Capital Requirements (Amendment) (EU Exit) Regulations 2018
Considered in Grand Committee
That the Grand Committee do consider the Capital Requirements (Amendment) (EU Exit) Regulations 2018 and the Bank Recovery and Resolution and Miscellaneous Provisions (Amendment) (EU Exit) Regulations 2018.
My Lords, Her Majesty’s Treasury is in the process of laying statutory instruments under the European Union (Withdrawal) Act in order to deliver a functioning legislative and regulatory regime for financial services in the event of a no-deal scenario. The two SIs being debated in this group are part of this programme and will fix deficiencies in UK law relating to the UK’s prudential regime, which ensures that financial institutions hold sufficient capital and appropriately measure and manage their risks, and also relating to the UK’s bank resolution regime, which ensures that the UK authorities have the necessary tools to manage the failure of a bank, investment firm or building society in an orderly way. The approach taken in these SIs aligns with that of other SIs being laid and debated under the withdrawal Act by maintaining existing legislation at the point of exit to provide continuity but amending it where necessary to ensure that it works effectively in a no-deal scenario.
The first statutory instrument being considered today concerns the capital requirements framework, which aims to prevent the failure of financial institutions by setting prudential rules that apply to banks, investment firms and building societies. These rules are currently set through the EU capital requirements regulation and the EU capital requirements directive. The second statutory instrument relates to the bank recovery and resolution directive, which sets out the requirements that ensure that firms’ failures can be managed in an orderly way, avoiding the need for costly public bailouts. In a no-deal scenario, the UK would be outside the European Economic Area and outside the EU financial services framework. To ensure that the legislation continues to operate effectively in the UK once the UK has left the EU, these SIs will make amendments to retained EU law in relation to the capital requirements regulation and the bank recovery and resolution directive so that the legislation will continue to function effectively in a no-deal scenario.
I note that, in line with the general approach taken to the onshoring of EU legislation, both statutory instruments will transfer a number of functions currently within the remit of EU authorities, particularly the European Banking Authority and the European Securities and Markets Authority, to relevant UK bodies. These functions, such as the development of detailed technical rules on certain provisions of the regulations, will now be carried out by appropriate UK bodies: the Financial Conduct Authority, the Prudential Regulation Authority or the Bank of England. For example, the responsibility for binding technical standards under the bank resolution and recovery regime is being transferred to the Bank of England, given that it is the UK’s resolution authority. The PRA and FCA have extensive experience in setting firm-specific rules for international firms, and are therefore the most appropriate domestic institutions to take on these functions from the European supervisory authorities. The regulators are undertaking public consultations on the changes that they propose to make to binding technical standards.
These statutory instruments further confer regulation-making powers on the Treasury to replace delegated powers that were previously conferred on the European Commission, in line with the approach taken in other Treasury legislation.
The draft capital requirements regulations 2018 make changes primarily to the retained EU capital requirements regulation but also to certain domestic secondary legislation implementing the EU capital requirements directive. First, they introduce changes to the group consolidation regime. When the UK leaves the EU, we will also leave the EU supervisory regime. This means that we will need to limit the geographical scope of the capital and liquidity consolidation rules to the UK, rather than on an EU-wide basis as currently. This will introduce a new layer of liquidity consolidation in the UK, though it will not affect the application of consolidated capital requirements, which are currently calculated at the member state level.
Secondly, the draft regulations remove preferential capital treatment currently available for exposures to certain EU institutions and assets, including sovereign debt. The EU capital requirements regulation currently applies a zero-risk weighting to certain categories of EU assets such as sovereign debt. This means that firms do not have to hold capital for their exposure to such assets and are therefore incentivised to invest in them. In line with our general cross-government approach, it is our policy not to grant the EU unilateral preferential treatment in the absence of an assessment of equivalence after exit day. We will therefore end the preferential capital treatment for EU assets currently subject to the zero-risk weighting.
Finally, the draft regulations introduce changes meaning that UK regulators will no longer have to obtain approval from EU institutions before using macroprudential tools to address systemic risks, including in a financial crisis. This is appropriate given the UK would be a third country and will need the UK regulators to be able exercise macroprudential functions effectively in times of financial stress.
