Considered in Grand Committee
That the Grand Committee do report to the House that has considered the Banking Act 2009 (Third Party Compensation Arrangements for Partial Property Transfers) Regulations 2009
Relevant Document: 8th Report from the Joint Committee on Statutory Instruments.
Noble Lords will recall that partial property transfers attracted significant interest in debates during the passage of the Banking Act. These statutory instruments provide legislative safeguards for creditors and counterparties of UK banks by directly responding to concerns that partial property transfers made under the Banking Act 2009 could negatively affect their rights and interests.
Although the debate should not be difficult, it is unlikely to involve simply going through the motions. Overall, the policy issues involved are complicated. Noble Lords will recall that there was close consultation with stakeholders in connection with the Banking Act 2009. I believe that these regulations provide strong legislative safeguards for creditors and counterparties of UK banks in the event of a partial transfer. They address the concerns put to the authorities that partial property transfers could negatively affect creditors’ and counterparties’ rights and interests. If counterparties and creditors of UK banks do not have legal certainty as to how partial property transfers may affect their contractual interests and their position as creditors of a failed bank, negative market consequences are likely. The contractual interests that could be affected include risk reduction arrangements, such as set-off and netting arrangements, and financial collateral arrangements. The possible negative market consequences of a lack of legal certainty in this area could include higher regulatory capital requirements and cost of funding for UK banks.
As stated in the consultation stages for the SRR and during the parliamentary stages of the Act, the Treasury's aim in providing these legislative safeguards has always been to avoid damaging negative financial market consequences as a result of taking partial property transfer powers. I believe that this aim will be delivered by these instruments, which provide legal certainty to the market and an assurance that the Government would have to have regard to leaving creditors no worse off after a partial property transfer.
As well as running a full public consultation process, with the publishing of a dedicated consultation document on 6 November 2008, the Treasury has worked extensively with industry stakeholders, particularly with the expert liaison group, presently being replaced by the statutory Banking Liaison Panel, to reach an outcome acceptable to both the market and the authorities. As the Committee may be aware, during this process, the Government listened to the concerns raised by noble Lords and others and moved their policy significantly towards providing the market with greater legal certainty.
I now turn to the safeguards order in more detail. The safeguards order is made under Sections 47 and 48 of the Act. In summary, it provides legislative protection against possible disruption under a partial property transfer for important risk management arrangements and other financial arrangements in use in the markets today. These arrangements include set-off and netting arrangements, financial collateral arrangements and structured finance arrangements.
The Committee will be aware that the Government have provided broad protection for set-off and netting. The order provides that property included under a counterparty’s set-off and netting arrangement with a bank may not be split up under a partial transfer. The possibility of damaging cherry-picking of a counterparty's relationship with a failing bank is therefore avoided, and the ability to obtain clean legal opinions in relation to the effectiveness of set-off and netting should not be compromised.
However, to allow the authorities necessary flexibility to carry out partial transfers in the interests of financial stability and depositor protection, the order features a number of carve-outs from the protection provided. The most notable of these is property belonging to a Financial Services Compensation Scheme eligible person, which is not covered by the set-off and netting safeguard. This particular carve out from the set-off and netting safeguard will allow the authorities to transfer, for example, the retail deposit book of a failing institution to a solvent new company in a short time-frame, which is important to allow the authorities to provide continuity of service, which was an interest of a number of noble Lords who spoke in the debates during the passage of the Bill, and to protect public confidence.
I now turn to an important point on the practical effect of the order. Property that is not covered by the set-off and netting safeguard under the order is referred to as “excluded rights” or “excluded liabilities”. Under the order, the authorities may choose to, for example, transfer only the excluded rights and liabilities and leave the remaining rights and liabilities in place in the original entity, regardless of any wider set-off and netting arrangement that the authorities would otherwise have needed to have kept whole. However, it is not the Government's policy intention that the presence of excluded rights or liabilities under a wider set-off and netting arrangement should render that entire arrangement unprotected by the order. I would like to make it clear that, in the Government's view, the drafting of the safeguards order does not yield this legal effect.
