United Kingdom Regulation

�

The Banking Regulation

Review

Law Business Research

Editor

Jan Putnis

The Banking RegulaTion Review

Reproduced with permission from Law Business Research Ltd.

This article was first published in The Banking Regulation Review, 1st edition (published in June 2010 – editor Jan Putnis).

For further information please email [email protected]

Contents

�

The Banking Regulation

Review

Editor

Jan PuTnis

law Business ReseaRch lTd

Contents

�

PuBliShER Gideon Roberton

BuSinESS dEvEloPmEnT mAnAGER Adam Sargent

mARkETinG ASSiSTAnT hannah Thwaites

EdiToRiAl ASSiSTAnT nina nowak

PRoducTion mAnAGER Adam myers

PRoducTion EdiToR Joanne morley

SuBEdiToR charlotte Stretch

EdiToR-in-chiEF callum campbell

mAnAGinG diREcToR Richard davey

Published in the united kingdom by law Business Research ltd, london

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i

AcknoWlEdGEmEnTS

The publisher acknowledges and thanks the following law firms for their learned assistance throughout the preparation of this book:

AFRidi & AnGElL

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ii

muñoz TAmAyo & ASociAdoS ABoGAdoS S.A.

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viEiRA dE AlmEidA & ASSociAdoS.

WEBBER WEnTzEL

WonGPARTnERShiP llP

Acknowledgements

iii

Editor’s Preface ��viiJan Putnis

Chapter 1 International initiatives �� Jan Putnis

Chapter 2 Argentina �� 6Santiago Carregal, Martín G Vázquez Acuña and Josefina Tobias

Chapter 3 Australia �� 8Louise McCoach and David Landy

Chapter 4 Belgium �� 49Anne Fontaine

Chapter 5 Brazil �� 6�Jose Eduardo Queiroz

Chapter 6 Colombia �� 70Carlos Gerardo Mantilla Gómez

Chapter 7 Denmark �� 86Tomas Haagen Jensen and Tobias Linde

Chapter 8 European Union �� 97Jan Putnis

Chapter 9 France ��Olivier Saba, Samuel Pariente, Jennifer Downing, Bernard-Olivier Becker and Hubert Yu Zhang

Chapter 10 Germany ��Thomas Paul and Sven H Schneider

Chapter 11 India ��8Shardul Thacker

Chapter 12 Italy ��8Giuseppe Rumi

conTEnTS

Contents

iv

Chapter 13 Japan ��69Hirohito Akagami and Toshinori Yagi

Chapter 14 Korea ��79Sang Hwan Lee, Chan Moon Park and Hoin Lee

Chapter 15 Latvia ��90Armands Skudra

Chapter 16 Luxembourg ��201Franz Fayot

Chapter 17 Malaysia ��Andri Aidham bin Dato’ Ahmad Badri, Julian Mahmud Hashim and Tan Kong Yam

Chapter 18 Malta ��Rosette Xuereb

Chapter 19 New Zealand ��36Guy Lethbridge and Debbie Booth

Chapter 20 Nigeria ��7Adamu M Usman and Zelda Odidison

Chapter 21 Norway��60Terje Sommer and Markus Nilssen

Chapter 22 Poland ��69Tomasz Gizbert-Studnicki, Tomasz Spyra and Michal- Bobrzynski

Chapter 23 Portugal ��80Pedro Cassiano Santos

Chapter 24 Romania ��93Adela-Ioana Florescu and Veronica Alexeev

Chapter 25 Singapore ��04Elaine Chan

Chapter 26 Slovakia ��7Sylvia Szabó

Chapter 27 South Africa ��29Johan de Lange and Johann Scholtz

Chapter 28 Spain ��Juan Carlos Machuca

Contents

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Chapter 29 Sweden ��60Mikael Kövamees, Carl Schwieler and Lina Williamsson

Chapter 30 Switzerland ��67Shelby R du Pasquier, Patrick Hünerwadel, Marcel Tranchet and Valérie Menoud

Chapter 31 Taiwan��8�Chun-yih Cheng

Chapter 32 Turkey ��9�Serdar Paksoy and Selin N Tiftikçi

Chapter 33 United Arab Emirates ��0�Amjad Ali Khan and Stuart Walker

Chapter 34 United Kingdom ��Jan Putnis

Chapter 35 United States��Luigi L De Ghenghi, Reena Agrawal Sahni and Cristina Fong

Chapter 36 Vietnam��7�Samantha Campbell and Nguyen Thi Tinh Tam

Appendix 1 ABouT ThE AuThoRS ��87

Appendix 2 conTRiBuTinG lAW FiRmS’ conTAcT dETAilS ��506

vii

editor’s preface

Legal and regulatory areas of concern come and go in their perceived importance. it is, however, very difficult to recall any other occasion when a subject regarded by many lawyers as so obscure and arcane as international banking regulation has come to such prominence in such a short period of time.

