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Capital Requirements (Amendment) (EU Exit) Regulations 2019

Volume 799: debated on Monday 7 October 2019

Motion to Approve

Moved by

That the Regulations laid before the House on 5 September be approved.

Relevant document: 61st Report from the Secondary Legislation Scrutiny Committee

I beg to move that the House considers the Capital Requirements (Amendment) (EU Exit) Regulations 2019 and the Risk Transformation and Solvency 2 (Amendment) (EU Exit) Regulations 2019.

Perhaps I may help the Minister. I think he wants to move that they be approved. His speech has been prepared for a different venue.

I beg to move that they be approved.

As the House will be aware, the Government had previously made all the necessary legislation to ensure that in the event of a no-deal exit on 29 March 2019, there was a functioning legal and regulatory regime for financial services from exit day. Following the extension to the Article 50 process, new EU legislation has come into force and, under the European Union (Withdrawal) Act, it will form part of UK law at exit. Further deficiency fixes are therefore necessary to ensure that the UK’s regulatory regime remains prepared for exit. The two instruments being considered today deal with two new pieces of EU legislation that have recently come into force.

The first instrument resolves deficiencies in the EU’s prudential regime for credit institutions and investment firms to take account of revisions the EU has recently made to the capital requirements regulation. This regime sets out how much capital institutions, such as banks and investment firms, need to hold. The CRR is a directly applicable EU regulation that has applied since 2013. An exit instrument correcting the deficiencies in retained law was laid and approved by Parliament in 2018. Earlier this year, the EU finalised a revised banking package, which included amendments to the CRR made by an amending instrument known as CRR2. This gives effect to some of the internationally agreed Basel reforms, which are the centrepiece of the post-crisis reforms aimed at making banking safer. Similar changes are expected in all G20 countries that follow the Basel guidelines.

Through the UK’s membership of the G20 and its Financial Stability Board, we have committed to the full, timely and consistent implementation of the Basel 3 reforms. Our deficiency fixes for CRR therefore need to be updated to take account of CRR2. There are three main areas where fixes are required: third country treatment, transfer of functions and updates to definitions.

Consistent with the approach taken in the 2018 exit instrument to amend the CRR, the regulations remove the preferential capital treatment given to the largest banks and investment firms in the EU 27 to reflect the fact that the EU and UK will treat each other as third countries in a no-deal scenario. In line with the approach that the Government are taking to all onshored financial services legislation, the instrument transfers a number of functions currently within the remit of EU authorities to the appropriate UK bodies. Functions such as the development of detailed technical rules on certain provisions of CRR will now be carried out by the Financial Conduct Authority, the Prudential Regulation Authority or the Bank of England. Where CRR2 confers a delegated legislation-making power on the Commission, these powers are converted into regulation-making powers conferred on the Treasury. Use of those powers by the Treasury will need the approval of Parliament. Finally, CRR2 amended some definitions used in CRR. The instrument corrects those updated definitions so that they can operate in a UK-only context.

The Treasury, financial regulators and industry agree that it is critical to have deficiency fixes in place by exit day for these new CRR provisions. Without them, there will be considerable legal uncertainty around the capital requirements that apply to banks and investment firms, particularly those that apply to global, systemically important banks. The powers of our regulators to supervise and enforce capital requirements would also be in doubt, increasing the risk of financial instability.

I now turn to the second financial services instrument we are considering today. In January this year, the Solvency 2 and Insurance (Amendment, etc) (EU Exit) Regulations were approved by Parliament. Those regulations addressed deficiencies in Solvency II as it will form part of UK law at exit. Since then, revisions by the EU to the Solvency II delegated regulation have updated aspects of the approach to setting insolvency requirements for insurance funds, including the simplification of capital calculations and greater alignment of capital requirements across insurance and banking legislation. These revisions took effect on 8 July 2019 and will form part of UK law after exit. The substance of the revisions will not result in deficiencies after exit, and the updated provisions will continue to operate in the UK as they do now.

