBA) under CRD IV. The provisions of the two remuneration codes affect certain senior and risk-taking individuals in UK banks, staff engaged in control functions, and those earning in the same remuneration bracket as senior management and risk-takers. In addition, UK banks are required to apply the provisions of the remuneration codes to their subsidiaries and other members of their consolidation group, including such entities that are established in countries or territories outside the EEA.
A central focus of the remuneration codes is the amount and nature of variable remuneration payments, such as bonuses. In general, firms must have a clear distinction between their criteria for setting basic fixed remuneration (which should reflect relevant experience and responsibility) and variable remuneration (defined as remuneration reflecting a 'sustainable and risk-adjusted performance as well as performance in excess of that required to fulfil the employee's job description as part of the terms of employment'). The EBA's guidelines emphasise that fixed pay should provide a stable source of income, whereas variable pay should incentivise prudent risk-taking and sound risk management.
The rules provide, inter alia, that:
- guaranteed variable remuneration is not consistent with sound risk management and is accordingly prohibited, except in exceptional circumstances when hiring new staff, and should not be part of prospective remuneration plans;
- the variable remuneration component must not exceed 100 per cent of the fixed component (i.e., the ratio is capped at 1:1) unless shareholder approval above a prescribed threshold is given to extend it. This approval may not extend the ratio above 2:1;
- a discount rate (up to 25 per cent) may be applied to total variable remuneration, provided that it is paid in instruments that are deferred for a period of not less than five years;
- at least 50 per cent of variable remuneration must consist of shares or equivalent interests in the relevant firm or (where appropriate) capital instruments that reflect that firm's credit quality;
- at least 40 per cent of variable remuneration must be deferred for between three and five years, rising to 60 per cent if the variable remuneration exceeds £500,000 or is paid to a director;
- the proportion of variable remuneration to be paid in shares or equivalent instruments mentioned above applies to both the deferred and non-deferred aspects of variable remuneration; and
- the variable remuneration component must be subject to malus or clawback arrangements, which must cover specific criteria for application (such as a failure to meet appropriate standards of fitness and propriety).
These rules will not generally apply, however, if an individual's variable remuneration is 33 per cent or less of his or her total remuneration and his or her total remuneration is not more than £500,000.
Additional remuneration rules apply in relation to senior managers, including a mandatory deferral of bonus payments for at least seven years (for senior managers), five years (for risk managers) or three years (for other material risk-takers). The clawback period for bonuses paid to senior managers can also be extended to 10 years if, at the end of the seven-year period, there are outstanding investigations that could lead to clawback.
The bank's board of directors must adopt and periodically review the bank's remuneration policy, and is responsible for its implementation. The remuneration policy should be subject to central and independent internal review for compliance. A bank that is 'significant in terms of its size, internal organisation or activities' (essentially, all large UK banks and investment firms that engage in proprietary trading) must establish a remuneration committee for this purpose.
Certain smaller banks, building societies and investment firms are not subject to the full range of restrictions in the remuneration codes; for example, smaller investment firms and asset managers may disapply the requirement to maintain ratios between fixed and variable remuneration.
In the event of a breach of the remuneration codes, the PRA or the FCA, or both, may (depending on the provision breached) prohibit a firm from remunerating its staff in a certain way; make void any provision of an agreement that contravenes such a prohibition; and provide for the recovery of payments made, or property transferred, in pursuance of such a void provision.
viii THE YEAR IN REVIEW
The regulatory agenda for the past year has been dominated by Brexit. At the time of writing, the final settlement that will be reached between the United Kingdom and EU27 remains unclear. Reflecting this uncertainty, UK and EU banks have been forced into worst-case contingency planning. These plans, many of which have now been implemented, have focused on the design of new operating and booking models, and in many cases include the incorporation of subsidiaries in the EU27 (in the case of UK banking groups) or the UK (in the case of EU banking groups) and the transfer of business and personnel to those subsidiaries.
While Brexit has occupied significant resources and management time in the past year, this has by no means been to the exclusion of other challenges. In common with previous years, UK banks continued to grapple with a number of ongoing regulatory change projects during 2018. In particular, the past year has seen the completion of a number of internal reorganisations intended to facilitate compliance with UK ring-fencing requirements, which came into effect on 1 January 2019. The adoption of the PSRs in January 2018, ongoing efforts to implement the CMA's Open Banking standard and the implementation of the General Data Protection Regulation14 (GDPR) have been key areas of focus for retail banks, in particular. A number of G-SIBs with resolution entities or material subsidiaries in the UK have also been required to undertake internal restructurings in response to the phasing in of MREL requirements above capital requirements from 1 January 2019.