Before the onset of the financial crisis in western economies in 2007, banking regulation was regarded by many as a discipline practised by technocrats who were, to put it politely, best left to themselves. The subject has risen up the agenda so quickly since then that few lawyers who advise financial institutions have had time to draw breath and assess the position now reached. The reality, of course, is that no final position has been reached and none is ever likely to be reached: banking regulation will continue to evolve, punctuated by bursts of activity every time there is a serious crisis to manage. What has happened is that the importance of this subject, and its rightful place amongst legal disciplines, has finally been recognised. This means that there is now great demand, from the banks themselves, but also from governments and regulators, for accessible and user-friendly explanations of the applicable rules.

The continual evolution of the rules makes any survey of banking regulation very difficult to write without risking almost immediate obsolescence. This book is an attempt to rise to that challenge and it is hoped that future editions will address the many further developments in this area that are expected to take place in the coming months and years. The book is aimed principally at lawyers and others who need access to an overview of the applicable rules in the important areas that the book covers and a commentary on recent developments. it also includes commentary on many of the areas of banking regulation that are of critical importance to the major cross-border transactions in which banks become involved.

Preface

viii

The book illustrates the many and differing approaches that governments and banking regulators have taken to addressing what they perceive to be the problems affecting the banks that they regulate. To that extent, the lack of international coordination is a potential source of dismay amongst politicians and others who have spent so much time over the past three years trying to develop common approaches to the international challenges highlighted by the financial crisis.

It is, however, to be hoped that surveys of the kind in this book also inform the continuing debate about how to minimise the risk of a further crisis on anything like the scale that we have just seen. It will, quite literally, pay for governments to appreciate that further significant financial crises are inevitable in the future, and that the principal aim of reform should, therefore, be to minimise their likely impact, both on the lives of the millions of people who rely on banks and on local and regional economies.

It is a tribute both to the contributors and the publishers that so many leading banking and regulatory lawyers have made themselves available to write chapters for this book. I would like to thank them all for the support and encouragement that they have provided at a time when many of them have been almost overwhelmed with work on other projects emerging from the financial crisis. Many of the contributors have also been involved in initiatives designed to stabilise and reform the banking sectors in their countries. I would also like to thank Gideon Roberton and his colleagues at the publishers for their efforts in coordinating the project that this book has become, and in bringing it to fruition.

Jan PutnisSlaughter and MayLondon June 2010

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Chapter 1

INTERNATIONAL INITIATIVESJan Putnis*

Slaughter and May

* Jan Putnis is a partner at Slaughter and May.

I INTRODUCTION

Banking regulation has never had a higher profile – and has arguably never been so important – as today. The subject has risen up the agenda as politicians have realised the damage that the failure of banks can do to national and regional economies.

If anyone assumed that an internationally agreed set of common principles as to how banks should be regulated would emerge from the financial crisis of 2007–2009 then they must now be quite disappointed: progress has been slow. That does not, however, mean that there has been no progress. It is fair to say that at the time of writing, more than enough international initiatives are underway on various aspects of banking regulation to mean that significant political embarrassment will follow if real further progress is not made.

In fact, since the global financial crisis first began to have publicly obvious effects in 2007, it has at times been difficult to keep track of the numerous international initiatives that have been launched. The initiatives may broadly be classified as those developed to try to understand what went wrong and those developed to propose and monitor the implementation of reforms to prevent the recurrence of problems that have been identified. The proliferation of international initiatives has reflected the number of stakeholders involved and differing approaches to identifying and addressing the causes of the crisis. It has also reflected a period of intense reflection among financial regulators and governments on the causes and consequences of the financial crisis. Cynics may argue that the world could have done with fewer ‘initiatives’ and greater clarity about the direction of reform in the past two years.

As far as banking regulation is concerned, we focus in this chapter on two main bodies that have emerged from the crisis to lead the debate. The first, the Basel Committee on Banking Supervision, has continued to propose regulatory reform and

International initiatives

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the second, the Financial Stability Board, emerged in 2009 as a new global leader of the debate on measures to improve international financial stability. European Union developments are discussed in the separate European Union chapter.

II BASEL COMMITTEE ON BANKING SUPERVISION

i Introduction

The Basel Committee on Banking Supervision (‘the Basel Committee’) is a forum for the development of standards and international cooperation on banking supervision. It is principally concerned with the prudential regulation of banks rather than the regulation of their business activities as such. It must, however, be recognised that there is much cross-fertilisation between these two areas of regulation, with capital requirements creating incentives for banks to engage in certain activities but not in others.

The Basel Committee comprises senior officials with bank regulatory and financial supervisory responsibilities from central banks and banking regulators in 27 countries and territories.� The current chairman is Nout Wellink, who is also chairman of the Netherlands Bank. The Basel Committee has a secretariat (largely comprising secondees from banking regulators that are members of the Basel Committee) based at the Bank for International Settlements in Basel, Switzerland. The Basel Committee was originally established as a committee by the central bank governors2 of 10 member countries in 1974 and first met in February 1975. It has since met three or four times annually.

