SPECIAL RESOLUTION REGIME: SAFEGUARDS FOR PARTIAL PROPERTY TRANSFERS

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1 SPECIAL RESOLUTION REGIME: SAFEGUARDS FOR PARTIAL PROPERTY TRANSFERS BBA Response to the HM Treasury Consultation Document 1. The British Bankers Association (BBA) welcomes the opportunity to comment on the latest consultation document issued on 6 th November This follows our responses to the earlier consultations, most recently those published in July. 2. The BBA continues to be supportive of the authorities intention to put in place a special resolution regime to address the difficulties that may be faced by an ailing bank. There remain, however, fundamental concerns across the industry at the potential impact of partial property transfers on the regulatory capital position and competitiveness of UK banks and the status of London as a leading international financial centre as regards the integrity of netting and set-off in particular for which the proposed way forward would not deliver net regulatory capital treatment. These concerns were exacerbated by HM Treasury s October impact assessment which paid very little regard to the risk factors arising. Not least because of the fast track legislative timetable we see a very real danger of self inflicted damage. BILL PROVISIONS 3. Before commenting on the proposed secondary legislation we should refer briefly to elements of the Bill itself. We are aware of the concerns that have been expressed by the City of London Law Society (CLLS), in particular on problems with key definitions in the Bill in the area of set-off and netting (clause 48) and on the impact that the contractual override provisions (clauses 22 and 38) could have on the effectiveness of set-off and netting agreements (papers dated 5 and 22 December respectively). We share these concerns and endorse the amendments proposed by the CLLS. SET-OFF AND NETTING 4. It is noted that the authorities have revised their proposals on safeguards for set-off and netting agreements in the light of feedback on earlier consultations and the views of the Banking Liaison Group which met for the first time at the end of October. The methodology in the latest consultation is to provide a broad safeguard for setoff/netting agreements but with a series of carve outs that would allow the authorities to interfere in agreements in defined circumstances. We consider that in principle this is the right approach but have major problems with the nature of most of the proposed carve outs.

2 2 5. In summary, we believe that: (a) (b) for reasons of commercial and legal certainty and in order to maintain a level playing field for regulatory capital, set-off and netting must be protected in all situations although an exception would be possible where the counterparty is a retail customer i.e. one that would be an eligible claimant under the Financial Services Compensation Scheme (but please see our comment on offset mortgage products in Paragraph 11) : a non-statutory commitment not to upset regulatory capital is unworkable; in respect of arrangements subject to set-off and/or netting (nettable arrangements) which include a foreign law element, the Safeguards Order must prohibit the transfer of any part of the arrangements from the failing bank;. Proposed Carve Outs 6. Foreign Property The consequences of the inclusion of foreign property in nettable relationships still do not appear to have been fully thought through. The Safeguards Order indicates that foreign property forming part of a nettable arrangement may be ignored for the purposes of the safeguards. This raises the possibility of the authorities cherrypicking nettable arrangements which include foreign property. Such arrangements are widespread and will typically include repurchase and stocklending transactions (where the securities sold or lent are held with a foreign depositary or custodian), prime brokerage agreements and exchange traded derivative clearing agreements. The ability to cherrypick foreign nettable arrangements is fundamentally inconsistent with the regulatory capital regime, as it will prevent counterparties receiving opinions as to the enforceability of such arrangements in accordance with applicable regulation. It also exposes counterparties to the commercial risk of cherrypicking. It seems unreasonable and is likely to be commercially unacceptable to counterparties that the mere presence of a foreign law element to a nettable arrangement should have that result. 7. Appreciating that the issues raised by foreign property are intractable given the jurisdictional limits of UK law, we believe that the authorities must accept that the only way to leave the UK banking industry competitive in international markets is to exclude all netting agreements involving foreign property from the partial transfer powers. Any power to transfer such arrangements in part will require regulated counterparties to hold capital on a gross basis against such arrangements. 8. Ultimately resolution of this issue may merit further consideration of the structure of the SRR tools and in particular whether the model may need to accommodate the residual company as good bank with the transfer of poor quality assets and/or liabilities to the bridge bank in order to give the authorities the greatest possible flexibility to deal with a failing bank with attractive foreign assets. 9. Debt Securities The stated rationale for carving out debt securities issued by a failing bank is not understood. It is justified on the basis that without the carve out the effect could be to accord a higher ranking than would otherwise be the case to subordinated debt. However, because of its subordinated nature, such debt is not included in set-off or netting agreements. Moreover the range of securities it is proposed be included in the carve out goes well beyond subordinated debt. The carve-out would also render nettable arrangements involving self-issued securities ineffective for regulatory capital purposes, with significant negative consequences for regulated counterparties (see below). The effect would be that banks would be

