216: After Clause 71, insert the following new Clause—
“Limitation on the powers of the PRA
The PRA may not accept an application from any insurance undertaking, reinsurance undertaking or third-country insurance undertaking for the application of a matching adjustment to a risk-free interest rate term structure for a portfolio of assets with a rating of less than BBB by Standard and Poors Global Ratings or its equivalent.”Member’s explanatory statement
This amendment seeks to prevent a matching adjustment being applied to a portfolio of high-risk and/or illiquid assets.
My Lords, I start by thanking your Lordships for your patience in putting up with me being gone over the past few weeks following surgery. Noble Lords from all sides of the House have been so kind; I have appreciated it very much. It is lovely to be back in this company today. Special thanks go to my colleagues who have carried the burden that I should have been here to carry.
In a way, it is almost ironic that the three amendments in this group are all in my name. Amendment 216 deals with insurance and matching adjustments; Amendment 241C deals with the ring-fencing brought in following the 2008 financial crash; and Amendment 241D deals with the senior managers and certification regime, which is also a feature of the remedies proposed after the financial crash. When I tabled these amendments, a number of people pointed out to me that they did not seem particularly pertinent to the time—what a difference two weeks make. We have had three mid-sized banks fail in the United States and HSBC has had to step in and take over Silicon Valley Bank’s UK arm. Of course, we have also had the debacle of Credit Suisse, now part of UBS.
All that underpins the consistent jeopardy and risk that exists in the financial services industry and, to my mind, underlines the importance of having proper regulatory mechanisms in place to remove that risk in the first place, deter risky behaviour and provide a resolution mechanism for when things go wrong, as they always will. I regard the three amendments in my name in this group as rather crucial.
Earlier in Committee, we discussed the concern that the new secondary objective of international competitiveness could compromise the primary objective of financial stability. However, in many ways, that was an abstract discussion. These amendments in these three crucial areas of the financial services sector—all are areas where the Government have clearly signalled both their intention to allow, indeed incentivise, a significant increase in risk and their determination to use the law to prevent regulators limiting that risk—provide us with something much closer to real-life examples.
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My Amendment 241D also prevents anyone but Parliament, in primary legislation, throwing away the lessons of the 2007 crash by changing key elements of the senior managers and certification regime. As I have said earlier on the Bill, the PCBS was utterly frustrated by the failure of any senior managers to take personal responsibility for the failings in their institutions, to the point that the commission recommended a new criminal offence of
“reckless misconduct in the management of a bank”,
which came into law initially with a reverse burden of proof, although that was later dropped. The centrepiece of the enforcement regime against incompetent or abusive bank leadership has been the SMCR. Like my noble friend Lord Sharkey, who spoke earlier on the Bill, I have been utterly frustrated by the FCA’s hesitancy to use this power and its continuing attitude of deference to high-status bankers.
The regulators will review the more granular details of that regime—I do not care about tidying up and efficiency; that is an entirely different issue—but the Government will be calling for evidence on the fundamentals, including the principles and framework. It is here that the industry is confidently relishing the expected dilution of the principle of individual responsibility, which it argues puts off new business from coming to the UK. If we go back to a much murkier collective responsibility where nothing can be pinned on anyone, as happened in 2007, that would draw in the kind of business that we would apparently like to see in London.
I cannot stress enough the degree to which many of the abuses that led to the 2007 crash were enabled by the absence of an effective individual responsibility rule. To quote again from the PCBS:
“Too many bankers, especially at the most senior levels, have operated in an environment with insufficient personal responsibility. Top bankers dodged accountability for failings on their watch by claiming ignorance or hiding behind collective decision-making”.
My Amendment 241D would require any modification or revocation of the relevant principles established in the Financial Services (Banking Reform) Act 2013 and FiSMA 2000 to come before Parliament in primary legislation. This decision is so fundamental that it is one that Parliament should make.
My Lords, the banking commission did sterling work in the years after the banking crisis, helping shape the content of the banking reform legislation. However, I cannot support these amendments because they are trying to set the findings of that conclusion in concrete, to apply for all time. One thing we know is that times change—sometimes for the better, sometimes for the worse. Having constantly to hark back to what the banking commission said before any sensible changes can be made under the existing available rules seems the wrong direction of travel.
If there was one thing that the HSBC/Silicon Valley Bank episode showed, it was the rigidity of the ring-fencing rules, which were effectively one of the great successes of the banking commission in making sure that rigid rules were set in statute. What had to happen to facilitate HSBC’s acquisition and takeover of Silicon Valley Bank were special statutory exemptions via a statutory instrument. The result was that HSBC now has permanent changes to the ring-fencing regime for it alone, which may well end up with it having permanent competitive advantage over its other rival ring-fenced banks in the UK.