The stated objective of the Basel Committee is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. Its main focus has traditionally been on internationally active banks, although the Committee’s standards have been applied more widely.

The Basel Committee formulates standards and guidelines and recommends statements of best practice. The principles adopted by the Basel Committee have no legal force, and their authority derives from the commitment of banking supervisors in member countries to implement the requirements agreed by the Committee. The Basel Committee has adopted standards on a wide range of issues relevant to banking supervision, including banks’ foreign branches, principles for banking supervision, internal controls, supervision of cross-border electronic banking and risk management guidelines for derivatives. In recent years, however, the Committee has devoted most of its attention to regulatory capital, principles for effective banking supervision and cross-

1 Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. The European Commission is also represented. Central banks from the member countries and territories are represented on the Basel Committee and, where the central bank is not charged with the prudential regulation of banks in a member country or territory, the authority with that responsibility is also represented.

2 The Committee was originally called the Committee on Banking Regulations and Supervisory Practices.


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border banking supervision. It has also more recently been active in the important areas of liquidity risk and developing frameworks for the recovery or orderly wind-down of internationally active banks that get into financial difficulties.

The Basel Committee operates four subcommittees:a the Standards Implementation Group, which concentrates on the implementation

of the Committee’s guidance and standards;b the Policy Development Group, which is charged with identifying issues of

importance to banking supervision as they emerge and with developing policies for the Basel Committee that promote a sound banking system and high supervisory standards;

c the Accounting Task Force, which is concerned with international accounting and auditing standards and, in particular, with ensuring that those standards promote sound risk management at financial institutions, underpin market discipline through transparency and reinforce the safety and soundness of the banking system; and

d the Basel Consultative Group, which provides an interface between the Basel Committee and non-member banking regulators.

Each of the first three subcommittees has working groups and/or subgroups reporting to them that are engaged in particular areas of work.

In addition to the Basel Consultative Group, there are other groupings which organise liaison between the Basel Committee and regulators of financial institutions that are not banks. One such grouping is the Joint Forum, which was established in 1996 to address issues common to the banking, securities and insurance sectors. The Joint Forum has its own secretariat which is provided by the Basel Committee. Another such group, the Coordination Group, brings together the chairmen and secretaries general of the Basel Committee, the International Organization of Securities Commissions (IOSCO),� the International Association of Insurance Supervisors4 and the Joint Forum in biannual meetings.

ii Basel I

The first comprehensive international bank supervisory framework that was drawn up by the Basel Committee was the Basel Capital Accord, which was adopted in 1988. It is sometimes now referred to as ‘Basel I’. It was required to be implemented by the end

� IOSCO is an international body of securities regulators that monitors the activities of securities firms and investment firms, although it has no direct legal authority.

4 The International Association of Insurance Supervisors represents insurance regulators and supervisors of some 190 jurisdictions in nearly 140 countries. Its stated objectives are to cooperate to contribute to improved supervision of the insurance industry on a domestic as well as on an international level in order to maintain efficient, fair, safe and stable insurance markets for the benefit and protection of policyholders, to promote the development of well-regulated insurance markets and to contribute to global financial stability.


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of 1992 and was indeed eventually followed as an international standard by banking regulators in over 100 countries.

Basel I was based on four core principles, which persist today. These are:a a common definition of regulatory capital;b the determination of the amount of capital that a bank is required to hold

through applying a risk weight to particular assets and off-balance sheet items (‘risk-weighted assets’);

c the setting of a minimum ratio of regulatory capital to risk weighted assets (the ‘risk asset ratio’); and

d consolidated supervision of banking groups.

One key feature of Basel I was a minimum ratio of capital to risk-weighted assets of 8 per cent, which is only now undergoing reform.

Following various incremental developments to Basel I, the Basel Committee conducted a review of market developments which led the Committee to identify several defects in that Accord. In particular the Basel Committee considered that:a capital ratios are not always a good indicator of a bank’s financial condition;b the approach of Basel I to risk weights provided only a crude indicator of risk;c a lack of sensitivity to credit risk in Basel I provided an incentive for banks to

exploit differences between economic capital and regulatory capital (for example, by increasing lending to poor credit quality borrowers, which attracted a higher rate of interest, but the same capital charge);

d credit risk mitigation techniques, in particular collateral and credit derivatives, were often not recognised under Basel I; and

e there were insufficient incentives for banks to develop more accurate internal measurements of risk as this generally did not, under Basel I, result in any capital savings.

The Basel Committee concluded that these difficulties resulted from a lack of sensitivity in Basel I. In other words, it was considered that Basel I was too divorced from the real world of what internationally active banks were doing. After nearly six years of work, in June 2004 the Committee replaced Basel I with a new Basel Capital Accord which is commonly referred to as ‘Basel II’.

iii The three pillars of Basel II

Basel II is based on three pillars that are intended to be interdependent and mutually reinforcing:a Pillar 1 : Minimum capital standards;b Pillar 2 : The supervisory review process; andc Pillar � : Market discipline.