On 23 June 2016, the UK electorate voted in a referendum to leave the European Union. The government triggered the formal process for the UK's withdrawal from the EU on 29 March 2017 by delivering a notice to the European Council under Article 50 of the Treaty on the European Union. The Article 50 process provides for a negotiation period of up to two years, after which the EU treaties cease to apply to the Member State seeking to withdraw from the EU.
Under that process, the UK was due to withdraw from the EU on 29 March 2019. This was subsequently extended by agreement between the UK and the EU27 following the UK government's failure to secure parliamentary approval for the terms of the UK's withdrawal from the EU, as set out in the draft withdrawal agreement between the UK and the EU27 (Withdrawal Agreement). At the time of writing, the UK is set to leave the EU on 31 October 2019 or earlier if the UK government is able to secure parliamentary approval for the Withdrawal Agreement. This assumes that the UK will hold elections to the European Parliament. If it fails to do so, the UK will leave the EU on 1 June 2019.
At present, the European Communities Act 1972 (as amended) (ECA) provides for the supremacy of EU law in the UK. The European Union (Withdrawal) Act 2018 (Withdrawal Act), which received Royal Assent on 26 June 2018, will repeal the ECA with effect from the date of the UK's withdrawal from the EU (exit day) and, together with subordinate legislation, sets out the UK legislative framework that will apply from that date.
The Withdrawal Act aims to create a snapshot of retained EU law, as it applied in the UK immediately before exit day. As such, the Withdrawal Act:
- preserves UK domestic legislation that has implemented non-directly applicable EU law (such as EU directives);
- converts directly applicable EU legislation (such as EU regulations and decisions and certain tertiary legislation) into UK domestic legislation;
- preserves as UK domestic law any EU rights (such as directly effective EU treaty rights) that are not otherwise captured by the preceding provisions; and
- gives HM Treasury the power to remedy (by subordinate legislation) deficiencies in retained EU law arising from its domestication under the Withdrawal Act.
The Withdrawal Agreement provides for a transitional period to 31 December 2020 (extendable by up to two years), during which the UK will continue to be bound by EU law. The European Union (Withdrawal Agreement) Bill (WAB), the instrument by which the government intends that the provisions of the Withdrawal Agreement should implemented in domestic legislation, contains saving provisions that would amend the Withdrawal Act to give effect to the transitional period. In very broad terms, this would involve preserving the effect of the ECA during the transition period, such that most EU law would continue to apply in the UK during that period.
The Withdrawal Act does not apply to 'in-flight' EU legislation. If Parliament approves the WAB, any regulations and other directly applicable legislation adopted by the EU after exit day, but during the transition period, would be directly applicable in the UK. The UK would also be required to implement any EU directives (and other non-directly applicable) legislation adopted during that period. If Parliament does not approve the Withdrawal Agreement and the UK leaves the EU with no deal, the Financial Services (Implementation of Legislation) Bill would, if passed, give HM Treasury the power to adopt subordinate legislation to give effect to specified EU financial services legislation that has been adopted but does not yet apply, as well as specified legislative proposals that have been published but not yet adopted by the European Parliament and European Commission (including the CRD V reforms discussed in more detail in Section III.i).
As noted above, the Withdrawal Act gives HM Treasury the power to adopt subordinate legislation to correct deficiencies arising from the domestication of EU law. HM Treasury has adopted or published in draft a number of statutory instruments intended to correct such deficiencies. HM Treasury has also adopted a large number of statutory instruments intended to establish new regulatory frameworks that will apply after exit day, and to effect the transition to a new relationship between the UK and EU on financial services.
