Considered in Grand Committee
My Lords, since the financial crisis, the Government have implemented significant reforms to address the problems of the past and make the financial sector safer and more stable. A key element of these reforms was establishing the Financial Policy Committee, which is responsible for identifying, monitoring and addressing risks to the financial system as a whole. The FPC addresses macro-prudential risks through its powers to issue recommendations and, importantly, directions to the Prudential Regulation Authority and the Financial Conduct Authority.
Successive Governments have legislated to provide the FPC with the powers of direction that it needs to address risks to financial stability. Through these existing powers, the FPC can ensure that firms are not allowed to take on excessive levels of leverage, effectively tackle systemic risks in the UK housing market, and vary firms’ capital requirements against exposures to specific sectors over time. This instrument amends the existing powers of direction granted to the FPC by Parliament to ensure that they continue to operate effectively given changes that have been made to the wider prudential regime since they were first introduced.
The Financial Services Act 2021 represents a major milestone in shaping a regulatory framework for UK financial services outside the EU. It enhances the competitiveness of the sector and ensures that it continues to deliver for UK consumers and businesses. The Act extended the powers for the PRA to make rules which apply to holding companies for the purposes of prudential regulation. Accordingly, the Act granted the FPC the ability to make directions or recommendations that relate to holding companies, ensuring a coherent regime under which holding companies become responsible for meeting prudential requirements. Consistent with these changes, this instrument amends the FPC’s existing powers of direction, where necessary, so that they can also be applied in relation to holding companies.
In addition, the Government have stated their intention to move the detail of the leverage ratio framework exclusively into rules made by the PRA using powers introduced by the Financial Services Act 2021. The leverage ratio is intended to be a broadly risk-insensitive measure of a bank or investment firm’s level of leverage. This instrument therefore amends the FPC’s powers of direction over the leverage ratio so that the method for measuring a bank’s exposures when calculating the leverage ratio is defined by reference to rules made by the PRA. This method will be subject to any specifications made by the FPC when it issues a direction in relation to leverage. For example, the FPC currently recommends that the PRA excludes central bank reserves from banks’ exposures for leverage purposes to ensure that macroprudential policy does not impede the smooth transition of monetary policy. Under this instrument, the FPC would instead be able to direct the PRA to make such an exclusion.
This House may wish to be aware that the FPC and the PRA recently published a consultation on proposed changes to the UK leverage framework. This followed the FPC’s comprehensive review of the framework in light of revised international standards, and its ongoing commitment to review its policy approach. The UK remains committed to the implementation of the Basel 3 standards, of which the leverage ratio is a key part, alongside other major jurisdictions.
It is important to emphasise that the FPC’s proposed leverage ratio framework delivers a level of resilience at least as great as that required by international standards, providing a vital backstop to secure the resilience of the banking system. The framework will continue to require that the vast majority of the UK leverage ratio be met with the highest quality of capital. However, I should make it clear that the changes introduced by this instrument are to ensure that the FPC can continue to make effective use of the existing powers of direction over the leverage ratio that have already been granted to it by Parliament. It is for the FPC, which is independent of government, to decide which of its levers, including its powers of recommendation and direction, would be most effective and appropriate to implement measures such as the proposed changes to the leverage ratio framework.
The Treasury has worked closely with the Bank of England to prepare this instrument. In accordance with our statutory obligations, officials have consulted the FPC, which agreed with the approach being taken. We have engaged with the financial services industry on the contents of the instrument.
This instrument is necessary to ensure that the FPC’s existing macroprudential tools continue to operate effectively given changes that have been made to the wider prudential regime since they were first introduced. I beg to move.
My Lords, I thank the Minister for introducing this regulation, which is consequential on the changes to powers laid out in the recent Financial Services Act—which we debated for many days earlier this year. As the Minister said, the matters covered today include the leverage ratio and the application of measures to holding companies.
I have no problem with the regulation but I want to say a few things about the policies which it will be used to put in place. As the Minister said, there are several significant FPC and PRA consultations concerning application of international Basel standards and the leverage ratio, which are made in consultation with HMT. I would like to spend my time on those underlying issues that will be given life through the powers in this instrument.