I am aware that some market participants are concerned that the scope of the safeguards order is not wide enough, in particular with regard to the protections provided for set-off and netting. I understand that these concerns are primarily related to technical drafting, rather than the property that the order clearly excludes as a result of government policy, and that there are varied legal interpretations on whether some relevant financial contracts have been excluded. Let me say that the Government remain committed to a safeguard regime that is as effective as possible and appreciate these potential concerns.
Indeed, the Government have already been clear that the safeguards will be subject to review and, as noble Lords will remember, the Banking Act provides for a Banking Liaison Panel of financial services representatives to keep the ongoing effect of the existence of the special resolution regime under review. As part of the Government's existing commitment to work in partnership with the industry in this area via the panel, I can announce that one of the first orders of business for the panel will be to review the safeguards order. If changes to the order are necessary and are compatible with the authorities' flexibility, the Government will make such changes before the Summer Recess. I hope this will reassure stakeholders on this point.
However, I should make clear that while an initial review this summer is appropriate, and while the panel will advise the Government on possible changes needed in the future, perhaps sparked by market innovation, it is not the Government's intention continually to change the safeguards order. Any perception that the order is subject to constant change could itself damage the certainty the order intends to bring to the market. Taking a little more time to review the order should allow a less hurried process for the Government and industry stakeholders definitively to iron out any the outstanding concerns in the medium term.
I now turn to the next safeguard featured in the order. This safeguard protects financial collateral and other secured arrangements to which a bank is party. In short, it provides that where either party has a security interest over an asset held by its counterparty, related to a liability owed by that counterparty, the asset may not be split up from the liability under a partial transfer. In this way, counterparties can continue to be confident that they will be able to have recourse to security they have taken.
There is also a safeguard for financial arrangements broadly covered by the term “structured finance”. These arrangements are referred to as “capital markets arrangements” and refer to, for example, covered bonds and securitised vehicles. The safeguard provides that partial property transfers may not interfere in the operation of such arrangements to which a bank is party by transferring some, but not all of the relevant property, rights or liabilities.
Noble Lords may recall from the later stages of the debates on the Act that we discussed issues related to events of default and financial contracts. The statutory instrument provides certainty for counterparties that a partial property transfer will not prevent them from calling events of default in relation to specified financial instruments, or set-off, netting or title transfer financial collateral arrangements. The measure also protects the operations of important central market counterparties, such as clearers and settlement houses from possible disruption under a partial property transfer. For example, clearing house default rules, which are given legal force by Part VII of the Companies Act, are given explicit protection.
I now turn to third party compensation arrangements regulations, which are made under Section 60 of the Act. Their purpose is to ensure that, following a partial transfer, no creditor will be worse off than he would have been had the whole bank been put into an insolvency procedure. In summary, the regulations provide that, where certain stabilisation options have been exercised under Part 1 of the Banking Act the,
“compensation scheme order or a resolution fund order”—
“include a third party compensation order”.
This compensation order must or may include certain provisions: for example, it must provide for the appointment of an independent valuer; and it must provide for the valuer to assess the treatment that the creditors of the failing bank that was subject to a partial transfer, would have received had the whole failing bank been put into insolvency. The order must also provide for the valuer to assess the treatment which such creditors have received, are receiving or are likely to receive if no compensation or further compensation is paid. If the independent valuer determines that a creditor in such a situation has been made worse off than he would have been had the bank entered insolvency, he must consider the compensation to be paid to that creditor. In assessing the amount of any compensation the valuer would be obliged to follow the principles specified in the regulations. These include the principle that no financial assistance would have been provided to the bank by the Bank of England or the Treasury after the relevant time specified in the regulations.
I remind noble Lords of the important protections that these statutory instruments provide to the market. I believe that this legislation, formed in intensive consultation with the industry, meets the vast majority of the market’s concerns. The Government are committed to working with the industry to ensure that the regime is as effective as possible. I thank various stakeholders for their hard work on this subject up to this point.
I commend the draft regulations and order to the Committee.
I thank the Minister for introducing the statutory instruments, which were not unexpected given the discussions that took place during the passage of the Banking Act earlier this year. We recognise that these initial statutory instruments dealing with partial transfers needed to be in place for the commencement of the Banking Act and have no problem with the fact that the Treasury has used the procedure laid out in Section 259 to lay the statutory instruments subject to later affirmative approval.