However, routine deficiency fixes, including removing references to the EU and EU institutions, will be needed to ensure the Solvency II regulation continues to operate effectively in the UK after exit. Nevertheless, the fixes are essential to ensure clarity and legal certainty around the procedures that insurers must follow to set their solvency requirements and certainty around the Prudential Regulation Authority’s ability to supervise and enforce the requirements. This comes at a critical time in the Solvency II calendar. Firms are currently preparing their annual supervisory reports, which must be submitted to the PRA by 31 December. Without clarity around the basis on which these important reports should be prepared, the effectiveness of the prudential regime for insurance in the UK would be undermined.

I will now cover the fixes to the UK’s Risk Transformation Regulations 2017 which were introduced to set up a new regime for insurance-linked securities or ILS. ILS are an innovative form of risk transfer that allows insurers and reinsurers to transfer risk to a special purpose vehicle. The new regime for ILS was introduced as part of our efforts to ensure that the UK remains a leading global centre for specialist reinsurance business. As the Risk Transformation Regulations were designed to follow Solvency II requirements for insurance special purpose vehicles, they include references to and definitions in EU law. This instrument fixes them by using references to relevant UK legislation and importing certain definitions from Solvency II, as it will form part of UK law at exit, with those definitions adapted to work in a UK stand-alone regime.

In addition, the Risk Transformation Regulations established two regulatory regimes: one for the transfer of risk by EEA insurers or reinsurers, and one for the transfer of risk by non-EEA insurers or reinsurers. This reflects the Solvency II directive, which applies only to EEA insurers and reinsurers that transfer risk to EEA special purpose vehicles. The provisions of this instrument remove this distinction, which will no longer be necessary once the UK leaves the EU, but the Solvency II-derived requirements will still apply to all transfers of risk to a UK special purpose vehicle after exit. In the drafting of these instruments, the Treasury has been working closely with the financial services regulators, and we have engaged extensively with the financial services industry, taking account of feedback from industry players that would be significantly affected.

Before I conclude, it is important that I address the procedure under which these instruments have been made. This and two other financial services exit instruments were made and laid before Parliament on 5 September, under the made affirmative procedure provided for in the European Union (Withdrawal) Act. This is an exceptional, urgent procedure that brings an affirmative instrument into law immediately before Parliament has considered the legislation, but the procedure also requires that Parliament must consider and approve a made affirmative instrument, if it is to remain in law. The Government have not used this procedure lightly and it must be remembered that, across departments, we have already laid more than 600 exit instruments under the usual secondary legislation procedures. However, as we draw near to exit day, it is vital to have all critical exit legislation in place, including legislation necessary to ensure that our financial services regulatory regime continues to function effectively. It would have been reckless to leave this until the last minute. Industry and our financial regulators need legal certainty on the regime that will apply from exit. Both the instruments before the House today are also being considered in another place this afternoon, consistent with the Government’s objective to ensure all critical legislation is in place before exit.

In summary, these two instruments are essential to ensure that the prudential regimes applying to UK credit institutions, investment firms, insurance firms and insurance risk transfer work effectively if the UK leaves the EU without a deal on 31 October. I hope that colleagues will join me in supporting the regulations.

My Lords, these capital requirements regulations and indeed the Solvency II ones follow a well-trodden path in terms of allocation of powers from the EU to UK regulators, as relevant. By and large I have no problem with that, apart from the fact that it occurs to me that this might be one of the very few occasions on which there would have been a possibility—I will save noble Lords by not indulging in it—to debate in this Chamber some very important things about bank resolution and bailing. For such important things following the financial crisis not to return, shall we say, with more frequency to this place is not the way it should be with our largest industry.