The leverage ratio presently is utilised essentially as a backstop in case the models used by banks to calculate their risk-weighted capital requirements become too light in their risk assessments. Currently, it is set at 3.5%, and it is the capital buffers that will tend to restrict the banks’ activities, essentially through cost, with the leverage ratio therefore seen as a sort of lower ultimate solvency test. Nevertheless, it effectively functions in a similar way to capital buffers rather than as a different economic tool.
I make that point because I thought that, with the Financial Policy Committee having a bigger role in relation to leverage, there might be an attempt to look at the outcome of the Macmillan committee report produced after the 1929 financial crisis, where it was suggested that, instead of controlling markets simply by interest rates and price, there should be a second leverage control that addressed total volume. So my question to the Minister is on what thought is being given to whether there needs to be a control on volume and money creation other than through price.
Returning to what is actually happening in conjunction with this instrument, and in line with new Basel standards, the leverage ratio framework is being applied to a wider scope of firms, at times to the consolidated or sub-consolidated level, and will extend to internationally active holding companies and firms with non-UK assets over £10 billion, which will cover larger, non-ring-fenced banks and broker dealers such as Goldman Sachs, JP Morgan and Morgan Stanley. I agree that these are all good moves for stability of the banking system in the UK.
Alongside that there is to be tweaking of, and some disapplication of, Basel standards. Schedule 3 of the Financial Services Act 2021, repeated again in this instrument, states that the PRA must have regard to, among other things:
“relevant standards recommended by the Basel Committee on Banking Supervision from time to time … the likely effect of the rules on the relative standing of the United Kingdom as a place for internationally active credit institutions and investment firms to be based or to carry on activities … the likely effect of the rules on the ability of CRR firms to continue to provide finance to businesses and consumers in the United Kingdom on a sustainable basis in the medium and long term … the target in section 1 of the Climate Change Act 2008”,
which is net zero,
“and … any other matter specified by the Treasury”.
As ever, it is “have regard”, so it promises nothing. In the proposed changes around leverage, there are areas where the second point, about the standing of the UK—effectively competitiveness—has prevailed over the first, and the Basel rules are not taken in full. The UK will not be Basel-compliant over its leverage buffer for globally systemically important banks, setting a lower-than-Basel level, and will also not be implementing the disciplinary measures, such as restriction of dividends on breach of a leverage ratio requirement. It is not hard to see the attractiveness of those measures to banks, but is not there a risk that it is saying, “We don’t care that you are getting close to dodgy solvency levels, just go ahead and pay dividends”? Which other jurisdictions are doing this, or is the UK leading the charge?
There are other departures, too, but the Economic Secretary to the Treasury said in the Commons on Monday that the FPC will argue that overall, on an outcomes basis, the UK is equivalent because a stronger measure of what qualifies as capital will be applied. That is a substantial attitudinal departure from international standards. I understand where it is coming from, but it is the UK back to its old tricks of saying it complies when in fact it picks and chooses and jiggles around? It can be the same on an outcomes basis to get to a destination going the wrong way along a one-way street, but it is not advisable and involves breaches of standards. Is not that what the UK is doing—saying that we were well under the speed limit on this road, so now we can take an illegal short-cut down the one-way street?
There is no great glory from being above Basel on capital standards. Basel rules are meant to be a minimum and already have aspects of lowest common agreement, which is in fact how some lower-grade capital gets in there. In my book, the lower standards look like breaches rather than outcomes compliance, and I worry that the UK has possibly started the undermining of Basel and a race to the bottom.
Can the Minister provide, if not now then by letter, calculations that show how the higher quality of capital compensates for lower buffers—for example through loss absorbency in the event of resolution? What was the basis, other than saying, “Come and headquarter here”, for removing the restrictions on dividends for a breach of the leverage ratio? I understand the importance of keeping investors, but what action will the regulator take for fast restoration of capital if dividends are still flowing out? Furthermore, are the differences from Basel in fact things that the UK argued for and lost—perhaps, if you like, giving a warning—or are they new approaches? Will it undermine the future effectiveness of the UK in negotiations if we have the reputation for just doing things our own way anyhow? Will not that remove the incentive for others to see things the same way as the UK?