While the statutory instruments were published in draft in November, we are aware that there have been debates on the substance of them right up to almost the last minute before they were laid—the Minister referred to that in part. It would have been a miracle had the Treasury’s legal team got the statutory instruments 100 per cent right first time. I shall refer to the specific points that have been made to us later on so that at least they are clearly on the record.
From the perspective of the financial services industry, the use of the expert liaison group was regarded as a very constructive and good way of dealing with the detailed concerns about the secondary legislation, even though not all of those concerns have in practice been addressed. I hope that the Treasury will continue to work with the Banking Liaison Panel in a similarly constructive way to resolve any remaining issues. The work of implementing the Bill cannot be regarded as being at an end when these statutory instruments are approved.
While it is clear that consultation has worked well for the industry, I should like to raise it from a different perspective: that of Parliament. The Merits of Statutory Instruments Committee of your Lordships' House raised in its eighth report the fact that the documentation for the statutory instruments includes relatively little about the consultation with stakeholders. It noted that it is seeking further information on that from the Treasury. The Minister did not refer to it in his opening remarks. Can he update the Committee on how the Government intend to respond to that request?
Processes such as the expert liaison group and the Banking Liaison Panel serve a good purpose of bringing the market experts into the same room as the Treasury, the Bank of England and the Financial Services Authority, which should enhance the quality of the secondary legislation that is developed. However, at the same time, there is a danger that the process of consultation becomes virtually secret. For example, I know that the Treasury had a large number of consultation responses to the November consultation document, to which the Minister referred. Those responses are available on the Treasury website, but the Treasury has given little or no direct public response to the matters raised in them. For example, the documentation accompanying the impact assessment for the partial transfer safeguards order deals with consultation over the whole period since the first proposals were put into the public domain more than a year ago and with the changes over that period. However, that obscures the fact that there were a number of consultation responses to the very specific draft statutory instruments contained in the November proposals. There was no focus on the changes, if any, that were made following the November document.
Parliament has to approve these statutory instruments, for which the affirmative procedure is mandated. Parliament may also debate instruments which are made under the negative procedure. The information that is normally available to Parliament is a consultation, the responses to it and the Government’s responses to it. But when there is an inner circle of consultees, such as the expert liaison group, considerably less information is available to Parliament, which is what the Merits Committee was reflecting in its request for further information on consultation.
We discussed during the passage of the Banking Bill what degree of transparency should be attached to the processes of the Banking Liaison Panel, and the Government resisted any formal reporting requirements in respect of it such as the release of minutes. While I had some sympathy for that position at the time, when faced with statutory instruments such as those that we are considering today, the process of consultation has become almost invisible to those of us not involved in the detail. Perhaps the Minister could comment on how the processes of consultation could be made more transparent for Parliament when we consider any later instruments under the Banking Act, which I am sure will be intermediated through the Banking Liaison Panel.
I also ask the Minister to set out whether and to what extent the Government intend transparency of the workings of the Banking Liaison Panel to be implemented notwithstanding the lack of a formal requirement, as set out in the Banking Act.
Moving from process to the substance of the statutory instruments, I have received no specific comments on the Banking Act 2009 (Third Party Compensation Arrangements for Partial Property Transfers) Regulations 2009, which the Minister referred to by their nickname of the “no creditor worse off” regulations. It is perhaps unsurprising that we received no comments on this statutory instrument, because our clear legal advice was that the “no creditor worse off” arrangements added nothing to legal certainty. They are nice to have, but not essential to the working of financial markets, so we must simply hope that if they ever have to be used—we hope they do not—the regulations are robust.
However, we received briefing from the British Bankers’ Association, the London Investment Banking Association and the International Swaps and Derivatives Association on the restriction of the partial property transfers safeguards order. This is what the Minister referred to in his introductory remarks. As I said earlier, I shall set out those concerns for the record. Those who have briefed us believe that they raise significant issues.