Pillar 1 replaced Basel I. It sets out the minimum capital requirements for banks. Pillar 2 sets out standards for banking supervisors in applying Basel II. In

particular, it requires that banking supervisors should have the power to compel banks to hold capital in excess of the 8 per cent minimum ratio where this is justified. This was


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already the case in some countries (for example, in the United Kingdom the Financial Services Authority had (and retains today) the power to set an individual capital ratio for banks in excess of the 8 per cent minimum ratio). Standards were also proposed for the control of interest rate risk in a bank’s loan portfolio, and to capture other risks not specifically covered under pillar 1 (for example, certain risks arising in securitisations).

Pillar � provides for extensive disclosure of information to the market. The intention was that pressure from a bank’s counterparties, analysts and rating agencies would serve to reinforce the minimum capital standards and ensure that banks carried on their business prudently. As we have seen in the financial crisis, it is highly debatable whether this aim was achieved even in those countries that implemented these requirements.

iv The structure of Basel II

Basel II provides a choice of different approaches for determining bank capital requirements. For example, it sets out three different ways of calculating credit risk and three or four ways of determining the capital charge for operational risk. Generally, banks are free to choose between more complex methodologies, with the potential for capital savings, and simpler approaches, that generally lead to a higher capital charge, but will have lower operational and systems costs.

The focus of Basel II is on internationally active banks. However, the Basel Committee still considers that the principles developed in Basel II may, when taken together with the reforms described later in this chapter, be suitable as an international benchmark. In addition, Basel II includes a simplified standardised approach containing all the simplest options for regulators that consider other approaches to capital calculations to be too complex.

Overall, Basel II is considerably more risk-sensitive than Basel I. It also marked a shift away from the approach in Basel I of allocating specific capital charges for particular exposures in favour of greater reliance on banks’ internal models and methodologies and external credit ratings. It was and remains the intention of the Basel Committee that most sophisticated banks will adopt internal models to determine their capital requirements once they have the operational capacity to do so, and it is expected that, in general, banks will continue to be encouraged by their national regulators to do so. Where banks decide not to progress to more advanced methodologies, to avoid higher capital charges because of the nature of their business portfolio, regulators will be able to impose an additional capital charge under pillar 2.

v Developmentof BaselIIbeforethefinancialcrisis

Basel II underwent a number of developments prior to the financial crisis. In July 2005 the Basel Committee published a document addressing the treatment of banks’ trading books under Basel II which it had prepared in conjunction with IOSCO. The Basel Committee integrated this document into Basel II and published a revised consolidated text of Basel II in June 2006.

The Basel Committee issued guidance on the sharing of information between banking regulators in relation to certain approaches to risk measurement under Basel II in 2006 and followed this with guidance on cooperation between regulators in this context in 2007.


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The workload and activism of the Basel Committee has increased very considerably since the start of the financial crisis. The following section summarises some of the most important activities of the Basel Committee in the past year.

III DEVELOPMENT OF THE BASEL II FRAMEWORK SINCE THE FINANCIAL CRISIS

i The limitations of Basel II

It is fair to say that critics of Basel II who blamed aspects of the financial crisis on features of that regime did not properly take into account the fact that when the crisis arose Basel II had not been implemented at all in a number of key jurisdictions and had not long been implemented in other jurisdictions. However, it is also fair to conclude that had Basel II been implemented in more countries for a longer period of time before the financial crisis, it is unlikely that the regime would have prevented many aspects of the crisis as they emerged. Hindsight is easy to employ, however, and there are many who argue that the crisis might not have been so severe had Basel II been implemented earlier.

In response to the crisis the Basel Committee has chosen to build on the Basel II framework rather than fundamentally change it. A consensus has emerged that there are a number of deficiencies in the existing Basel II regulatory framework that need to be addressed, including:a a focus on capital at the expense of leverage and liquidity;b a failure by firms and supervisors to see the overall picture;c inadequate capital requirements in respect of the trading book; andd deficiencies in respect of the treatment of securitisations.

The lack of emphasis on liquidity in the Basel II framework is striking. Capital requirements are concerned with solvency and seek to enable an institution to continue trading in times of financial adversity. However, a bank could equally fail as a result of insufficient liquidity. In its initial stages the financial crisis manifested itself through a lack of liquidity in such institutions as Northern Rock in the United Kingdom and Bear Stearns in the United States.

Another feature of the Basel II regime that has received criticism is that it did not impose restrictions on leverage. This gave rise to incentives for banks to engage in riskier trading activities in the relatively benign economic conditions that prevailed prior to the onset of the financial crisis in 2007, which boosted revenues and profits in that period, but at the same time increased systemic risk and the possibility of individual bank failure. A focus on capital also resulted in regulators neglecting the growth of systemic risk as they concentrated on the position of individual institutions in isolation.