I shall give an interesting bit of history about the particular requirements here. Country-by-country reporting was inserted in CRD, as is mentioned in the Explanatory Memorandum. We had been told how damaging such revelations would be to the banks, but nevertheless I found a way to get country-by-country reporting included so that if there were proof of damage, the Commission could come in and stop that provision from coming into force. And—guess what?—that provision was never exercised. So it is just a question of being persistent. Of course, I had hoped that country-by-country reporting would extend still further into other areas, but I was not the person in charge of those negotiations.

A lot of the substance of the capital requirements regulations 2019 now relates to minimum requirements and eligible liabilities—the so-called MREL—that banks must hold so that in resolution they can both recapitalise themselves and hopefully proceed as a new bank or make funds available for resolution. Under those rules, as the Minister said, there are ways in which assets and liabilities from within the EU receive preferential treatment. They receive, if you like, better valuations, but those priorities will go when we are no longer in the EU, which will mean higher provisioning. One assumes that a reciprocal thing will happen at the EU end so that it will no longer be giving favourable treatment to UK assets and liabilities.

The Bank of England is proposing to postpone those changes. I do not necessarily object to that, but some of the changes in terms of how the MREL is to be held within subsidiaries merit a little more examination. That is because I have been trying to work out in my own head, and I tried to explain this to the Minister in the Tea Room, I am afraid rather badly, what actually happens to the group when the MREL additional provision is waived. We could have a situation where, because we are giving a kind of transitional relief in the UK to a subsidiary of a UK business, but corresponding relief is not given on the other side of the Channel to a UK bank with a significant EU subsidiary, although we are not going to be asking the EU bank to find more MREL, the EU could be asking for that to happen.

What would happen to the UK group and its MREL when a greater amount of it is going to be allocated to the subsidiary that is in the EU? One thing that could happen is that it just uses up some of the spare MREL in the group. But, realistically, if there is no change happening at the UK end to increase the required MREL, that means that there is now more MREL backing what happens in the EU on resolution than what happens in the UK on resolution.

It may be that this is very minor or technical, because many of these changes are still being phased in, and I strongly suspect that the period in which we are not going to impose it will be covered, at least in part, by the fact that there is this transformation. I suppose it boils down to this bottom-line question: can we be sure that there is not an additional risk being imported to the UK end of things in resolution?

I noted that the response to the Secondary Legislation Scrutiny Committee’s second question seems to make it look as if these things are irrelevant for large groups where they base things on internal models, because they make up or compute their own risk. I would like to know whether that is the case and whether this is therefore yet another occasion when the smaller organisations will find that their costs are going up and the larger organisations will find that theirs are not.

The other point is that if we do not have equivalence provisions with existing third countries with which the EU has equivalence decisions—if we have not remade those equivalence decisions—a similar kind of change of treatment will come about. Do we have all those equivalence decisions under way or queued up, ready to happen at the relevant point?

I will switch now to risk transformation and Solvency II; I have very little to say on that. It seems right that a UK special-purpose vehicle has the same rules no matter from which country it is going to receive assets. I do not think I believe in the notion that you give better treatment in any particular circumstance. Giving shoddy treatment if the assets are coming in from one country, better treatment if they are coming in from another and different treatment again if it was entirely UK-based would be a way to get a bad reputation, so that seems to be a highly sensible outcome. No doubt the other way around is also true: our insurers and reinsurers are likewise not able to transfer assets into any kind of what one might term a less rigorously regulated special-purpose vehicle.

My Lords, I will be very brief. We on these Benches are obviously not going to oppose either of these SIs. We understand why they have been produced in such a hurry. Like my colleague, I really have no issue with the risk transformation and Solvency II SI. It genuinely seems to be simply technical and not to raise any non-technical questions.

I have two sets of questions about the capital requirements regulations, some of them picking up on my noble friend’s comments. The first is a democratic deficit comment. Reading this, it looks as though the European Banking Authority and European Securities and Markets Authority, which would have been supervisors of many of these functions within the European Union, have quite a strong accountability relationship with the European Parliament. In the process of transfer, initially to Treasury and then on to the FRA and FCA, that is lost. It looks as if we now have a series of fundamental and important decisions and issues removed from the purview of any democratic body at all. Can the Minister comment on that? Frankly, it is an underlying problem with quite a few of the SIs that we have seen and the kind of changes they make.