The first concern is the approach to safeguards for netting arrangements, and whether the definition of “excluded rights” in Article 1 is correct. I am told that there are two issues here. First, the definition of “financial instruments” cross-refers, in effect, to MFID, which will exclude a number of instruments and contracts that are commonly subject to netting arrangements. These include spot and forward foreign exchange contracts, physically settled commodities derivatives, and spot and forward bullion transactions as well as derivatives on newer asset classes such as longevity and mortality. Quite a number of areas appear not to be covered by the current reference.
Secondly, the definition of “excluded rights” is in terms of contracts entered into otherwise than in the course of an activity that relates solely to relevant financial instruments. The fear is that many contracts will become excluded rights just because they could include non-relevant financial instruments issues. I am told that this could be a problem, even if all the transactions under a master netting agreement are protected, but used to hedge a non-protected transaction such as a loan.
The Minister implied that the Treasury was aware of the technical issues; I am sure that it is fully aware. The Minister said that this would be on the first agenda of the Banking Liaison Panel, and that if any changes were necessary, they would be brought in before the Summer Recess. That is welcome up to a point, but I am also told that, as we speak, legal opinions on existing arrangements are being drawn up. If clean legal opinions cannot be given on existing arrangements, that could cause significant problems for those with material amounts of such contracts. In addition to causing specific difficulties for particular institutions, it could also put a further dent in the attractiveness of the UK and English law as the home for many of these financial instruments. I am sure that the Minister agrees that that would be undesirable given the pre-eminence of our financial services industry.
The second issue raised with us concerns the inclusion of small companies, which are protected by the Financial Services Compensation Scheme. The Minister also referred to this. A consequence appears to be that the FSA is saying that it is required by the EU capital requirements directive to treat balances with these customers on a gross basis. This obviously increases the regulated capital required to be held and the cost of capital that banks incur and—other things being equal—would lead to higher costs of borrowing for the small businesses within the retail deposits carve-out. I am sure that the Minister would not regard that as desirable either, especially in today’s economic environment.
The Minister will recall that we debated the problem of regulatory capital during the passage of the Bill. The November consultation document, at paragraph 2.16, said in terms that,
“the Government’s clear intention is to protect contracts relevant for regulatory capital purposes from the threat of disruption under a partial transfer”.
We urged the Government to place that clear commitment on the face of the Bill, but they declined to do so. We now appear to be facing an issue where regulatory capital will indeed be affected by the threat of a partial transfer. I am told that discussions are continuing with the FSA on this point and I do not know whether the Minister can update the Committee on that, but I understand that even if the regulatory capital issue is resolved, the same issue can also affect clean legal opinions where a group of companies contains one or more small companies, which most groups do.
I have a further point to put to the Minister on a more general level about future statutory instruments under the Banking Act. The Treasury was asked by the Merits Committee about the breach of the 21-day rule in relation to statutory instruments made under the 2009 Act and the Banking (Special Provisions) Act 2008. I have no problems with the responses that the Treasury gave in respect of the specifics, but when dealing with the issue of further statutory instruments made under the 2009 Act, the Treasury's memorandum submitted to the Merits Committee said at paragraph 27 that the Treasury's intention is to observe the 21 day rule,
“where this is necessary and appropriate”.
That is completely the wrong approach. The Treasury should observe the 21-day rule unless it can establish that it is necessary and appropriate to ignore it. Will the Minister confirm that the Treasury will regard the 21-day rule as of the utmost importance unless it is necessary genuinely to breach it?
I conclude with foreign property. The responses to the November consultation have one consistent theme—that foreign property is a problem. I note that the compensation arrangements do not cover the purported transfer of foreign property which is not effective due to foreign law, and the partial property safeguards order singles out ineffective foreign property transfers as not breaching the order. We discussed in Committee the broad area of who bears the risk of ineffective property transfers and I understand that the Government want to leave the risk wholly in the market. I will content myself today with one prediction, which is that foreign property will cause some real problems in respect of partial transfers whether in this country or—perhaps more likely due to regulatory action—in other countries, where the uncertainties regarding foreign property may lead to regulatory capital inefficiencies. I do not know whether those problems will in turn have an effect on our financial services market, but I hope that the Minister will confirm that the Banking Liaison Panel and indeed the Treasury will keep this firmly under review.
I, too, am grateful to the Minister for setting out the background and content of these regulations so fully. As the noble Baroness said, the concerns fall into two parts. The first relates to the consultation procedure and the second to the substance.