In addition, the capital requirements for the banks’ trading book and securitisations failed to reflect the real level of risk in these areas. Financial institutions were, therefore, incentivised to book transactions in the trading book, many of which were illiquid assets such as the now-infamous collateralised debt obligations (‘CDOs’). In the absence of a ready market, institutions marked these assets to model, but little trading in these assets took place. Once the crisis broke, firms experienced increasingly large losses in their trading portfolios. Rating downgrades to assets became a significant cause of mark-


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to-market losses but, unlike credit defaults, the Basel II framework did not take this problem into account.

The financial crisis also demonstrated structural flaws in the value at risk (‘VaR’) models used by financial institutions: short observation periods combined with historically low volatility in market prices (with limited data sets that did not include data from a severe economic downtown), models systematically underestimating the significance of low frequency high impact events, overlooking the importance of systemic risk and the presence of uncertainties that are not capable of modelling. Perhaps most damning of all was that many of the senior managers of the institutions most at risk did not understand, and in many cases were not in a position to understand, these matters. This resulted in an overreliance in many institutions on technical staff who effectively determined matters of critical importance to the stability of the institutions concerned. In many cases banks’ trading book portfolios, or parts of them, proved to be extremely difficult to value, the models previously employed by the banks having broken down and senior management of many banks having lost confidence in those models and their seemingly indecipherable mathematical complexity.

The role of incentives to individuals in the form of their remuneration has, of course, also come under very close scrutiny in all of the countries that were adversely affected by the financial crisis.

ii The Basel Committee’s July 2009 reform package

The first package of changes to Basel II following the financial crisis was adopted by the Basel Committee in July 2009 and included the following:a increasing the capital charges of banks to securitisation exposures, including

introducing a higher capital charge for so-called re-securitisations (e.g., CDOs and certain conduits) as well as increasing the capital charge for certain liquidity facilities; banks that invest in securitisations will be required to carry out due diligence on the underlying asset pool and if they fail, or are unable, to do so they will be required to deduct such positions from their capital;

b eliminating the regulatory arbitrage under which banks that choose to hold securitisation exposures in their trading book can avoid higher capital charges – instead, capital requirements for such exposures will be aligned across the banking and trading books, based on the former’s requirements;

c improvements to banks’ models used to calculate capital charges for non-securitisation positions held in the trading book through the introduction of a new ‘stressed’ value at risk calculation taking into account a defined observation period relating to significant losses; the intention is to capture the risks of low frequency high impact ‘tail’ events, as well as significant market movements over a sustained period; and

d introduction of an incremental risk charge to cover the effect of credit risk mitigation (i.e., ratings downgrades) on a bank’s holdings of debt instruments in the trading book; this reflects the fact that trading book losses in the financial crisis did not principally result from defaults but from credit migrations combined with the widening of credit spreads and the loss of liquidity in assets.


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ii Strengthening the resilience of the banking sector: the Basel Committee’s December 2009 proposals

The Basel Committee’s July 2009 reform package addressed the treatment of trading book exposures. However, the Committee also recognised the need for a comprehensive set of measures to strengthen the regulation, supervision and risk management of the banking sector. The result was the Basel Committee’s consultation entitled ‘Strengthening the Resilience of the Banking Sector’, which was published on 17 December 2009. Through the proposals in this consultation the Basel Committee intends to:a improve the quality of bank regulatory capital by:

• harmonising the definitions of core tier 1 capital, non-core tier 1 capital and tier 2 capital;

• abolishing innovative tier 1 capital and tier � capital;• simplifying tier 2 capital by removing the current distinction between, and

limits on, upper and lower tier 2 capital;b establish a harmonised treatment for deductions from capital, with most

deductions being made from common equity (i.e., core tier 1 capital);c introduce new requirements to address counterparty risk on derivatives, repos

and securities financing transactions;d introduce a leverage ratio for banks as a backstop to the Basel II risk-based

framework; ande seek to promote the building up of capital buffers in good times that can be

drawn down in periods of stress.

The Basel Committee intends to review the minimum level of capital that banks should hold in the second half of 2010 to arrive at an appropriately calibrated level and quality of capital. The new rules are expected to be published by the end of 2010 with the aim of implementation by the end of 2012.

At the same time as its December 2009 consultation, the Basel Committee published a draft framework for liquidity risk measurement, standards and monitoring. The document proposes two standards for liquidity risk: a liquidity coverage ratio (to ensure that institutions have sufficient high-quality liquidity resources to survive an acute stress scenario lasting one month) and a net stable funding ratio (to promote resilience over a longer time horizon – one year – creating additional incentives for banks to fund their activities from more stable sources of funding).

iv Basel Committee initiatives since December 2009

The Basel Committee has published proposals on a number of important areas of banking regulation since December 2009, including assessment methodologies for remuneration principles and standards (January 2010), principles for enhancing corporate governance (March 2010) and good practice principles for supervisory colleges (March 2010). In addition, in March 2010 the Basel Committee published the report and recommendations of its Cross-Border Bank Resolution Group, setting out 10 recommendations under the headings of strengthening national resolution powers and their cross-border implementation, firm-specific contingency planning and reducing contagion.