3 3 unable to use self issued securities as collateral for repurchase or stock lending arrangements (other than where those arrangements fell under the Financial Collateral Directive). Such limitations would create real costs for the industry and inevitably impact on competitiveness. 10. Regulated Mortgage Contract, Deposits It is understood why the authorities might wish to carve out retail deposits and regulated mortgage contracts. But the draft statutory instrument allows for the carve out of all deposits. This would cast doubt on the enforceability of on-balance sheet netting agreements for counterparties, and any set-off/netting agreements which included deposits would not be eligible for net regulatory capital treatment in the hands of a regulated counterparty (see below). Non-retail deposits must be excluded from the carve out. 11. We believe that carve outs for retail contracts would not have significant negative commercial consequences for banks, and would to a large extent achieve the aims of the authorities (at least so far as they pertain to depositor protection), by allowing free transfer of retail exposures to a bridge bank or private sector purchaser. Consumers are not generally concerned about set-off and netting largely because they are protected under the FSCS. In order to give the authorities the maximum flexibility, we would therefore advocate widening the scope of the carve-outs to include all arrangements to which an eligible claimant (for the purposes of the FSCS) is party. (An exception would have to be made for retail customers operating an off-set mortgage product and any other products where the splitting of the different elements would be very difficult.) 12. Any Liabilities The rationale for the proposed carve out of a transfer of any or all liabilities is presumably to insulate certain counterparties from the problems of the ailing bank where it is judged that this would serve the SRR s objectives. This may be commercially desirable, but cuts across enforceability: if the authorities have the power to transfer all the liabilities owed to any of a bank s counterparties banks would not be able to obtain clean legal opinions on any netting agreement. It would also render all nettable agreements ineffective for regulatory capital purposes, with serious negative consequences for regulated counterparties (see below). As a result potential counterparties would no longer wish to transact with UK banks, further undermining competitiveness. 13. Non-Banking Business Exposures It is to be expected that such exposures would be of very limited significance in the broader scheme of things. We think it would be better to avoid having a carve out for this business as there would inevitably be uncertainty as to precisely what was covered by it. Contracts Relevant for Regulatory Capital Purposes 14. Our concerns on the proposed carve out package could potentially have been partly assuaged by the message in Paragraph 2.16 of the consultation that contracts relevant for regulatory capital purposes will be protected from the threat of disruption under a partial transfer as in these circumstances the carve outs will not apply. However, the Minister s subsequent announcement in Committee (11 November) that this assurance would not be replicated in legislation means that it will be ineffective. The reason for this is that netting must be enforceable as a matter of legal certainty governmental reassurance alone cannot achieve that certainty.