As far as the consultation procedure is concerned, there is no doubt that the expert liaison group played an important and positive role as the Banking Bill was going through the House. The regulations that we see today are the fruits of its work. Equally, the Banking Liaison Panel should carry forward at least the spirit of that work. The noble Baroness talked about the fear of the process becoming secret. One has to strike a balance—which she discussed. We want the process to be transparent but should avoid everyone spending their time reporting on what they are doing rather than doing it. In terms of good process, the process that led to the regulations that amended the Lloyds market had a lot to recommend it in the way in which it was reported to Parliament. We had a set of statutory instruments with a document attached—which was rather fuller than the documentation we have had today—that set out the representations that had been made and, as the noble Baroness suggested, the Government’s response to them. Therefore, at the time the statutory instruments came forward, we had a narrative of all the issues that had been raised, where there were still outstanding difficulties and why the Government had not felt able to accept proposals that had been made. That was a very satisfactory way of proceeding and is probably more satisfactory than having endless minutes, although, if one wants, one can have them as well.
The noble Baroness set out the concerns expressed by the BBA and others on the substance of the regulations. As the process moves on, the concerns become more technical and narrower. When we started, we were both being lobbied by the banking industry on the basis that unless the Bill changed quite significantly, it would be the end of banking as we know it in London. Although there is still a faint echo of that in the representations, great progress has been made. I was always slightly sceptical, given everything else that is going on in world financial markets, that London’s position would be undermined to the extent that was suggested if this legislative framework was not absolutely right at first blush. It is important that further discussions go ahead between now and the summer so that any outstanding concerns can be addressed as far as possible. However, I would be slightly surprised if, at the end of the process, there was not at least one eminent lawyer who disagreed with the consensus. My experience, not least in listening to eminent lawyers in your Lordships' House, is that getting consensus on many of these technical matters is absolutely impossible and, beyond a certain point, not worth seeking.
Finally, I echo the point made by the noble Baroness about the 21-day rule. It is difficult to see many circumstances in which the 21-day rule should not be followed. The terminology used by the Treasury is typical Treasury-speak; namely, “Oh, I suppose we might do this if we’ve got no option”, rather than, “We will do it, unless there is a real emergency”.
I thank noble Lords for their inputs on this subject. The noble Baroness, Lady Noakes, made the powerful point that the work of Banking Liaison Panel does not cease with the approval of these statutory instruments but is part of a continuing dialogue and role. The innovation and creativity of financial markets will almost certainly mean that we regularly have to revisit this and achieve clarity in our own minds that the existing provisions are appropriate to cope with new instruments as they emerge.
The noble Baroness also raised wider issues relating to consultation. I have considerable sympathy with her comments. A good consultation process is a dialogue. It is one in which people who take the trouble to respond are entitled to a considered and reasoned response. There are perhaps some pointers here that we should bear in mind in further consultations. The submissions we receive are posted on the Treasury website, which helps enhance debate and discussion, but it is a somewhat incomplete meal because it does not explain the responses, save in statements made to this House and in the other place during the evolution of legislation and instruments.
The noble Baroness raised questions also in connection with process in respect of the publication of the minutes of the Banking Liaison Panel. The Government are not opposed to their publication; indeed, we would be very happy to have them published if that was the wish of the Banking Liaison Panel. The first thing to do is to ensure that the panel is content that that is a way of working which will not inhibit it fulfilling the role that we expect from it. The forerunner, the expert liaison group, was happy with summary minutes being published; I hope that the Banking Liaison Panel may be drawn towards a similar conclusion, but we should leave it to it to establish its own views on that.
I have already referred to the issue relating to formal responses to the consultation process. I have added in that respect that I can commit that the published minutes of the BLP should be accompanied by a narrative on the Government’s response to consultation responses. I hope that that will take us a further, significant step forward in achieving an open dialogue and debate. The noble Baroness made another important point about the need to ensure that the Act and these statutory instruments are consistent with promoting the UK as a good place in which to conduct the business of banking. One of the ways that we shall do that is by showing clearly the way in which we arrive at public policy decisions.