My second set of issues—around trying to get to the bottom of the impact—has been well described by my noble friend, so I will not go through it in detail. The problem with the impact assessments is that they do not really tell us what happens to the industry, just the admin cost of making a change. I share my noble friend’s concern that one of the costs involved would be making it more expensive to do business in financial services than it has been, and it therefore being advantageous for financial services companies to move that business out of the UK to the EU. That seems a rather awkward and pointless way to set up future arrangements.

To pick up my noble friend’s points, small companies will find their flexibility in meeting higher capital requirements constrained because of the complexity of dealing with organisations whose subsidiaries are groups that have grown up across borders. They will therefore incur greater cost, which they will have to pass on to their customer base. Bigger companies will have a lower burden, having much greater flexibility because the rules are different for them and because they can manage themselves in a more complex way. Are we almost deliberately disadvantaging the financial services facing towards corporations and others across the European continent through the changes that we are making? Are we effectively putting in place a disadvantage for a small organisation compared to a large one?

My Lords, I agree with the noble Baroness, Lady Bowles of Berkhamsted, that we debate the whole issue of resolution too infrequently. The tone of much of the paperwork here is concern about whether we are putting burdens on the industry that put it at a disadvantage, but one must remember that the whole issue of resolution is about catastrophe. We have had a serious resolution issue only in the 2008-09 crisis, and that was a frightful example of the taxpayer taking the losses in an area where the banks had previously taken the profits. Therefore, resolution is a very important issue, which we should perhaps bring to more democratic discussion more often. I say that with some trepidation because I am at some disadvantage compared with my Liberal Democrat colleagues, since they are professionals and tend to know what they are talking about in this area.

I have to glean the essence of the debate from the Explanatory Memorandum, which I therefore look to a more robust test of the quality of. The problem with British legislation is that so much of it is a statutory instrument that modifies another that amends another that amends a previous Act of Parliament which is by now a decade or so old. It is almost impossible to understand the meaning of this particular statutory instrument from looking to the instrument itself; one is entirely dependent on the Explanatory Memorandum to bring out the essence.

On Saturday—a lovely day to be in, reading an Explanatory Memorandum—I therefore set out and got about as far as paragraph 2.2:

“The EU’s prudential policy regime for banks, building societies and investment firms consists of the CRR”—

the capital requirements regulation—

“and the Capital Requirements Directive IV … together with a range of Binding Technical Standards (BTS). CRR is directly applicable while CRDIV was implemented in UK legislation, predominantly through the Capital Requirements (Country-by-Country Reporting) Regulations 2013 … the Capital Requirements (Capital Buffers and Macroprudential Measures) Regulations 2014”,

at which point I went to the guidance for Explanatory Memoranda. The best bit of guidance comes from the Secondary Legislation Scrutiny Committee in May 2015:

“The purpose of the EM is to provide members of Parliament and the public with a plain English, free-standing, explanation of the effect of the instrument and why it is necessary. It is not meant for lawyers, but to help people who may know nothing about the subject”—

that is me—

“quickly to gain an understanding of the SI’s intent and purpose”.

I have said things like this before: at its best, the Treasury produces some excellent documentation, but the real burden of these SIs is getting some feel for what they mean.

As has already been mentioned, we will not object to or vote against the statutory instrument. That would produce a constitutional crisis, and we have got enough people creating those at the moment without the Labour Front Bench in the Lords doing it. Accordingly, the Minister may have no fear of a Division. I am therefore going to do no more than pick out one or two issues that concern me.

The first is about the commencement. Regulation 1 states:

“(1) These Regulations may be cited as the Capital Requirements (Amendment) (EU Exit) Regulations 2019.