We need to learn lessons from what has happened over recent weeks; the noble Baroness, Lady Kramer, is absolutely right about that. I would be interested if my noble friend the Minister could give more of an idea on the timing of when we might get a lessons-learned report—I think she spoke about that when she first spoke at the Dispatch Box about the HSBC takeover. The answer is not necessarily that we should be taking less risk and making things more difficult to happen, as that is not necessarily the right conclusion from what went wrong.
I hope that the Government will not be frightened by the recent events into not carrying out some reforms of ring-fencing. They have shown themselves willing to consider some sensible reforms to make sure that ring-fencing works well, particularly with regard to small and medium-sized banks. Only a few weeks ago in Committee the noble Baroness, Lady Kramer, agreed that the MREL rules caused a particular problem in the UK; indeed, she said that she constantly reminded the chief executive of the PRA about that. There is an issue about how the rules apply to small and medium-sized banks in the UK. We have to remember that the thresholds used to establish what is a small and medium-sized bank in the UK are way below the thresholds which were increased by the Republicans and which may well have contributed to the problems with Silicon Valley Bank in the US.
The Archbishop of Canterbury
My Lords, I have added my name to Amendments 241C and 241D tabled by the noble Baroness, Lady Kramer, and wish to speak briefly in support of them here. I am particularly grateful to the noble Baroness, Lady Noakes, who made some very helpful and powerful points.
As the noble Baroness, Lady Kramer, said, this marks 10 years since the publication of the Changing Banking for Good report from the parliamentary commission, on which I sat with her. The two amendments to which I have added my name are probing amendments to stress the importance of not forgetting the lessons of 2008-09, because people and sectors entirely can have very short memories.
As the noble Baroness has explained, the amendments seek to prevent alteration to two elements of the banking reform Act 2013 by statutory instrument without proper debate in Parliament, and to prevent changes which go against the recommendations of the parliamentary commission. Our memories have certainly been refreshed this week. If the debate on this group had been held when it was first scheduled two or three weeks ago, I think we would have had a very different reception. If one is grateful for anything in the present crisis, it is that we have been so warmly reminded of why we need a clear memory.
The ring-fence was first recommended by the Vickers commission in 2012, and it was “electrified”—in the words of the noble Lord, Lord Tyrie, in the Parliamentary Commission on Banking Standards report—to address the issue of banks seeking to test it. In our first report in 2012, we commended the coalition Government’s intention to introduce the ring-fence but said, as has been quoted, that it would be worn down in time, and that it had to be
“sufficiently robust and durable to withstand the pressures of a future banking cycle.”
After 10 years, we are now in a future banking cycle. We have gone through a long period of very easy money in which the banks have been able to make a great deal of money and to recover and increase their capital to much better standards than were around in 2008.
The very rapid increase in interest rates right across the western economies—particularly in the United States, which has the fastest increase for 50 years—has resulted in, as usual, the exposure of risks being taken that had not been foreseen. It is the “had not been foreseen” and possibly the “unforeseeable” that are important to stress when looking at this.
Electrification gives banks a disincentive to test the limits of the ring-fence. It is human nature—especially in a corporate entity—to test the limits of any regulation and see if they hurt when you hit them. But 2008-09 hurt far more people than simply the banks. It caused a global recession, and it hurt the poorest in the land more than anyone else. At that time, I was working in Liverpool and living in Toxteth, and we saw the impact on those who were least able to live with it. It is still hurting the whole economy, because for at least a generation after a financial crisis, as opposed to a normal economic recession, there is a deep fragility in confidence. The ring-fence and the other regulation of banks and higher capital are all about maintaining confidence, not about making it impossible for people to go bust.
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The ring-fence exists to protect the taxpayer when a bank that is very large and has the functions of a utility—in other words, it is big and simple—runs into trouble through its other activities. Secondly, the SMCR, the senior management regime, reflects the fact—as does the ring-fence—that in almost every banking crisis on record, the banks have privatised profits and socialised losses. It happened back in 1929, 1932, 1906 and in the Barings crisis in the 1880s. If we look around, we see that it is happening now.