The Government responded to the Merits Committee’s eighth report and its request for more information on the consultation process. Our response appeared in the Merits Committee’s 10th report and I direct noble Lords to it. I am also inclined to agree with the noble Baroness and the noble Lord, Lord Newby, about the form of words used in respect of the 21-day rule, which we should always endeavour to respect. Rather than say that we shall comply where necessary and appropriate, I would prefer to reverse that and say that we shall comply unless there are circumstances in which we judge that to be unnecessary or inappropriate. In such circumstances, we would explain why we had reached that conclusion.
The noble Baroness, Lady Noakes, raised a point in respect of smaller companies. In making the order, the Government needed to strike a balance between ensuring that they can deliver vital continuity of service, about which the noble Baroness was particularly concerned when we debated the Bill, and liquidity for small businesses in the event that their bank fails and suitable protection for the more advanced risk mitigation techniques that may exist between larger firms and their banks. For this reason, the Government believe that a carve-out from the netting protection for all FSCS-eligible depositors, including small companies, is appropriate to allow the authorities effectively to provide continuity of service for those depositors.
However, we are aware that certain stakeholders believe that the combination of this carve-out and the FSA’s interpretation of the relevant European rules could lead to firms requiring more regulatory capital. We are investigating this concern and are aware that there will be a meeting between the FSA and the banks on this topic soon. Irrespective of the FSA’s position, I note that how banks meet increased regulatory capital costs is a commercial decision for them. The Government will be watching developments in this area carefully. I have already indicated that the Banking Liaison Panel will review the order now that it has been made. This issue will be picked up as part of that review.
The noble Baroness raised a point about foreign property and made a forecast, which we shall watch with interest. Foreign property is not carved out of the safeguard. We think that the likelihood of foreign banks withdrawing from lending to UK banks due to formulation of the safeguard is very small. We have formulated the safeguards to ensure that the UK authorities have the necessary flexibility to make partial transfers of failing banks in the interests of financial stability, reducing risk for the UK taxpayer. The Government take this position for the following reason: foreign property is not carved out of the set-off and netting safeguard. The order simply states that if property that UK authorities attempt to transfer is not transferred due to the failure of a foreign court to recognise the transfer, this failure does not constitute a breach of the order by virtue of not all the relevant property rights or liabilities being transferred.
Foreign counterparties are likely to want to be transferred and ought to be able to take action before their local courts to get a transfer recognised. Counterparties could write into their contracts the need for a foreign bank to recognise a transfer under the SRR. A partial transfer under the SRR is almost certainly a reorganisation measure under the Credit Institutions Winding-Up Directive. As such, EEA states are required to recognise the transfer.
The noble Baroness asked, too, about the scope of the safeguards order and whether it was wide enough for relevant financial instruments. As I indicated in my opening remarks, we are aware of concerns in this area that some stakeholders hold. It is our understanding that these concerns are primarily related to technical drafting and that there are varied legal interpretations on whether some relevant financial contracts have been excluded. I should note that in drafting we amended the order to address the core concern in relation to relevant financial instruments—the need for the order to cover loans. As I mentioned earlier, as part of the Government’s existing commitment to working in partnership with the industry, the Banking Liaison Panel will review the safeguards order. If changes to the order are desirable, the Government will make such changes before the Summer Recess; we certainly recognise the need to do that as quickly as we can, subject to doing a good piece of work, because we understand that opinions will be developed on the basis of these statutory instruments.
The noble Baroness reminded us that when this Act was first discussed, many forecast that the roof would come tumbling in on our heads. A considerable degree of credit for the fact that it has not is due to this Chamber and the debates that took place over a number of days, when we progressively improved the quality of the Bill that had been presented to Parliament. A great deal of credit is also due to the expert liaison group for the work that it has done, which I am sure that the Banking Liaison Panel will continue to do in what I think we all acknowledge is an extraordinarily tricky but very important area for an important part of our financial economy.
I hope that these comments go some way to assuaging noble Lords’ concerns. I reiterate that the legislation was formed in close consultation with the industry and it was necessary to make it in time for the commencement of the Act. As I have indicated, it will be subject to further review this summer in close consultation with the industry, under the auspices of the new Banking Liaison Panel.