(2) Parts 1 and 2 come into force on the day after the day on which these Regulations are made.

(3) Part 3 comes into force on exit day”.

I have a real problem with that. My understanding is that this is a no-deal-only SI. I do not understand what happens if we exit the European Union—as is the declared intention of the Prime Minister and many others on the Government Front Bench—with an agreement. Perhaps the Treasury has decided that it is an unreal possibility. If we leave with an agreement, we surely go into a transition period during which this SI would not apply. Can the Minister explain what happens on 31 October if we in fact leave with a deal?

I plodded on through the document and more or less understood what it was about until I got to paragraph 2.16:

“A resolution-specific example of the removal of preferential treatment for the EU27 relates to provisions introduced by CRRII regarding MREL. CRRII imposes additional internal MREL requirements for non-EU G-SIIs”—

which I understand to be global systemically important institutions.

“This has the effect of increasing the amount of MREL that material subsidiaries of non-EU G-SIIs should maintain from a range of 75%-90%, to 90% of the full amount of external MREL that the entity would be required to maintain if it were a resolution entity”.

Since it is in the EM, I assume that that is important. However, I do not have the faintest idea what it means. I would be grateful if the Minister could explain. Lest Members feel that I am being unfair to the Minister, I did alert him to this point this morning.

Later in paragraph 2.16, I found it slightly worryingly that it says:

“The Bank of England, supported by HM Treasury, has proposed to apply its transitional powers to delay the impact of this change until 31 December 2020, giving affected firms in the UK time to adjust to changes to meet their obligations”.

That seems to say in plain language that the MREL reserves will be less than is required in the long term under these regulations, during a period when the world is likely to be particularly turbulent. This seems somewhat unwise. Granted, it has the effect of reducing the burden on the appropriate firms, but I would like to have seen in the document some examination as to what inquiry the Government have made to assure themselves that the increases in risk due to the reduced reserves have been thought through and are deemed to be satisfactory. While I can see that the Treasury has moved with respect to the burden on the industry, it does not seem to have considered the possible increase in risk.

At paragraph 3.1, we are told that this is an “urgent ‘made-affirmative’ procedure”. It is obviously urgent now, but it seems to me that it did not need to become so; it was possible to see somewhat earlier that this statutory instrument was needed. Why were these problems not anticipated? Why could this instrument not come to us under the normal procedure?

I turn to the second statutory instrument. Paragraph 2.1 in the Explanatory Memorandum says:

“This instrument also addresses deficiencies in the UK’s Risk Transformation Regulations 2017 (‘the RTR’) and related legislation. The RTR implements a competitive UK regime for Insurance Linked Securities … business”.

That sounds to me as though it is introducing policy, although it is too complicated for me to be sure. One of the almost sacred tenets of the withdrawal Act was that it would not introduce policy; it would essentially only use the appropriate powers where necessary. That assurance is repeated in paragraph 7.2, which says:

“The financial services onshoring SIs are not intended to make policy changes, other than to reflect the UK’s new position outside of the EU, and to smooth the transition to this position”.

What I found even more confusing was that I could not find where this promise in paragraph 2.1 was. I wondered—as they are in quite separate places—whether it was anything to do with the various references to “special purpose vehicles”. I know that the financial services industry is comfortable with special purpose vehicles—more than at the receiving end in industry—but, having come across them, I slightly shudder. I hope there is no material change to the use of special purpose vehicles brought about by this instrument.

I thank noble Lords for this powerful debate on a highly technical subject. I endorse the noble Baroness, Lady Bowles, in her opening comment that this Chamber does not see enough discussion of financial services and this critically important industry. By this afternoon’s account, that is a very great shame; there is a huge amount of expertise in the Chamber and it would be great if that could be put to use more often.