I turn now to the bank recovery and resolution statutory instrument, which amends the Banking Act 2009 and related domestic and retained EU legislation by making the following principal amendments. First, the draft regulations amend the scope of the UK’s third-country resolution recognition framework to include EEA-led resolutions. This ensures that, in a no-deal scenario, the same approach will be followed for both EEA and third countries in recognising third-country resolution actions.
Secondly, this statutory instrument removes deficient references requiring UK regulators to follow the specific operational and procedural mechanisms set out in the BRRD to co-operate with the EEA authorities. The removal of these references will not, however, prevent UK regulators from co-operating with their EEA counterparts after exit. UK regulators will remain able to share information with EEA authorities in the same way as they currently do with authorities in third countries such as the United States. Additionally, the UK will continue to participate in international crisis management groups which enhance co-operation between home and host authorities of systemically important banks.
Finally, the draft regulations address deficient cross-references to the BRRD in UK legislation and ensure that delegated regulations retained by the European Union (Withdrawal) Act continue to be in a workable form following exit.
To summarise, the Government believe that these statutory instruments are needed to ensure that the regulatory regime applying to banks, building societies and investment firms works effectively if the UK leaves the EU without a deal or an implementation period. I commend the regulations to the Committee.
My Lords, before the debate begins, it may be helpful if I explain that the rather quaint little hats sitting on the ends of some of the microphones are an indication that they are not working.
Thank you. On the assumption that I do not have a little hat on my microphone, I should say that when I read through these two sets of draft regulations and their Explanatory Memoranda, they were a depressing reminder of the consequences of leaving the EU with no Brexit deal in place.
The regulations allow the Treasury and relevant regulators to take steps to ensure that, in the event of no deal, the UK has a functioning financial services regulatory regime, can protect consumers and ensure financial stability. At the heart of that stability are the prudential standards developed in the aftermath of the 2008 financial crisis, measuring and mitigating risk through maintaining adequate capital reserves and establishing an effective recovery and resolution framework. No one who can recall the vivid fear of a financial meltdown in 2008 can fail to understand the importance of a robust system of prudential regulation. The capital adequacy and resolution regime for banks and other financial institutions was the subject of considerable debate and scrutiny post 2008.
These SIs make amendments to certain aspects of the capital requirements regulation, to ensure that it continues to operate effectively after Brexit day, and to certain other statutory instruments that implement the capital requirements directive. Key changes for when the UK leaves the EU include: amending the geographical scope of supervisory consolidation of capital and liquidity reporting processes to restrict it to the UK; transferring functions from the European supervisory authorities to the UK regulators; transferring responsibility for all binding technical standards from those European authorities to the UK regulators; and macroprudential measures that ensure that the tools available to national regulators in the event of systemic risk, for example an asset bubble, remain available to the UK regulators.
The draft SI which addresses the onshoring of the bank recovery and resolution framework post Brexit aims to ensure that the UK special resolution regime is,
“legally and practically workable on a standalone basis”,
when the UK leaves the EU. The draft regulations also make further provisions on contractual recognition of bail-in, with new Bank of England powers to make technical standards on requirements for recognition. The Bank of England, the Prudential Regulation Authority and the FCA are expected to consult on changes to their rules affected by these regulations, and the special resolution regime code of practice will be updated. These are matters of significance that will have to be addressed with urgency.
Obviously, if the UK were to crash out of the EU with no deal, I would certainly want the Treasury and regulators to take action to protect the UK’s financial stability. Any Government faced with a no-deal exit will have to firefight and move quickly to protect the national interest. Those would be exceptional times. However, it is 12 December 2018, and we are due to leave on 29 March 2019. Ignoring Christmas, that gives us about 12 weeks to introduce measures to ensure continuing confidence in the UK financial services regulatory regime. Delivering such a challenge in such a tight timetable requires a great deal of assurance.