4 4 European capital requirements on netting 15 Taking the European capital framework as a starting point, each European member state is required to implement the Capital Requirements Directive (CRD), which establishes detailed minimum requirements for (inter alia) the recognition of netting. 16. In relation to netting of off balance sheet exposures, Part 7 of Annex III sets out the relevant requirements. These include that: (i) any netting agreement must create "a single legal obligation such that, in the event of a counterparty's failure to perform owing to default, bankruptcy, liquidation or any other similar circumstance, the credit institution would have a claim to receive or an obligation to pay only the net sum of the positive and negative mark to market values of included individual transactions". (ii) netting agreements should be recognised by competent authorities only if there is "a written and reasoned legal opinion to the effect that, in the event of a legal challenge the relevant courts and administrative authorities would find that the credit institution's claims and obligations would be limited to the net sum of their transactions and rights under: - the law of the jurisdiction in which the counterparty is incorporated - the law that governs the individual transactions included, and - the law that governs any contract or agreement necessary to effect the contractual netting" (paragraph (b) (ii) of Part 7). 17. Similar requirements apply in respect of on-balance sheet netting, credit derivatives and guarantees. 18. Absent satisfaction of this condition netting may not be recognised resulting in the need to hold capital on the basis of a gross, rather than net, exposure. To give some idea of the scale of this effect evidence from our member banks shows that it is common for them to have netting agreements in place where gross exposure exceeds the net amount at risk by a factor of 20 or 30. Significantly higher multiples are not unusual. 19. In these circumstances much of the business concerned would no longer be economic and could be expected to migrate to other jurisdictions or other legal entities within a financial group as a result most of the additional flexibility that the authorities were hoping to have given themselves would prove illusory. Also banks could be expected to cut trading lines and seek to mitigate their risks in other ways for example with break clauses becoming more common, and also more likely to be invoked. This could have a particularly adverse effect on relatively weaker counterparties/potential counterparties in terms of market access and liquidity. In the interbank market too the impact of the proposals could be severe, in the sense of reducing further the propensity to lend and causing a flight to quality. Application 20 As has been emphasised before safeguards articulated in consultation papers or a code of practice will not provide the degree of legal certainty required to enable

5 5 lawyers to give unqualified legal opinions as to the effectiveness of netting or set-off agreements it must be the case that the courts would find netting effective. 21. It will be clear that, in light of the requirement cited above, each of the carve-outs for deposits, all liabilities transfer, debt securities and foreign property would, if implemented, prevent regulated entities from recognising netting with UK banks. This is because the courts would no longer be able to find that netting would be effective under English, Scottish or Northern Ireland law (the jurisdictions in which a UK bank is incorporated), and accordingly legal counsel will no longer be able to affirm that they would so find. 22. In seeking to explain why the government had not replicated its assurance in the draft statutory instrument, the Minister referred to the circularity issue namely that arising where a clean legal opinion would be needed for net regulatory capital treatment but at the same time an assurance of net capital treatment would be a prerequisite for the provision of a suitable legal opinion. We do not think that this need be a major issue. The commitment in paragraph 2.16 of the consultation paper could be reflected in the legislation to the effect that none of the carve outs to the safeguard would be exercised in respect of set-off or netting agreements between regulated parties. Further consideration would need to be given to the appropriate definition of regulated parties. But this could be along the lines that regulated parties were those within the scope of the EU Capital Requirements Directive or a comparable regulatory capital framework consistent with Basel standards. 23. If the authorities are resolved to have the power to disrupt at least some setoff/netting agreements, this would leave the matter of agreements between regulated and unregulated parties. Manifestly it would be wholly unsatisfactory (and unfair) for unregulated parties to be left exposed to the risk of loses caused by cherrypicking in a partial transfer situation. Whilst it would be very much a second best solution, the only way forward would appear to be through the proposed compensation arrangements. It would be likely of course that in the circumstances posited unregulated parties would no longer be willing to enter into agreements with UK banks. We therefore believe that the correct approach would not be to differentiate between regulated and unregulated counterparties, but rather remove all the carve outs other than that for retail contracts. Possible Additional Flexibility for the Authorities 24. As discussed above, we believe that any full carve outs going beyond retail contracts would cause major problems for the UK banking industry. We have, however, explored a number of models that might give the authorities further flexibility. One possibility that may merit further consideration would involve the authorities having a conditional power to effect a further carve out. This would entail the Bank of England having the right to transfer all deposits (and possibly other liabilities) to good bank at the point of resolution but with counterparties having the right to insist that the transfer was subsequently reversed. This would allow the authorities to take action swiftly in line with some of the aspirations expressed in the consultation document and it is not apparent that counterparties would have any incentive to have (netting agreement) claims transferred back to the residual company. It would need to be clear though that the authorities having a power of this kind would not lead the lawyers to qualify their opinions in such a way as to compromise net regulatory capital treatment.

