GAZELLE PENSIONS ADVISORY UNDERSTANDING SCHEME PENSION RISK OF BANKS IN THE UK FINANCIAL INSTITUTIONS RESEARCH JANUARY 2013

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1 UNDERSTANDING SCHEME PENSION RISK OF BANKS IN THE UK FINANCIAL INSTITUTIONS RESEARCH JANUARY 2013 Gazelle Corporate Finance Limited 41 Devonshire Street London W1G 7AJ T+44 (0) F+44 ( Authorised and regulated by The Financial Services Authority

2 UNDERSTANDING SCHEME PENSION RISK OF BANKS IN THE UK FINANCIAL INSTITUTIONS RESEARCH VARAN SELVARAJAH JANUARY 2013 Currently in the UK, the FSA s position on pension risk is that it does not have a remit to protect members of defined benefit pension plans against failure of their plans Following the late-2000 s financial crisis, the Basel Committee on Banking Supervision, which seeks to promote and strengthen supervisory and risk management practices globally, developed reforms of its existing framework (known as the Basel Accords) the latest being Basel III which was centred on the perceived failures of the banking sector where the crisis was amplified by weaknesses such as excessive leverage, inadequate and low-quality capital, and exacerbated by procyclical deleveraging and the interconnectedness of systemically important financial institutions 1. In the UK, the financial crisis led to the Chancellor of the Exchequer to announce the creation of the Independent Commission on Banking which was tasked to assess how to reduce financial risk in the banking sector; mitigate moral hazard in the banking system; deal with banks seen as too big to fail ; and promote competition in both retail and investment banking. In this paper, we have looked at the how these reforms could lead to changes in UK banking and specifically the treatment of defined pension obligations. The current UK framework The Financial Services Authority (FSA) acts as the leading UK regulator 2 (itself to be split into the Prudential Regulation Authority and the Financial Conduct Authority in 2013) for banks in the UK and sets the standards which these businesses must meet. The FSA framework acts as an overlay to the Basel Accord, which was implemented in the European Union via the Capital Requirements Directive (CRD), and was designed to ensure the financial soundness of credit institutions including banks. The CRD framework was revised by the introduction of Basel II, initially published in June The Basel II framework introduced the concept of three 'pillars'. Pillar 1 sets out the minimum capital requirements firms are required to meet for credit, market and operational risk. Under Pillar 2, firms and supervisors have to take a view on whether a firm should hold additional capital against risks not covered in Pillar 1 and must take 1 Bank for International Settlements: The Basel Committee s response to the financial crisis report to the G20 (October 2010) 2 FSA: FSA publishes Business Plan for 2012/13 3 FSA: The Basel Accord and Capital Requirements Directive 1

3 action accordingly. Pillar 3 aims to improve market discipline by requiring firms to publish certain details of their risks, capital and risk management Currently in the UK, the FSA s position on pension risk is that it does not have a remit to protect members of defined benefit pension plans against failure of their plans. Their philosophy towards capital required for pension risk, or pension obligation risk capital, is that it exists to enable a firm to meet its pension obligations through a period of stress and beyond. Consistent with the Basel framework, this pension obligation risk capital is calculated so that Pillar 2 captures risk not included within Pillar 1 as follows: Pillar 1: The recognised accounting pension deficit or five years worth of projected pension contributions 4. Most banks opt to use the five year method with this typically resulting in a lower deduction from capital. Pillar 2: Banks should submit an ICAAP (Internal Capital Adequacy Assessment Process) to the FSA which measures required capital beyond the minimum requirement under Pillar 1, and capital required through a stressed scenario. In respect of Pillar 2 pension obligation risk capital (P2PRC), the FSA will use the trustee valuation as a starting point for this assessment and consider a 1 in 200 stress event 5. Although the full actuarial deficit on a trustee valuation basis is factored into the required capital through the FSA s guidance, only the strongest form of capital, Tier 1, is eligible to be held against the Pillar 1 requirement. The Pillar 2 requirement, which in many cases is a significant element, could be against weaker types of capital. Change is on the horizon There are two pending changes which could affect how pension schemes in banks are viewed by the market and their sponsor employers. These could have profound implications for covenant assumptions and recovery plans. Basel III The Basel Committee on Banking Supervision have set a revised global regulatory standard, implemented through Basel III, on bank capital (to be phased in by 2019) to increase the sector's ability to absorb shocks arising from financial and economic stress, 4 GENPRU FSA: Letter to British Bankers Association Pension obligation risk and the Internal Capital Adequacy Assessment Process (14 February 2011) 2