These include the EEA Passport Rights (Amendment, etc., and Transitional Provisions) (EU Exit) Regulations 2018 (SI 2018/1149) (TPR Regulations) which, in the event of a no-deal Brexit, will establish a temporary permissions regime (TPR) for EEA firms currently operating in the UK in reliance on EEA passporting rights in the event of a no-deal Brexit. At present, EEA banks and financial services firms are able to carry on business in the UK without requiring separate authorisation under the FSMA, in reliance on passporting rights under the relevant EU directives. UK banks and financial services firms are also currently able to carry on business in other EEA states in reliance on such rights. These passporting rights will cease to apply to UK firms, and (in relation to activities carried on in the UK) to EEA firms operating in the UK, from exit day (subject to any transitional period that may apply). In the event of a no-deal Brexit, the TPR will allow EEA firms that currently rely on passporting rights to carry on business in the UK to continue doing so for a period of up to three years following exit day, pending their authorisation under the FSMA. EEA banks wishing to make use of the TPR were required to notify the PRA of their intention to do so by 12 April 2019, but may still enter the TPR if they submit an application for the authorisation of a third-country branch before exit day. Firms in the TPR will be invited to apply for authorisation in several 'landing slots' stretching from October 2019 to March 2021, and will be required to comply with specified PRA and FCA rules while in the TPR.
HM Treasury has also adopted the Financial Services Contracts (Transitional and Saving Provision) (EU Exit) Regulations 2019 (SI 2019/405), which will amend the TPR Regulations to provide for the creation of the financial services contracts regime (FSCR). The FSCR will allow EEA firms currently operating in the UK in reliance on passporting rights, but which do not enter the TPR (or exit the TPR before obtaining full authorisation under FSMA), to run off their activities in an orderly manner in the event of a no-deal Brexit.
Changes to regulatory rules and guidance
The Financial Regulators' Powers (Technical Standards etc.) (Amendment etc.) (EU Exit) Regulations 2018 (SI 2018/1115) give the Bank of England, PRA, FCA and Payment Systems Regulator the power to make instruments (which must be approved by HM Treasury) correcting deficiencies in domesticated implementing technical standards and regulatory technical standards. The PRA and FCA have also reviewed the rules in the PRA Rulebook and FCA Handbook, respectively, and introduced a number of changes that are intended to ensure that the existing rules continue to operate as intended following exit day. Key changes are discussed throughout this chapter where relevant.
The Bank of England, PRA and FCA have also issued guidance clarifying their approach to guidance and other non-binding materials issued by the European Supervisory Authorities (ESAs). Under the approach adopted by the UK regulators, these materials will continue to be relevant following exit day unless the relevant UK regulator had previously informed the relevant ESA that it did not intend to comply with them. As such, UK firms will be expected to continue to apply such material as they did prior to exit day. The UK regulators, for their part, will continue to have regard to this material as appropriate.
Impact on UK banking groups
As noted above, UK banks and other financial services firms are expected to lose the benefit of passporting rights under the relevant EU sectoral directives with effect from exit day (subject to any transitional period). As a result, they may not be able to conduct business in other EEA jurisdictions without obtaining separate authorisation there. This has prompted a number of banking groups domiciled or active in both the UK and EEA to establish or upsize existing EEA subsidiaries to ensure continuity in their provision of services after exit day. While EEA firms operating in the UK can benefit from the TPR in the event of a no-deal Brexit, there is at the time of writing no equivalent transitional regime that will apply to UK firms operating in the EEA in such circumstances.
ii Regulatory change
Following the introduction of an array of EU financial services legislation in January 2018, large-scale regulatory change projects (other than those relating to Brexit) were a less prominent feature of 2018 than in the previous year. There have, however, been a number of significant regulatory changes over the past year to which UK banking groups have had to adapt.
Benchmark reform remains an ongoing issue for UK banking groups. The Benchmarks Regulation,15 which has applied since 1 January 2018, required benchmark administrators to seek authorisation or registration by that date. Transitional measures, however, extended this to 1 January 2020 for entities already providing benchmarks on 30 June 2016. This includes many banking group companies, which will need to obtain authorisation or registration during 2019.
UK banking groups (and other financial and non-financial institutions) also continue to prepare for the transition from LIBOR. The FCA announced in 2017 that from 2021 it would no longer compel banks to submit rates to enable the calculation of LIBOR, and that firms could therefore not assume that LIBOR would be available from that date. In September 2018, the FCA and PRA wrote to major UK banks regarding their preparations for the transition from LIBOR to the alternative risk free rates (RFRs) that are intended to replace it. The FCA required banks to provide the regulators with a summary, approved by their respective boards of directors, of their assessment of the key risks relating to the discontinuation of LIBOR, and to identify senior managers responsible for overseeing the implementation of any transition plans, in each case by 14 December 2018. Planning for the transition to alternative RFRs is likely to escalate as 2021 approaches.