6 6 Breach of the Safeguard 25. The draft order is concerned more with process than with the substance of redress. If a partial transfer was effected in breach of the safeguard we believe that either the property transfer order should be deemed invalid or it would have to be reversed. Redress in the form of an ex post compensation payment would not be adequate. SECURITY INTERESTS 26. The proposal to protect security interests without exception (including all floating charges) is welcome. As regards the restriction proposed in Paragraph 3.8 of the consultation document, it is essential that the integrity of netting, collateral and set-off is fully respected for contracts with all non retail counterparties. STRUCTURED FINANCE 27. We believe it would be essential to have explicit safeguards protecting the integrity of all aspects of structured finance arrangements. It is understood that Allen & Overy are about to present a detailed proposal. THIRD PARTY COMPENSATION 28. The objective of no creditor worse off (NCWO) is very much to be welcomed in principle though various elements of how this would work in practice are unclear some of these would be likely to remain so for as long as the framework remained untested. Also (to state the obvious) any exercise which involves calculating the outcome of a series of hypothetical events is unlikely to be straightforward. The resulting uncertainties serve to underline the observation made in previous BBA comments on the operation of the SRR that the availability of compensation would be far from a panacea for the disruption caused by interference in property rights. The thinking behind the decision to allow for a broader range of hypothetical counterfactual insolvency outcomes, including administration, in the NCWO methodology is understood. However, it is feared that in practice this would render the exercise even more complex. 29. We do not support the proposal to limit application of the NCWO principle to contracts governed by UK law. It is highly questionable whether such discrimination against holders of foreign law rights would be legal. 30 We would make the following further observations: i) It needs to be clarified that a party having a netting or set-off agreement with the ailing bank which was cherrypicked on partial transfer would receive compensation on the basis of any agreement wide in the money position at the time of partial transfer. ii) With regard to the payment of compensation under a TPCO clause 4(3) makes reference, inter alia, to sums the creditor is likely to receive other than through the TPCO. It would make more sense to wait until the value of the payments in question could be established before finalising the TPCO calculation. We agree that compensation payments should be made in a timely manner and with the principle of interim payments on account. Interim payments should be followed by a balancing payment once all information is known.

7 7 iii) Clause 7 would allow the authorities to direct the independent valuer that property would have been sold for a specified price or sold under certain conditions. Confidence in the process might be greater if such matters were left to the judgement of the independent valuer. In this regard it would obviously be essential for the valuer to have access to all relevant information. RESTRICTION OF SCOPE 31. Clause 47 (formerly 42) of the Bill refers, inter alia, to the making by order of conditions for partial property transfers. Our proposal that agreements including foreign law contracts should be exempt from partial transfer powers would seem to fall within scope. Supplemental and Reverse Transfers 32. Restrictions should be placed on the transfer back of any liability of the bridge bank. The possibility that a creditor could have his claim assigned to the bridge bank only then for it to be transferred back to the residual company destined for insolvency would only add to uncertainty. Any position which is subject to safeguards should also be protected from reverse transfer. CODE OF PRACTICE 33. As stressed earlier in this response and elsewhere, any assurances provided in the Code could not be an adequate substitute for legislative provision as they would be incapable of providing legal certainty (absent specific provision). This is particularly apposite in regard to commitments made in the area of safeguards for partial transfers. 34. Nevertheless the Code should have value as a source of information on how the authorities intend to operate the SRR framework. Whilst the text we have seen has not shed a great deal of additional light on the issues of most concern to the industry, it is recognised that this is very much a first draft and that a further iteration is in the course of preparation. We look forward to having the opportunity to offer feedback when this is available. At this stage we would make three further comments : i) It is noted that further sections are to be added to the Code including in the area of partial transfer powers. Depending on the final form of the safeguards material included in the legislation itself, it would be highly desirable for certain Code provisions on safeguards to be legally binding. ii) iii) The status of the Code needs to be as clear as possible. We believe that the authorities should operate on a comply or explain basis. When changes to the Code are under consideration going forward we believe the authorities should commit to prior public consultation. SPECIFIC QUESTIONS 35. Responses to the specific questions posed in the consultation are set out in the appendix. January 2009