4 improve risk management and governance, and strengthen transparency. These measures are aimed to strengthen banks and in some cases, from a pension trustee perspective, the sponsor employer. With regulatory focus on the ratio of common equity to risk weighted assets this will mean that banks must address the total accounting pension deficit to meet core tier 1 capital ratio requirements Of direct relevance to pension schemes are the proposed changes to capital requirements and the recognition of pension deficits. Defined benefit pension fund liabilities, as included in the balance sheet, are to be fully recognised in the calculation of Common Equity Tier 1 6. As noted above, under the current framework the FSA currently only requires this kind of capital against the next five years worth of pension contributions. With regulatory focus on the ratio of common equity to risk weighted assets this will mean that banks must address the total accounting pension deficit to meet core tier 1 capital ratio requirements. We expect that stock market analysts will pay closer attention to pension deficits, where currently analysis is limited, due to this becoming a more pertinent factor in capital strength. We note that although analysts are likely to focus more on these pension deficits, these will still be measured on an accounting basis rather than the actuarial technical provisions basis used by pension trustees. Independent Commission on Banking (ICB) proposals On 16 June 2010, the Chancellor of the Exchequer announced the creation of the Independent Commission on Banking (ICB), chaired by Sir John Vickers. The Commission was asked to consider structural and related non-structural reforms to the UK banking sector to promote financial stability and competition. Following publication of the findings of this Commission, the UK government accepted most of the recommendations and, through a process of consultation, published the Draft Financial Services (Banking Reform) Bill on 12 October The Government remains committed to have all legislation enacted by the end of this Parliament (2015) and reforms will be in place by The ICB recommended a package of measures, including ring-fencing vital banking services and increasing banks loss absorbency, to create financial stability. A challenge with the ring-fencing proposal is that under current pension regulation, ring-fenced banks may be liable for funding any deficit in group-wide pension schemes should the wider banking group fail. The Government s preferred option is to require banks to separate, using commercial means, the pension fund for employees of a ring-fenced bank from the pension funds of other group entities, to ensure that the ring-fenced bank cannot be made jointly and severally liable for any pension deficit arising elsewhere in 6 Bank for International Settlements: Basel III A global regulatory framework for more resilient banks and banking systems (June 2011) 3

5 the group. However, the Government appears to have appreciated the difficulties in separating schemes, the potential implications including trustees demanding shorter recovery plans and a change in prudence assumptions, and as a result has not set a targeted date or specific guidance for full separation of pension schemes. Within the Draft Bill, pension provisions regarding ring-fencing do not feature and once finalised this will be included in the legislation. Other recommendations from these proposals include depositor preference 7 over other creditors which would move pension schemes lower as a priority creditor. The drafters of the Bill considered pension liabilities and concluded that insured deposits will rank above them. This will impact pension schemes, specifically when considering recovery on insolvency, and affect how trustees view the strength of their sponsor employer. What next? The changing regulation around banks in the UK and globally is intended to strengthen these institutions and is designed to improve the resilience of individual banking institutions in periods of stress. However, it should be noted that these measures have been designed to protect depositors not staff pension schemes, and it needs to be considered whether they result in a strengthening or weakening of their position as a side effect. The current FSA framework limits the strongest form of capital to five years worth of contributions and with the introduction of Basel III and the ICB proposals pension risk will become an increasingly important factor around capital planning, risk to sponsor employer businesses and creditor hierarchy. Banking reform is an ongoing and gradual process. We have focused on the UK dimension, but interplay with the wider European banking sector is still in its early stages, notably with the high-level Group on reforming the structure of the EU banking sector (the Liikanen report ), recently published. 7 Deposits insured by Financial Services Compensation Scheme (FSCS) 4

6 This document is provided for information purposes only and is not a complete analysis of every material fact regarding the matters considered herein. Statements of fact have been obtained from sources considered reliable but no representation is mad by Gazelle Corporate Finance Limited as to their correctness, completeness or accuracy. Opinions expressed constitute our judgment at the date of this document and are subject to change without notice. Nothing stated in this report should be treated as an authoritative statement of the law or market practice, as constituting or providing investment or financial advice, or as a recommendation to purchase, sell or hold particular securities. Gazelle Corporate Finance Limited accepts no liability whatsoever for any direct or consequential loss arising from the use of this report or its contents. Action should not be taken on the basis of this document alone. For specific advice on any particular aspect you should consult your usual contact at Gazelle Corporate Finance Limited. Individuals named in this document are for contact purposes only. Copyright 2012 Gazelle Corporate Finance Limited 41 Devonshire Street, London W1G 7AJ. All rights reserved. This report or any portion of it may not be reproduced, distributed or published by any recipient for any purpose without the written consent of Gazelle Corporate Finance Limited. 5