The UK Treasury this month set out its plans to implement the Independent Commission on Bankings (ICB) reforms for the UK banking sector. But lawyers have raised doubts on several key points, with some even calling for a rethink of the entire approach.
The White Paper on Banking Reform was published on June 14 in response to recommendations by the ICB to ring-fence retail and investment banking activities of so-called too big to fail institutions.
The ICB, chaired by Sir John Vickers, suggested the government would only prop up the ring-fenced part, making it affordable for the country and fairer for the UK tax payer. But in its White Paper the Treasury suggested initially ring-fencing deposits owned by individuals and small and medium-sized businesses, rather than other products such as mortgages.
Lawyers in the UK have, however, criticised the reports lack of detail.
Linklaters Benedict James said a lot of the proposals sounded quite good on paper, until you tried to figure out how they would work in practice.
The requirement, stipulated within the report, that banks within the ring fence only make loans to EEA entities was cited as one fundamental problem.
Assuming the idea is, at least in part, that the UK taxpayer shouldnt be standing behind foreign business, does the government really think the UK taxpayer actually feels any better about loans in Poland or Slovenia than loans to the US or Jersey, which are outside the EEA? asked one City lawyer.
Its difficult to see how this proposal would work with an English company with a high percentage of its assets outside of the UK or the EEA, for example. It remains unclear as to whether it would be viewed as an EEA company that banks inside the ring fence can make loans to.
But, according to Simon Gleeson of Clifford Chance, the matter could be easily resolved if companies place of incorporation was used to determine its standing in this regard.
James, meanwhile, branded the depositor preference proposal as a mistake. It reverses the sensible trend of removing preferred creditors so that everyone ranks pari passu, he said.
Suddenly weve got depositors ranking ahead, he said. He questioned whether it was sensible to overtly protect UK deposits ahead of internationally-held bonds, at a time when banks were desperately trying to rebuild their balance sheets.
Gleeson said such depositor preference ensured no uninsured depositor would ever deposit with that bank because they are subordinated to all the preferred depositors.
Insured banks with depositor protection can only raise money from either retail deposits or from repo-ing securities. Gleeson said this meant that the corporate banking business had to stay in the real bank. It means the ring-fenced bank is a very retail bank indeed, he said. I think thats deliberate.
That the proposals would also seemingly make every bank operate two sets of payment infrastructure systems - one for the ring-fenced bank and one for the real bank could present another potential issue, Gleeson said.
For the ring-fenced bank to be resolvable, it must have its own independent access to payment systems.
This could make retail payments a lot more expensive, Gleeson said. In the long-term this might encourage the development of mobile phone-based and other non-bank payment systems.
Proposals to let ring fences offer so-called simple derivative products to its clients have also drawn criticism around how they will work in reality.
James said banks do not currently hedge item by item. They hedge on a macro basis across their whole book, he said. Banks will now need to spend an awful lot of time with lawyers trying to work out what is permitted hedging and what isnt, within a macro position like this.
Shearman & Sterlings Barney Reynolds questioned whether or not the Treasury had taken the right approach.
He believed we were reaching the end of the line in terms of regulating the too big to fail issue.
I dont think we can keep layering on much more without killing the industry or completely changing it, he said. And I dont think we can have an entirely risk-free system.
The market now needed consider whether the biggest banks should never go insolvent, he said.
The idea of just adding more equity capital and cost to keep banks going, come what may, has run its course, said Reynolds. We need to start changing the debate.
Why is there this presumption that everyone can sue to the last drop and the whole thing has to go through an insolvency process? he asked.
Within the shipping industry, a ship owner can set up a limitation fund ensuring that when an incident occurs, everyone can sue for their stake but they have to sue against this limitation fund. Ship owners can therefore only lose a pre-defined amount and thereby carry on business.
There needs to be something similar for banks, Reynolds said.
But Gleeson said making banks limited recourse would fail to address the fundamental problem.
We need to keep banks going not just because of credit, but also to keep money flowing around the payment system, he said.
The collapse of a major bank does such damage because the bank performs as a transmission mechanism for ordinary commercial business. For a bank to continue to be able to do that, it needs access to payment systems.
The trouble with limiting the recourse of banks is that no sane payment system will allow a bank configured this way to be a member of it and will certainly close out its access immediately upon the event occurring, said Gleeson.
Responses to the UK government must be submitted by September 6 2012.