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IV FINANCIAL STABILITY BOARD

Introduction

The Financial Stability Board, or ‘FSB’, has its origins in the Financial Stability Forum (‘FSF’), which was founded in 1999 by the Finance Ministers of the G7 countries.5 The foundation of the FSF arose from work carried out by the then Deutsche Bundesbank President, Hans Tietmeyer, on structures to enhance regulatory cooperation and cooperation between regulators and international financial institutions to promote international financial stability.

The FSF was re-established as the FSB at the G20 Summit held in London in April 2009 following calls in November 2008 by leaders of the G20 countries to enlarge the FSF’s membership and subsequent calls for the FSF to assume a more central role in developing structures and mechanisms to address international financial stability issues.6 So the FSB emerged from the G20 Summit in London with a broader mandate to promote financial stability.

The Charter and organisation of the FSB

The Charter of the FSB came into effect on 25 September 2009 and is not intended to create legal rights and obligations. It does, however, set out the FSB’s objective, which is:

to coordinate at the international level the work of national financial authorities and international

standard-setting bodies (‘SSBs’) in order to develop and promote the implementation of effective regulatory,

supervisoryandotherfinancialsectorpolicies.Incollaborationwiththeinternationalfinancialinstitutions,

theFSBwilladdressvulnerabilitiesaffectingfinancialsystemsintheinterestof globalfinancialstability.

The mandate and tasks of the FSB are stated in the Charter to be to:a assess vulnerabilities affecting the global financial system and identify and review

on a timely and ongoing basis the regulatory, supervisory and related actions needed to address them, and their outcomes;

b promote coordination and information exchange among authorities responsible for financial stability;

5 France, Germany, Italy, Japan, the United Kingdom, Canada and the United States.6 The member jurisdictions of the FSB now comprise Argentina, Australia, Brazil, Canada,

China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Switzerland, Turkey, the United Kingdom and the United States. Other members comprise the European Central Bank, the European Commission, international financial institutions (comprising the Bank for International Settlements, the International Monetary Fund, the Organisation for Economic Co-operation and Development (OECD) and the World Bank) and international standard-setting, regulatory, supervisory and central bank bodies (comprising the Basel Committee, the Committee on Payment and Settlement Systems, the Committee on the Global Financial System, the International Accounting Standards Board, the International Association of Insurance Supervisors and the International Organization of Securities Commissions).


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c monitor and advise on market developments and their implications for regulatory policy;

d advise on and monitor best practice in meeting regulatory standards;e undertake joint strategic reviews of the policy development work of the SSBs

to ensure their work is timely, coordinated, focused on priorities and addressing gaps;

f set guidelines for and support the establishment of supervisory colleges;g support contingency planning for cross-border crisis management, particularly

with respect to systemically important firms;h collaborate with the International Monetary Fund to conduct ‘early warning

exercises’; andi undertake any other tasks agreed by its members in the course of its activities and

within the framework of its Charter.

The FSB has also taken on the task of coordinating the alignment of the activities of the SSBs.

The FSB comprises a plenary group, steering committee, chairperson and secretariat. The ‘plenary’ is the decision-making body of the FSB and comprises representatives of the members of the FSB,7 chairs of the main SSBs and committees of central bank experts and senior representatives of the IMF, the World Bank, the Bank for International Settlements and the Organisation for Economic Cooperation and Development. The plenary may establish standing committees and working groups as necessary.

The steering committee of the FSB is mandated with providing ‘operational guidance’ for the FSB between meetings of the plenary. The duties of the steering committee include monitoring the progress of the FSB’s work, distributing information to members of the FSB and reviewing the policy development work of the SSBs for the plenary to consider.

The FSB has three standing committees, addressing assessment of vulnerabilities, supervisory and regulatory cooperation and implementation of standards.

The current chairperson of the FSB is Mario Draghi, governor of the Banca d’Italia. The FSB held its inaugural meeting in Basel in June 2009.

Activities of the FSB since its launch

i G20 London Summit (April 2009)

Before the London G20 Summit at which the FSB was launched, its predecessor, the FSF, published an important paper setting out recommendations and principles to strengthen the financial system, which included:a recommendations for addressing pro-cyclicality in the financial system (the

concern that regulatory measures could heighten booms but deepen recessions);

7 The representatives are to be at the level of central bank governor or immediate deputy, head or immediate deputy head of the main supervisory/regulatory agency and deputy finance minister.


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b principles for sound compensation practices (‘Principles for Sound Compensation Practices in Financial Institutions’); and

c principles for cross-border cooperation on crisis management.

This work fed into the preparation for that summit and a number of the FSF’s documents were endorsed at the summit itself.

ii Preparations for Pittsburgh

Following their meeting on 4 and 5 September 2009 and ahead of the G20 Summit held in Pittsburgh on 24 and 25 September 2009, G20 finance ministers and central bank governors published a communiqué reporting on their discussions, together with a more detailed declaration and progress report relating to the policy actions agreed at the Washington, DC and London G20 summits.