I take on board completely the comments of frustration about the Explanatory Memorandum. I too spent some of Saturday negotiating it and share that frustration; it is incredibly difficult to navigate. I reassure the noble Lord that there is no deliberate effort to obfuscate or be unclear. This is simply a very technical area where, unavoidably, one layer of legislation is on top of another in the British manner. There is no simple explanation for technical SIs such as this without running through the narrative in the way that he, frustratingly, found.

I start by answering the questions of the noble Baroness, Lady Bowles, and the noble Lord, Lord Tunnicliffe, about the MREL, which is possibly the most delicate and central issue raised by these SIs. The noble Lord, Lord Tunnicliffe, questioned the timing, and whether that opened up some form of gap or concern, where Britain might be underregulated. I reassure him that that is not the case. The SI does not in itself delay the change until 31 December 2020. Rather, the Bank of England, like all financial regulators, has a general legal power to phase in Brexit-related changes by law. In this case, the Bank has proposed to delay the MREL requirement until 31 December 2020.

The Treasury is very sympathetic to this proposal because it gives the industry the ability to make arrangements for compliance instead of facing some kind of cliff edge, which would create uncertainty and a rush to do things on 31 November 2019. The industry is also completely sympathetic to the Bank’s proposals. In other words, this SI does not introduce new risk or appreciably increase existing risk. If anything, it reduces risk by phasing the introduction of a difficult measure in a reasonable, pragmatic and sensible way.

The noble Baroness, Lady Bowles, raised questions about the use of subsidiaries and whether capital in one subsidiary in one country might in some way be favoured over capital in another subsidiary in another country. I reassure her that the Bank of England may waive requirements for UK subsidiaries of UK banks without reciprocity but only if, in the Bank of England’s judgment, it would be a means of preserving UK financial stability rather than importing risk from the EU. That decision lies with the Bank of England and hopefully provides some reassurance.

The noble Baroness, Lady Kramer, raised the question of democratic deficit. Under the new arrangements, the European Parliament will not have oversight over British arrangements. However, both the FCA and the PRA are creatures of statute. They are both accountable to Parliament through existing primary legislation. They must both act within their statutory objectives; this provides scrutiny that we believe is comparable to that exercised by the European Parliament.

The noble Baroness, Lady Bowles, asked about MREL equivalence. I reassure her that the Treasury has legal powers to replicate any existing EU equivalence decisions and import them into UK law vis-à-vis third countries. The Treasury is in the process of reviewing all these decisions before retaining them.

The noble Baroness, Lady Kramer, asked about the impact on business. I reassure her that we are absolutely not hurting small firms; these firms do not hold capital across borders and therefore do not need to worry about the scope of these changes. More generally, this SI seeks to preserve legal stability, so any impact on commercial profits will be a function of a firm’s response to the business environment.

The noble Lord, Lord Tunnicliffe, asked about the affirmative procedure. I share his concern about such measures being used without need or care. I reassure him that in this instance the use of the affirmative procedure was reviewed very carefully and only because this was felt to be extremely important. The Government have laid over 600 Brexit SIs to ensure that we have a functioning statute book when we leave the EU, in all scenarios. We have been incredibly careful and very limited in our use of the “made affirmative” urgent procedure under the EU withdrawal Act, using it for a tiny percentage of the total figure. In this instance, using the “made affirmative” procedure was really the only reliable way we could make the necessary legal changes given the uncertainty around the number of sitting days. The timetable was also driven by fresh EU legislation which made it difficult for us to lay these at an earlier stage.

Lastly, I reassure the Chamber that these SIs are not the vehicle for new policy. They are very much about implementing existing policies. They are supported by industry after a large amount of engagement with all the major players and in no way is this an effort to try to cook up new ways of doing things. The Government believe that these instruments are essential to ensure that prudential regulation of UK credit institutions, investment firms, insurers and insurance risk transfer continues to operate safely. I hope that the House has found today’s sitting informative and that it will join me in supporting these regulations.

Motion agreed.