The regulation will pass, as it is part of the new structure but, despite references in the documents to the “new accountability structure”, it is regrettable that these first, important decisions that I have commented on are happening without more prior reference to Parliament. As we said during the debates on the Financial Services Bill, everything is being front-run and front-loaded. The Government fixed their influence and have, unhappily, left Parliament behind.
My Lords, this is one of the first statutory instruments arising from the passage of the Financial Services Act 2021. As well as looking at the changes introduced by this instrument, this debate provides an opportunity to briefly discuss some of the wider issues arising from the new legislation.
This order provides an update to the powers of the Financial Policy Committee, so that it can direct the Prudential Regulation Authority on matters relating to certain holding companies. We welcome this extension of existing macroprudential measures and the various consequential changes in the instrument, which ensure consistency in terminology, application and so on. We also understand the Treasury’s desire, as stated in the Explanatory Memorandum, to bring this instrument into force as quickly as possible and minimise any gaps that may exist in the FPC’s current powers.
As the Minister outlined in his introduction, this instrument also makes changes to the total exposure measure, or the overall leverage ratio, the framework of which is being transferred from the retained Capital Requirements Regulation to PRA rules. This was discussed when the SI was debated in the Commons earlier this week.
The comments of the Economic Secretary, John Glen, were extremely helpful in outlining the process to date, as well as ongoing and next steps. It was particularly useful to have confirmation that excluding Bank of England balances will make no material difference to the leverage ratio—that is, the amount of capital that a bank is expected to hold in relation to its overall loan book. One area where the Economic Secretary’s answer was slightly less clear was on whether he foresees the UK changing capital requirements now that we are outside the EU. The answer provided, that the Government’s objective is to
“align to the highest global standards”,—[Official Report, Commons, Delegated Legislation Committee, 6/7/21; col. 7.]
did not directly address the question from Pat McFadden, the shadow Economic Secretary. Can the Minister shed some light on this today?
At the beginning of my speech, I forewarned the Minister that I would make some general points. I will turn to these now. The changes in this instrument are clearly the first of many. Implementation of Basel 3.1, coupled with the Government’s desire to transfer other measures from retained EU law to domestic prudential rules, will mean a steady stream of regulatory changes in the coming months.
The Treasury will no doubt have a document containing the target dates and absolute deadlines for enacting each of these changes, as well as an indication of which parliamentary procedure—if any—they will be subject to. Can the Minister commit to sharing this work plan, to ensure that colleagues who wish to do so can engage at an early stage?
Following on from that question, now also seems an appropriate time to return to one of the big debates from the passage of the Financial Services Bill. The regulators are, separately or jointly, consulting in a range of areas ahead of exercising their expanded rule-making powers. For example, the Financial Conduct Authority launched its consultation on a new consumer duty in May, fulfilling the first requirement of Section 29 of the 2021 Act. Although the Minister was not intimately involved in that Bill’s passage through your Lordships’ House, he will be aware of undertakings from the FCA and the PRA that they would engage with Parliament as part of their day-to-day work. Although the FCA approached me, is the Minister satisfied that consultation exercises and draft rules that have emerged since the passing of the Act have indeed been brought to the attention of relevant parliamentary committees?
Finally, although it may not be something he can provide in this debate, can the Minister give an update on the future regulatory framework review, which is considering issues such as accountability and scrutiny?
My Lords, I thank the noble Lord, Lord Tunnicliffe, and the noble Baroness, Lady Bowles, for their thoughtful contributions. It is the Government’s view that this instrument is necessary to ensure that the FPC’s existing macroprudential tools continue to operate effectively, given changes that have been made to the wider prudential regime since they were first introduced. On the question from the noble Lord and the noble Baroness about the leverage ratio, it is for the FPC, which is independent of government, to decide which of its levers, including the powers of recommendation and direction, would be most effective and appropriate to implement measures such as the leverage ratio. It is important to point out that the ratio itself increased from 3% to 3.25% in 2016 and banks are today reporting core capital ratios almost three times higher than before the 2008 global financial crisis.