The communiqué included agreement on standards of corporate governance and compensation through:a greater disclosure and transparency of remuneration of employees whose actions

have a material impact on risk-taking within financial institutions;b global standards on pay structure (including on deferral of variable remuneration

(bonuses), effective clawback, the relationship between fixed and variable remuneration, and guaranteed bonuses) to ensure compensation practices are aligned with long-term value creation and financial stability; and

c corporate governance reforms to ensure board oversight of compensation and risk.

The FSB was requested to report to the Pittsburgh G20 Summit with specific proposals for achieving this framework, as well as to consider various approaches for limiting total variable remuneration in relation to risk and long-term performance.

The FSB held its second meeting in September 2009 and published a press release reporting on the matters that were discussed. The FSB’s assessment of risks, vulnerabilities and responses released after that meeting contained a prominent statement that:

Althoughmanyfinancialinstitutionshavereturnedtoprofitabilityinrecentquarters,thisowesmuchtothe

extraordinaryofficialmeasurestostabilisethesystem.Itisimportantthatfirmsretaintheseprofitsinorder

torebuildcapitaltosupportlendingafterofficialsupportmeasureshavebeenremovedandpreparetomeet

futurehighercapitalrequirements.Totheseends,banksneedtotakeacombinationof capitalconservation

measures,includingactionstolimitexcessivedividendpayments,sharebuybacksandcompensation.”

The FSB stated that it would, as requested by the G20 finance ministers, set out, for the G20 Pittsburgh Summit, specific implementation guidelines on the governance, structure and disclosure of compensation, which would ‘limit the level of compensation’ in the light of the need to conserve capital, and structure and align incentives with good risk management principles as set out in April 2009 in the Principles for Sound Compensation Practices in Financial Institutions.

The FSB also discussed the sustainability of the markets’ recent recovery, the market impact of rapidly rising government debt, the timing of exit strategies from


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current government support measures and how to sustain an appropriate balance and pace of regulatory reform.

iii G20 Pittsburgh Summit

The FSB submitted two reports to the G20 Pittsburgh Summit:a an interim report entitled ‘Overview of Progress in Implementing the London

Summit recommendations for Strengthening Financial Stability’, which describes the implementation to date of recommendations made by the FSB and the G20 at the April 2009 G20 Summit in London; and

b a report entitled ‘Improving Financial Regulation’, which sets out a number of reforms aimed at creating a more robust and less pro-cyclical financial system, including: • strengthening the global capital network for banks; • introducing a new minimum global liquidity standard; • reducing the moral hazard represented by systemically important

institutions; • strengthening accounting standards; • improving remuneration practices; • expanding oversight of the financial system to hedge funds and credit

rating agencies; • strengthening the robustness of the OTC derivatives market; • relaunching securitisation on a sound basis; and • promoting adherence to international standards.

The leaders of the G20 welcomed the reports and called on the FSB to report on progress to the G20 finance ministers and central bank governors in advance of the next G20 Summit to be held in Canada in June 2010.

iv G20StAndrewsmeetingof financeministersandcentralbankgovernors

The FSB published four reports submitted to the G20 Finance Ministers and Central Bank Governors at St Andrews on 7 November 2009:• ‘Progress since the Pittsburgh Summit in Implementing the G20 Recommendations

for Strengthening Financial Stability’. This report provided an update on the actions taken to implement policy measures designed to strengthen financial stability after the Pittsburgh Summit in September 2009. Updates were provided in relation to: building high quality capital and mitigating pro-cyclicality; strengthening accounting standards; reforming compensation practices to support financial stability; improving over-the-counter derivatives markets; addressing cross-border banking failures and systemically important financial institutions; strengthening adherence to international supervisory and regulatory standards; and other issues, such as those relating to hedge funds, credit rating agencies and crisis management.

• ‘Guidance to Assess the Systemic Importance of Financial Institutions, Markets and Instruments: Initial Considerations’. This report, written by the IMF, the Bank for International Settlements and the FSB, outlined conceptual and analytical


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approaches to the assessment of systemic importance and discussed a possible form for general guidelines that would be sufficiently flexible to apply to a broad range of countries and circumstances.8

• ‘The Financial Crisis and Information Gaps’. This report explored information gaps and provided appropriate proposals for strengthening data collection. One of its objectives was to assist in capturing the build-up of risk in the financial sector.

• ‘Exit from extraordinary financial sector support measures’. This report reviewed exit policies for the withdrawal of financial support arising from the financial crisis. It considered: recent developments; general considerations and principles to guide the formulation of exit strategies; and areas for potential coordination. It included as an attachment a report dated September 2009 entitled ‘Note by the Staffs of the International Association of Deposit Insurers and the International Monetary Fund on Unwinding Temporary Deposit Insurance Arrangements’.

January 2010 activity

i Peer review on compensation

In relation to remuneration, the FSB was requested by the G20 in September 2009 ‘to monitor the implementation of FSB standards and propose additional measures as required by March 2010’. As part of this, in January 2010 it launched a peer review, aimed at member jurisdictions, although it also requested input from financial institutions. The FSB asked for information from member jurisdictions in December 2009.