I therefore want to ask the Minister four questions. Will the Treasury, the PRA and the FCA have sufficient staffing resources with the necessary level of skill and expertise to deliver what is needed by 29 March? The Bank of England, the FCA and the PRA will update their rules and relevant binding technical standards to mirror the changes introduced by these SIs and consult on their proposed changes. Is there sufficient time to identify and make all the necessary changes required by 29 March, as well as fit in the promised consultation? What happens if there is not sufficient time? Finally, under these regulations, to what extent will the PRA and the FCA have the authority to weaken the binding technical standards currently required to be met by firms to a standard below those currently applied?
My Lords, probably few if any other people would stand up and say that CRD IV is their favourite piece of legislation, but for a variety of reasons it is my favourite. I do not mean to alarm the Minister or his officials by that, because we seem to have stuck within the rules of onshoring and the transfer of powers in the way with which we are now familiar. However, inevitably that process opens the door to future changes without it having to return to Parliament, as is the case in the EU, because a lot can be done via the interpretation of binding technical standards—if not immediately then at the next stage. It is not entirely clear from the explanation and from what is set out in the Explanatory Memorandum whether the binding technical standards will essentially just replicate what we have at the moment or whether they will make additional policy changes; that is, is it going to stay entirely within the “no policy change” of the withdrawal Act, or will changes be made simultaneously or subsequently?
For now, I want to concentrate on two points of personal interest. The first is the change to what counts as zero-risk weighted sovereign debt. This has long been a pet subject of mine and now it has become mainstream—in particular, that zero-risk weighting is actually inappropriate for eurozone sovereign debt because the European Central Bank cannot print money, although it has done a pretty good approximation of that in recent years. It would be interesting to explore a little more the effect of moving the zero-risk weighting from non-UK sovereign debt, given that sovereign debt is the main tier 1 liquid asset for banks. Will that mean that there is an incentive to reduce diversification in liquid assets?
More generally, how are banks currently dealing with sovereign debt in their risk calculations? The international banks most likely to have other EU sovereign debt can, and probably should, be using internal models to calculate risk rather than rely on the standard model and therefore the zero-risk weight. However, when I looked at this a while ago, the risk allocated in that way seemed to be pretty minimal, and I wonder whether that is still the case. Will minimal risk in the internal models be affected once the near-zero justification has gone? Also in the past some large banks have availed themselves of permanent partial use as a standard model under Articles 149 and 150 of the CRR, the reasoning being that it would otherwise be rather complicated due to holding a lot of different sovereign assets. Of course, Articles 149 and 150 will now apply only to UK sovereign debt, so what will happen there? Can the Minister also advise whether any UK banks are still using Article 150?
The second point I want to raise out of interest is the country-by-country reporting which comes from Article 89 of the directive and has the distinction of being enshrined in the EU withdrawal agreement as part of the BEPS commitments. The particular matter I want to highlight is that the onshoring has replaced the reference to the EU directive 2006/43/EC on statutory audits and annual accounts with the words:
“International Standards on Auditing (United Kingdom and Ireland) issued by the Financial Reporting Council Limited or a predecessor body”.
Frankly, I wish that it had not done that. At present, we have both the Kingman inquiry into the future of the FRC and the Competition and Markets Authority inquiry into audit, which encompasses the FRC and standards matters. I would expect a certain amount of criticism of the way in which the standards as applied in the UK under the FRC have not measured up to the company law of either the UK or the EU. So is that a future-proof amendment, given that the inquiry reports possibly as soon as next week?
On bank recovery and resolution, I am very happy to see the FSB key attributes referenced as a default. I spent quite a lot of time in Brussels having to wave those around during negotiations when things were going in slightly the wrong direction from time to time. As a practical matter, does the Minister consider that there is a substantial difference caused by being in only the international crisis management groups of a bank rather than in the full EU resolution procedures? I repeat my references to what the BTS are going to be doing, given the reference in paragraphs 7.19 and 7.20 in the Explanatory Memorandum. Does that suggest two lots of consultation, or is it just the same lot?
My Lords, I thank the Minister for presenting these two instruments. I cannot but agree with the early paragraphs of the Explanatory Memorandum—which is the same in all these Explanatory Memorandums—that, essentially, if these instruments end up being used, it will be in a no-deal scenario, which would be disastrous for the United Kingdom.