To expand on the comments of the Economic Secretary, since 2016 the Financial Policy Committee has used its powers of recommendation to implement a leverage ratio, which excludes central bank reserves, and the FPC’s current consultation proposes to maintain that policy. The changes in this SI will instead allow it to direct the PRA to implement such changes to the framework, appropriately reflecting that the PRA will become responsible for defining the total exposure measure on an ongoing basis. On the noble Lord’s question about how the Government foresee capital requirements changing now that we are outside the EU, the UK remains committed to maintaining the highest international standards, including the Basel standards. This has not changed now that we have left the EU. However, I should note that the capital requirements in relation to the implementation of Basel 3 and 3.1 standards and the prudential regime for investment firms are set by the regulators and therefore independent of government.
The Government believe that delegating responsibilities to expert and independent regulators remains appropriate. The regulators have the expertise to set rules in the complex and technical area of financial regulation. They do so in an agile way which corresponds to the changing context. The PRA will decide exactly how these Basel 3 standards will be implemented, subject to any recommendations or directions made by the FPC based on the specificities of the UK market, in line with statutory objectives and accountability frame- works set out in the recently passed Financial Services Act. The PRA’s recent consultation on Basel 3 implementation set out several areas where it proposed to tailor the implementation of the outstanding Basel 3 standards to better reflect the UK context.
The noble Lord requested a timeline for ongoing prudential regulation. Last year, the Treasury and regulators published their intention to implement the outstanding Basel 3 reforms and the investment firms prudential regime for 1 January 2022. To enable this, Her Majesty’s Treasury intends, in the near term, to lay an affirmative SI which revokes the relevant aspects of the onshore to capital requirements regulation, therefore allowing the PRA to make rules that fill the space of those revocations and, in so doing, implement the outstanding Basel 3 standards. The Treasury will also, later in the year, lay an affirmative SI which makes consequential amendments needed as a result of the aforementioned revocations.
I want to highlight the Regulatory Initiatives Grid, the third edition of which was published in May of this year and includes the proposed timeline for other prudential reforms, such as the implementation of Basel 3.1. The grid adds to the extensive co-ordination mechanisms already in place between HMT and regulators, giving firms a clear picture of upcoming regulatory initiatives, including consultations, so they are better placed to plan for them. In relation to consultation exercises and draft rules to emerge since the passing of the Financial Services Act 2021, I can confirm that the PRA sent its consultation and its draft rules on Basel 3 implementation, shortly after their publication, to the Treasury Select Committee, the Lords Economic Affairs Committee and the Lords EU Services Sub-Committee. The PRA intends to follow a similar process when it publishes its subsequent policy statement and near-final rules.
The FCA has also engaged with parliamentary colleagues on its two consultations and policy statement on the investment firms prudential regime. Indeed, the first IFPR consultation was discussed by Parliament during the passage of the Financial Services Act and the FCA has notified the Treasury Select Committee of all the IFPR publications to date. I am confident the FCA will follow a similar process for future consultations, policy statements and final rules. As set out in their letters to parliamentarians during the passage of the Financial Services Act, both regulators are happy to hear views and discuss ongoing work in more detail with MPs, Peers and parliamentary committees wherever this is helpful.
Finally, the noble Lord also asked for an update on the ongoing future regulatory framework review. The FRF review aims to build on the strengths of the UK’s existing framework as set out in FSMA to ensure that it is fit for the future. The review considers whether changes are required to the regulator’s statutory objectives and principles, how we ensure that accountability and scrutiny arrangements with the Treasury, Parliament and stakeholders are appropriate, given the regulator’s new responsibilities, and how we return responsibility for designing and implementing the specific requirements that apply to firms in certain areas of retained EU law to the regulators within a framework set by government and Parliament. An initial consultation exploring these key issues and a proposed approach was published in October 2020 and closed in February 2021. The Government are considering the 120 responses received ahead of a second consultation in the autumn.
On the question asked by the noble Baroness, Lady Bowles, about the plans for the UK framework to take a different approach to Basel, the design of the leverage ratio framework is a matter for the FPC and the PRA, which are independent of government. The UK’s proposed leverage ratio delivers a level of resilience at least as great as that required by international standards. Interested parties are able to respond to the ongoing consultation that I referred to, which is being carried out by the FPC.
I hope that the Committee has found today sitting informative and that it will join me in supporting this order, which I commend to the Committee.