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I start with Amendment 216, which addresses the insurance industry. Of course, this also encompasses many people’s pensions; in a sense, that was clarified in the Budget by the Chancellor, who talked about, in essence, opening up defined benefit pension plans to holding illiquid high-risk assets, in the same way as he anticipates Solvency UK opening up insurance companies to holding a far greater portfolio of illiquid high-risk assets. Under the EU regime, Solvency II, insurance companies are required to build a capital buffer based on the risks in their investments—their asset portfolio. The provision is designed to provide a safeguard if an insurance company fails, protecting both policyholders and the taxpayer. Solvency II allows an insurer to reduce its buffer where the insurance company is holding long-term assets that match the cash flows of its life and annuity insurance and its reinsurance obligations. That relief is called the matching adjustment. It allows adjustment to the discount rate that the firm is required to use to value its cash flows in order to determine the size of the buffer.
With Brexit, Solvency II is being replaced by Solvency UK. No one, including me, denies that Solvency II is probably overly restrictive and requires a degree of reform. I have not objected that Solvency UK is reducing the level of capital—the sort of raw capital buffer—by 65% for life insurers and 35% for general insurers. But the Government are now choosing to go much further. At present, the matching adjustment, which, as I said, has the effect of reducing the buffer even further, applies only to long-term assets held by the insurance company that qualify as investment grade. The change now proposed allows long-term, high-risk, illiquid, sub-investment grade assets—subprime is another word that is often used—to get the benefit of the matching adjustment. There is nothing that the regulator can do about it.
Why would the Government take such a risk? I think the answer is sheer desperation. They are hoping that the insurance companies and the defined benefit pension funds, to which we now know that this will extend, if they do not need to hold much of a buffer, will invest much more in the scale-up of innovative businesses, because scale-up money is hard to find in the UK. Unfortunately, scale-up is the phase at which many companies fail. The standard rule of thumb is that 40% of companies scaling up fail.
The Government are also hoping that the money will go into infrastructure. I should explain that many infrastructure projects are investment grade. TfL bonds, for example, are investment grade, as are the bonds for the M6 toll road; they qualify for the matching adjustment. But many infrastructure projects are high-risk and the bonds they issue are very illiquid. Just look at the pattern for most major infrastructure projects, and small ones as well. There have been delays and overruns in Crossrail, HS2 and pretty much every nuclear power project anywhere in the world. The worst part with infrastructure is that you rarely know that it is in trouble until it is very close to its official completion date. The matching adjustment would apply a far more extensive range of sub-investment grade investments. I know from talking to many companies that they see this as their way to get back into subprime mortgages and subprime property arrangements.
I am very old-fashioned. I believe that the primary purpose of an insurance company is to pay its policyholders on time and in full, and the primary purpose of a defined benefit plan is to pay its pensioners on time and in full. As I said at Second Reading, many people point out that these are pools of money and that the equivalent pension funds in Canada invest heavily in global infrastructure. I point out yet again that, if anyone reads the comments of the rating agencies on those Canadian pension funds, they will become very aware that the Canadian Government are regarded as a backstop should those funds collapse.
That is very different from the situation that we have in the UK, unless the Minister is about to tell me that the UK taxpayer is now willing to become a backstop for pension funds and insurance companies in the UK. The only example that I know about is one that we discussed earlier—Equitable Life. We know that nearly a million policyholders lost more than three-quarters of their investments when Equitable Life failed and that the Government did not bring them back to full recovery, even though the financial ombudsman found serial maladministration by both the Treasury and the regulator. I would very much like to know from the Minister, as we look at Solvency UK, which is enabled by the Bill, whether the Government now propose to give an equivalent backstop to that provided by the Canadian Government.
My amendment basically says that:
“The PRA may not accept an application from any insurance undertaking”—
I will not give you the rest of the details—
“of a matching adjustment to a risk-free interest rate term structure for a portfolio of assets with a rating of less than BBB by Standard and Poors … or its equivalent.”
This is my attempt to stop that reduction in the capital buffer for illiquid, high-risk investments.
I will try to be briefer in dealing with the other two amendments in this group. I shall take Amendments 241C and 241D together. These amendments sprang from the Chancellor’s speech on the Edinburgh reforms. I have referenced before my concerns, which are shared by many who, like me, sat on the Parliamentary Commission on Banking Standards, that we are seeing the rollback of the safeguards that followed our commission’s report Changing Banking for Good. Let me quote from it:
“An important lesson of history is that bankers, regulators and politicians alike fail to learn the lessons of history … measures that are implemented while memories are fresh will be at risk of being weakened once the economic outlook improves, memories fade, and new, innovative and lucrative approaches to global finance emerge.”