Having had an original career in aviation, I intellectually accept that it is right and proper to prepare for all credible scenarios. That is what we are doing today, and we will do it in the usual polite way about another 40 times between now and the end of March. But, today of all days, one has a feeling that the no-deal scenario has crept a little closer, and I have almost a sense of being asked to dig my own grave against the possibility that extreme Brexiteers will win the day and we will end up in a no-deal situation.
The European Union (Withdrawal) Act highly limits what we are doing here, and I hope that the constraints of that Act are being fully respected. We are not here, frankly, to debate the merits of the instrument; we are here to debate whether it stops within the agreed constraints, which are rehearsed in many places. Perhaps the strongest sentence is in paragraph 7.4 of the Explanatory Memorandum, which states:
“These SIs are not intended to make policy changes, other than to reflect the UK’s new position outside the EU, and to smooth the transition to this situation”.
The process called for by the Act, in a sense, divides into two. The first part of the process, which is true of all the things we discuss today, is to reassign responsibilities—in other words to recognise that appropriate authorities are necessary for the business of the various Acts to work and they have to be moved from EU institutions into UK institutions. The second is to make policy changes within the strict limitations of the sentence that I just read out.
Discharging our narrow duty to ensure that the Government have stuck to the rules is very difficult to achieve. In theory, we could go through each SI, line by line, regulation by regulation and Act by Act to see if that is possible. I recognise that the wisdom of the noble Baroness allows her at least in part to do that, but I am afraid that with our available resources that is not possible. A poor second to that is to skim the document and look at its structure and the language that it uses.
Let me take the bank recovery and resolution SI first. It looks as though the reassignment of responsibility has been discharged because, in page after page, one finds that it takes a responsibility from an EU institution and moves it to a UK institution. However, the area that I am particularly concerned about is where the instrument uses entirely new language, because it seems to me that, where there is entirely new language, I have no way of knowing whether policy variations have accidentally arisen. Therefore, I am very surprised to see areas of entirely new language, because I would have assumed that the object of the exercise is to take rules presently in place and translate them into English law.
The most dramatic example of that is on pages 41 and 42 of the bank recovery and resolution SI, where there are two pages of fresh language that talk about the recovery plan that institutions must put in place. Now, I assume that the requirements for that plan are already effectively enacted at this time. Why, then, is it not written over—or whatever the right term is—or why is it not referenced back into the law as it exists today, so that we can see that there is no change in policy? I ask that question to see whether there is any new thinking buried in the text, and I would value an assurance from the Minister that there is good reason why those parts of the instrument are written in fresh language, as opposed to being cross-referenced to language that already exists.
In the second SI, on capital requirements, there is a clear policy change, which is there because the situation demands it. The change, as has already been spoken about, is the recognition of EEA countries as not being of zero risk and hence requiring a capital buffer. In a no-deal scenario, after 29 March such sovereign debt will have to be assigned a risk factor. Surely this will put UK banks at a commercial disadvantage. It is no good to give as an excuse, as is done in the impact assessment—and it was great to see an impact assessment, by the way, so I must put that on record—that most institutions will use the “internal ratings based” approach. Whilst assigning risk to EEA loans is not mandatory with the IRB banks, if they do not take account of the fact that, for other purposes, such assets will be recognised as having some degree of risk, one would hope that this would be challenged by the regulators. Does the Minister agree with that analysis? Why did the impact assessment not look at some way of maintaining the status quo? For instance, it might have contained a statement that the sovereign debt of EEA countries would be treated as zero risk, or it could have included an order-making power for the Treasury to define individual countries as having zero risk.
I thank noble Lords for bringing their considerable expertise to bear on the important regulations before us. I will address some of the points raised.
First, the noble Baroness, Lady Drake, asked whether there is sufficient time for the regulators to put the consultation in place. I am confident that regulators are making adequate preparations and effectively allocating resources ahead of March 2019. They have been actively participating in a wide range of groups developing these technical and regulatory rules. They have also chaired a number of committees and task forces, and have considerable experience in implementing EU legislation. This means that the responsibilities of EU bodies can be reassigned effectively and efficiently, providing firms, funds and their customers with confidence. Since October, regulators have begun consulting, and I am confident that they will complete their consultations ahead of exit day. The noble Baroness also asked whether the regulators have adequate resourcing for a no-deal scenario. I repeat my confidence that the regulators are making adequate preparations and have the resources and expertise to ensure that this happens.