While the MiFID II regime has applied since 3 January 2018, a number of banks and other financial services firms did not meet the implementation deadline, and spent much of 2018 implementing and adjusting to the new requirements. To date, the FCA has adopted a pragmatic and somewhat sympathetic approach to the delayed implementation of the MiFID II requirements, although the regulator's approach will harden as the new requirements settle. It is therefore likely that there will be increased supervisory and enforcement activity in this area during the year to come.
iii Ring-fencing regime
After several years of planning, banking groups subject to the ring-fencing regime are now adjusting to the operational and structural realities of its requirements, which have applied since 1 January 2019. In anticipation of this deadline, 2018 saw the completion of a number of ring-fencing transfer schemes by banking groups subject to the ring-fencing requirements.
Whether driven by new regulation or by market forces, UK banks remain under considerable business and regulatory pressure to innovate in their provision of services to customers.
PSD2, implemented in the United Kingdom by the PSRs, created two new payment services: account information services (whereby a payment service provider accesses customer data relating to a payment account held with another payment service provider, and displays it to the customer in a consolidated form); and payment initiation services (whereby a payment service provider allows a customer to initiate payments drawn on an account held with another payment service provider). This, with the CMA's Open Banking standard (described in more detail below), is spurring innovation in the sector, with a raft of new firms emerging to take advantage of the opportunities created by the changes.
Despite these changes, and the growing number of challenger banks and innovative financial technology companies that have emerged in the UK in recent years, new market entrants are yet to have a truly disruptive effect on the UK banking market. UK banks are nevertheless having to adapt to an increasingly innovative and agile marketplace, and to customers who are increasingly engaged with their personal finances.
Perhaps for that reason, the FCA and the PRA continue to be enthusiastic about the potential for innovation in the sector. The FCA, in particular, has recognised the benefit of new technologies in overcoming regulatory challenges in financial services. Its regulatory sandbox, which allows firms to test innovative products and services in a controlled environment, remains the most advanced programme of its kind in the EU, if not globally, having now accepted four cohorts of firms.
The issue of bankers' remuneration, and in particular bankers' bonuses, has been a politically charged issue in recent years.
As the regulatory emphasis shifts towards the accountability of senior management for conduct and culture, senior managers at UK banks will increasingly be at risk of bonus cancellations and clawback claims. Prior to this, banks may have been reluctant to seek to recover the bonuses of employees who have been dismissed. However, the new rules mean that banks will be under greater regulatory and reputational pressure to claw back bonuses than previously.
vi Conduct investigations
The impetus for banking reform in recent years has been fuelled by a number of controversies affecting the banking sector.
Over the course of the past year, four of the five individuals accused of manipulating Euribor16 have been convicted, receiving custodial sentences of between four and eight years. One of the defendants was acquitted.
While the convictions have been welcomed by the Serious Fraud Office, which brought the prosecutions, it is striking that investigations into the manipulation of Euribor and LIBOR have resulted in only a handful of successful convictions, and that no charges were brought against the firms that employed those convicted.
UK banks also continue to be subject to complaints relating to the mis-selling of payment protection insurance (PPI), over a decade since the initial controversy emerged. The volume of complaints increased following the FCA's imposition of a deadline of 29 August 2019 for consumers to bring complaints relating to PPI policies sold before 29 August 2017 and its development of a communications campaign designed to inform consumers of this deadline. The FCA has also recently consulted on proposals that would require firms that failed to disclose details of PPI commission or profit share arrangements, or both, to their customers to write to affected complainants and inform them that they can make a new complaint in light of that non-disclosure. This would apply to complainants whose complaints the firms had previously rejected on the grounds that they were out of jurisdiction, did not involve an unfair credit relationship, or both.
If these proposals are adopted, they may contribute to a short-term increase in complaints as the August 2019 deadline approaches, or require banks to revise their estimated PPI losses.