That is exactly what we are seeing today, and the past two weeks have illustrated it in spades. The failure of three significant mid-sized banks in the United States was enabled by the rollback of regulation, a rollback that had been sought by the siren voices of the industry. Those same siren voices are currently extremely influential in the Treasury, and I am hoping that we will hear from the Minister that she will go back and look at the decisions to weaken that regulation in the light of the reality that we have seen over the past two weeks and the experience in the United States. Many of these regimes, particularly the senior managers regime, are now to be carried over into the shadow banking world. I am sure that is a good thing, but it is very concerning if those projects are watered down before they are carried over.
I am very concerned about the watering down of ring-fencing. Today, I asked some questions in the Economic Affairs Committee, and it is clear that the Chancellor intends to make changes to the ring-fencing regime. I accept that there are times when one could claim that ring-fencing has been overzealous with small and medium-sized banks and there are some arguments for the need to change MREL, but it is shocking to see that the Government are backing the recommendation of the Ring-fencing and Proprietary Trading Independent Review that if a bank is deemed “resolvable” its ring-fencing features can be removed.
The proposition behind ring-fencing was that retail banking is an entirely different animal from the casino banking of investment banking. It is essentially in many ways a utility, and it needs to be kept safe and separated by the virtues of the ring-fence. On the commission we also saw constant cross-contamination—in other words, risks being taken within the retail bank because of the impact in the universal banking model of their investment banking colleagues. Things such as PPI and various other forms of general abuse of customers clearly sprang from the internal pressures that were created by the overall culture of the combined firm. We could also see that many of the risks that the investment bankers tended to take were fuelled by their access to retail bank accounts that paid no or very little interest and were protected by insurance and which almost, in a sense, provided a honeypot that incentivised the taking of undue risks and played a very significant role in the kind of failures that led to the crash.
To quote Paul Volcker,
“it is the damage that it does to the culture of the whole institution … Trading operations and impersonal proprietary trading operations are simply different from a continual banking relationship.”
In other words—of which there were many—the linkage between retail banking and investment banking contributes fundamentally to all kinds of abuse of customers and small businesses, from PPI, the asset stripping of RBS GRG and the mis-selling of interest rate swaps. It also lay behind the complete collapse in credit standards and the short-term funding strategies that sank HBOS. Ring-fencing is a vital tool to provide for financial stability. With the plans to remove the cap on bankers’ bonuses, which the Government and industry treat as one of their highest priorities, it is even more important that this protection stays in place. My Amendment 241C would prevent any such destruction of the ring-fence without a decision by Parliament in primary legislation.
I hope that the Government will press on with their consultation on ring-fencing and on the senior managers regime. Having been on the receiving end of the senior managers and certification regime for the nine years that I was on the board of what is now NatWest, I know that it is very bureaucratic and inefficient, and it does not necessarily target the kind of things that people thought it was going to be targeting at the time. It is therefore time to step back and ask whether this is the best way of achieving the objectives, which are to ensure that people take responsibility for their actions. What this has ensured is that there is a whole industry of chopping down forests, in order to fill files of evidence that you have taken reasonable steps to carry out your responsibilities, and I do not think that was the intended outcome of the reforms at the time.
I therefore make a plea: let us not get panicked by what has happened in recent weeks into not accepting that there is a good case for reviewing both the ring-fencing and the SMCR rules. I have nothing to say on insurance because it is not my specialist subject.
The recent failure of SVB in the US, and the ease with which what is by global standards a major bank was reclassified as a systemically important bank and thus eligible to be rescued—even though there is a system for resolving banks which is meant to be robust—demonstrates that the issues of systemically important banks are very difficult to handle. Again, the problem is one of confidence: we are talking about the contagion of a lack of confidence, and not simply about the failure to observe rules and regulations.
The resolution of banks is part of the system in the USA. It applied to SVB and to Credit Suisse, but it was not enough to protect the taxpayers of the US or Switzerland from having to put in significant implicit and explicit support. This is all about confidence. If we go on bailing out the system as it is, one of the unintended consequences is likely to be further damage to confidence.
For me, one of the most memorable moments of the banking standards commission was hearing the very broken and tragic testimony of a former head of a global bank outside this country. He was a man of absolute integrity who had been brought to the point of complete breakdown—I suspect my colleagues remember it—by the impact of the failure of the bank he led. Right at the end of his testimony, I asked him, “When you wake in the night, what do you remember and wish you had done differently, because we all do that over events in our past?” He said, basically, “That’s easy. I remember that you can run a small, complicated bank safely, or a big, simple bank safely, but you cannot run safely a big, complicated bank”.