8 8 APPENDIX RESPONSES TO CONSULTATION QUESTIONS 1. Do you agree that there should be a broad catch-all set-off and netting safeguard, with appropriate carve-outs? As per our responses to previous consultations, we are concerned that the legislation on partial transfers is being progressed in such haste and believe that there is a real danger of undermining the competitiveness of the UK banking system. That said, on set-off and netting the general safeguard/specified carve outs approach is judged to be more appropriate than the other methodologies that have been proposed. We believe that the only acceptable carve out would that proposed for retail contracts. 2. Do you have any views on the likely effectiveness of this safeguard? Please see our answer to Question 1 3. Do you agree with the proposed carve-outs? Please see our answer to Question 1 4. Do you agree with the proposed actions to be taken following a breach of this safeguard? Please see Paragraph 24 of our response. 5. Do you have any views on how the safeguard is framed in the draft Order? As drafted the safeguard would fail completely to deliver net regulatory capital treatment. Please see Paragraph 4-24 of our response. 6. Are there any practical considerations (for example around the operation of events of default) that the Government will need to address to ensure that the set-off and netting safeguard works as planned? Please see the reference to clauses 22 and 38 of the Bill in Paragraph 3 of our response. 7. Do you agree that this safeguard should encompass all charges? Yes. This is welcomed. 8. Do you agree that the likelihood of banks beginning to grant wide-ranging floating charges over their assets (whether in normal conditions, or under stress) is low? Yes. We are unaware of UK banks having granted wide ranging floating charges. 9. Do you have any other views on how the issues related to floating charges and SRR flexibility could be addressed?

9 9 If necessary (which we doubt), this issue could be addressed by regulation. 10. What are your views on the Government s proposal to restrict the observance of EU law to the strict Directive definitions? Are there elements of the UK implementation of the relevant EU laws that the Government should consider protecting in the safeguard? Please see Paragraph 25 of our response. 11. Do you agree with the proposed actions to be taken following a breach of this safeguard? Please see Paragraph 24 of our response. We believe that the same principle should apply. 12. Do you have any views on how the safeguard is framed in the draft Order? Please see Paragraph 3 of our response. 13. Are they any practical considerations (for example around the operation of events of default) that the Government will need to address to ensure that the security safeguard works as planned? Please see Paragraph 3 of our response. 14. Do you agree with the Government s position that structured finance arrangements should not be subject to possible disruption in a partial transfer situation? Yes. Avoidance of disruption to structured finance arrangements is essential. 15. Do you think that an additional explicit term protecting structured finance arrangements from disruption is required in the order? Yes. 16. If this is necessary, do you have any suggestions for how this term might be framed in a sufficiently powerful but flexible way as to provide legal certainty and avoid damage to the Authorities ability to execute a partial transfer? It would be difficult to provide the necessary protection without constraining the authorities flexibility in the context of a partial transfer. 17. Do you agree with the need for the NCWO safeguard? Yes, but please see Paragraph 27 and 28 of our response. 18. Do you have any views on the process stated above, or on the assumptions we suggest that an Independent Valuer should work under? Please see Paragraph 29 of our response. 19. Do you have any concerns over the likely effectiveness of the safeguard Regulations as they are presently framed? Yes. Please see Paragraph 27 and 28 of our response.

10 Do you have any views on how the Regulations could be better framed? Please see Paragraphs 28 and 29 of our response. 21. Do you agree that there should be no general restriction of scope safeguard in secondary legislation given the other legislative safeguards that the Government is proposing? No. Please see Paragraphs 6 and 8 of our response, on foreign property. 22. Do you think there are other scope restrictions that would help give the industry certainty without unnecessarily reducing the Bank s flexibility to execute a partial transfer? As immediately above. 23. Do you agree that there should be restrictions placed on reverse property transfers? Yes. 24. Do you agree that the restriction should take the form of a list of property which cannot be transferred under reverse property transfer powers? Yes. 25. If so, what property should be protected from being transferred back? Restrictions are needed for the transfer back of any liability and any position which is subject to the safeguards. 26. The Government is seeking general views on the draft code attached in Annex C and requesting suggestions for other issues under parts 1, 2 and 3 of the Banking Bill that it should cover. Please see Paragraphs 31 and 32 of our response.