The FCA has in recent years initiated a number of market studies in the financial services sector. In October 2016, it published the final findings of a market study in the investment and corporate banking sector identifying possible conflicts of interest in that sector as well as competition issues relating to the transparency of information and the bundling or cross-selling of services. The FCA subsequently updated its conduct of business rules to include restrictions on the use of clauses that restrict a client's choice of future providers of primary market services (defined as debt capital market services, equity capital market services and merger and acquisition services). The amended rules came into force on 3 January 2018 and, together with the focus on the unbundling of services under MiFID II, have had a significant effect on how investment banks price their services and draft certain of their customer engagement terms.
The CMA completed a market investigation into the retail banking sector in the United Kingdom in August 2016. The final report identified features of the relevant markets that are having an adverse effect on competition in the retail banking sector and, in February 2017, the CMA published an order implementing certain remedies intended to address these adverse effects. This included the development and implementation of the Open Banking standard, which requires the nine largest banks in the UK to develop an application programming interface to allow read and write access to bank account data.
ix OUTLOOK and CONCLUSIONS
While the pace of regulatory change arising from the financial crisis of a decade ago has slowed in recent years, UK banks and their groups continue to navigate a challenging regulatory and business landscape.
The UK's decision to withdraw from the European Union has created unprecedented regulatory challenges for UK banks, which have been compounded by the persistent uncertainty as to the UK's future relationship with the EU. It is therefore not surprising that Brexit has dominated the regulatory agenda over the last year, and threatens to do so for the foreseeable future as the shape of the UK's future relationship with the EU continues to emerge.
UK banks and their groups continue to face other challenges, however. In particular, the relatively recent implementation of the ring-fencing requirements by the largest UK retail banking groups will have a substantial impact on the sector as affected groups settle into their new legal and operating structures under the regime. It remains the case that the ring-fencing regime presents a fundamental challenge to the universal banking model, and it is not yet clear what effect this may have on the competitiveness of the UK banking groups to which the regime now applies.
It is in part because of the complexity of the regulatory landscape faced by UK banking groups that the extent of mergers and acquisition activity in the sector remains relatively limited. Where such activity does occur, regulators can be expected to apply close scrutiny to the proposed arrangements. While recent government policy has been directed at encouraging competition from new market entrants and 'challenger banks', it may be the case that future activity in the sector focuses on acquisitions and strategic investments by incumbent players in innovative new providers of financial services.
During the coming year, it seems likely that all this will develop against the backdrop of significant structural changes to the UK legal and regulatory system, alongside perennial banking sector issues, such as the remuneration paid to senior bankers and alleged mis-selling of financial products. There seems little prospect of the banking sector stepping out of the political and media spotlight in the near future.
1 Jan Putnis and Nick Bonsall are partners and David Shone is an associate at Slaughter and May.
2 The five largest UK banking groups ranked by market capitalisation as at 23 April 2019.
3 The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (as amended) (SI 2001/544) and the Financial Services and Markets Act 2000 (PRA-Regulated Activities) Order 2013 (as amended) (SI 2013/556). The latter specifies the regulated activities that, if carried on, bring a firm within the regulatory purview of the PRA.
4 Regulation (EU) No. 575/2013.
5 Directive 2013/36/EU.
6 Directive 2014/59/EU.
7 Following Brexit, it is anticipated that this consolidation will instead apply at the level of the highest UK holding company. See the Capital Requirements (Amendment) (EU Exit) Regulations 2018/1401, and Section VIII.i.
8 The Financial Services and Markets Act 2000 (Ring-fenced Bodies and Core Activities) Order 2014 (SI 2014/1960) (as amended), the Financial Services and Markets Act 2000 (Excluded Activities and Prohibitions) Order 2014 (SI 2014/2080) (as amended) and the Financial Services and Markets Act 2000 (Banking Reform) (Pensions) Regulations 2015 (SI 2015/547).
9 Directive 2014/17/EU.
10 Comprising Directive 2014/65/EU, Regulation 600/2014/EU and other implementing measures.
11 Directive 2015/2366/EU.
12 Directive 2007/44/EC (no longer in force).
13 Certain shareholdings may be disregarded to a specified extent, including those held by a UCITS management company (or its parent), a custodian or its nominee or, subject to certain conditions, an underwriter of a securities offering (in each case acting in its capacity as such).
14 Regulation (EU) 2016/679.
15 Regulation (EU) 2014/1011.
16 Euro Interbank Offered Rate.