The noble Baroness, Lady Drake, also asked whether the capital requirements regulation statutory instrument will decrease the level of accountability for the Prudential Regulation Authority or the Financial Conduct Authority. Although certain functions, such as the mandate to develop binding technical standards, are being transferred to the regulators from EU authorities, such functions are currently carried out not by the Commission or the UK Government but by agencies with specific expertise in setting and calibrating firm-specific macroprudential rules. The Treasury will work closely with regulators in the development of binding technical standards; those standards will also be subject to consultation, ensuring that key stakeholders’ views are taken into account. Regulators will not be able to make significant policy changes.
The noble Baroness, Lady Bowles, asked whether there is a substantial difference in being in only the crisis management groups. Nothing in the SI will change the UK’s ability to co-operate with third countries on planning for executing the resolution of cross-border banks. The majority of the work takes place in international crisis management groups designed to facilitate international co-operation through bodies such as the G20. Of course, we are a key part of the financial stability group’s work on key priorities. There is an existing robust framework in UK law for resolution co-operation with third countries, such as the United States.
The noble Baroness, Lady Bowles, spoke a great deal about the loss of zero-risk weighting on EU debt calculation. It could seem as if that were a new policy. When we leave the EU, the EU will treat us as a third country, without any special arrangements to treat the UK differently. The UK Government have said that we will also treat the EU as a third country; we are therefore being consistent with other SIs that have been passed through your Lordships’ House. Since sovereign debt already attracts a very low risk weight, the change in capital requirements should not be significant. None the less, we have discussed the risks associated with the loss of zero-risk weighting on EU sovereign debt for the industry, and we understand that the issue will affect only a small number of firms. The exact impact cannot be estimated because firms will change their capital holdings and restructure.
We are also developing broad transitional powers for the regulators that will allow them to phase in new requirements gradually. The regulators are already consulting on a proposal to delay all changes to risk weights. This would eliminate any cliff-edge risks and give firms additional time to prepare for these changes.
The noble Baroness, Lady Bowles, asked about the predecessor body in respect of the reference to a predecessor body in the statutory instrument. This was inserted to ensure that we have a consistent approach across every file being onshored. The wording is drawn from existing UK statutes, such as the Payment Services Regulations 2012.
The noble Lord, Lord Tunnicliffe, asked whether the SIs make policy changes. As I said in response to the noble Baroness, Lady Drake, they are not intended to make policy changes other than to reflect the UK’s new position outside the European Union if we leave in March 2019 in a no-deal scenario.
The noble Lord also asked whether UK firms would be disadvantaged by the changes in risk weights. I made detailed reference to that in my previous answer to the noble Baroness, Lady Bowles, but since sovereign debt already attracts a very low risk weight, the change in capital requirements should not be significant. As I mentioned, regulators are consulting on a proposal to delay all changes to risk weights, which would eliminate a potential cliff edge.
The noble Lord then drew the Committee’s attention to page 41 of the BRR SI and asked whether the relevant section existed beforehand and, if so, why it was not cross-referenced. The insertion of Schedule A1, on page 41 of the SI, addresses deficiencies stemming from the UK’s departure from the EU and does not bring about any policy changes. In particular, it corrects a reference in the Bank Recovery and Resolution Order 2014 to the requirements of the directive with regard to resolution plans. This will not be appropriate after exit day as the directive will not have the force of law in the UK. To ensure that such information can still be referenced, we are bringing this content into UK law. The schedule uses text from the relevant sections of the directive but with some minor additional fixes, as is allowed under the EU withdrawal Act, to take account of the UK’s exit from the EU. For example, references to “central banks” will be replaced by references to the UK’s central bank, the Bank of England.
I will of course review the official record of our debate today to see whether there are any questions which I have not answered. I thank noble Lords again for their contributions.