The information requested from financial institutions included descriptions of how compensation arrangements at financial institutions have changed in practice (governance, pay structures, risk adjustments), areas where implementation is proving challenging and issues of consistency in regulatory responses across sectors and jurisdictions. This information was to be provided by 1 February. Individual submissions will not be made public.

The press release that the FSB issued on this initiative included a template of questions addressed to member jurisdictions and space for inclusion of evidence from financial institutions.

This peer review was the first under a new FSB Framework for Strengthening Adherence to International Standards announced at the same time. Under this framework:a member countries of the FSB will disclose their level of adherence to international

financial standards;b they will undergo periodic thematic and single-country peer reviews to evaluate

their adherence to these standards; andc the FSB will identify non-cooperative jurisdictions (especially those of systemic

importance with weak adherence) and then assist them with adherence.

8 In this regard the International Association of Insurance Supervisors (‘IAIS’) published a note on 25 October 2009 setting out its initial analysis of the relationship between the insurance sector and systemic risk.


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Annex B of the Framework document contains a summary of the regulatory and supervisory standards concerning international cooperation and information exchange set out in these standards.

The FSB met in Basel on 9 January 2010. As well as the peer review on compensation and the framework to strengthen adherence to international standards mentioned above, members discussed:a financial conditions;b bank capital and liquidity;c reducing moral hazard and strengthening capacity for cross-border resolution – a

preliminary assessment will be presented to the June 2010 G20 summit with a final package due to be published by October 2010;

d the perimeter and consistency of regulation – the FSB welcomed a Joint Forum Report on the differentiated nature and scope of regulation and made clear that it would monitor policy developments on the issues identified and propose action where issues are not being addressed; and

e strengthening accounting standards – the FSB welcomed the International Accounting Standards Board’s plan to conclude its full review of the ‘financial instruments’ standard by the end of 2010.

Later in January 2010 the FSB took the opportunity presented by the announcement of US proposals to tackle the moral hazard risks from institutions that are ‘too big to fail’ to give an update on its work on that subject. The FSB began work on this topic in September 2009 and is due to make recommendations to the G20 in October 2010, with an interim report due shortly after the June 2010 G20 Summit.

March 2010 activity

The FSB published its peer review into the progress made in applying its ‘Principles for Sound Compensation Practices and their Implementation Standards’, together with a full set of recommendations, in March 2010. The review based its findings and recommendations on information collected from FSB members as well as private sector input, including a report (also published) commissioned from external consultants on industry progress and implementation challenges, and direct feedback from stakeholders invited via the FSB’s website.

The report found that there had been material progress but that effective implementation was far from complete. The report concluded that a sustained and cooperative effort would be needed to align effectively the compensation structures in major financial institutions with prudent risk-taking by the end of 2010.

Among its specific recommendations, the FSB called on the Basel Committee to consult by the end of October 2010 on the range of methodologies for risk and performance alignment of compensation schemes and their effectiveness in light of experience to date. The FSB also proposed that the Basel Committee should, in consultation with the FSB, also consider incorporating disclosure requirements for compensation into pillar � of Basel II, to add greater specificity to the current requirements for compensation disclosure under pillar 2, by the end of 2010.


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The FSB stated that it would conduct a follow-up review on compensation in the second quarter of 2011.

Subsequent activity

The FSB is currently working on its next peer review, on the theme of risk disclosures by market participants. The FSB has also launched its first country peer reviews, looking at the implementation and effectiveness of financial sector standards and policies agreed with the FSB in Italy, Mexico and Spain.

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Chapter 34

United KingdomJan Putnis*

Slaughter and may

* Jan Putnis is a partner at Slaughter and may.

I THE REGULATORY REGIME APPLICABLE TO BANKS

Relationship with the prudential regulator

the Financial Services Authority (‘FSA’) is the banking regulator in the United Kingdom and undertakes both prudential supervision of banks and regulates their conduct of business. the authority of the FSA stems from the Financial Services and markets Act 2000 (as amended) (‘FSmA’). FSmA empowers the FSA to make rules and guidance governing, amongst other matters, the prudential and conduct of business regulation of banks, insurance companies and investment firms. It has done so in the FSA Handbook of Rules and guidance, which is divided into numerous volumes (referred to variously as ‘sourcebooks’ or ‘manuals’), many of which are relevant to a wide variety of the different financial services firms that the FSA regulates.

the FSA’s Principles for Businesses underpin these rules and comprise a series of high-level principles governing prudential and conduct of business matters for FSA-authorised firms. Of most importance in the context of prudential regulation is Principle 4 (financial prudence), which states simply that ‘a firm must maintain adequate financial resources’. Arguably the most important principle in the context of conduct of business regulation is Principle 6 (customers’ interests), which states that ‘a firm must pay due regard to the interests of its customers and treat them fairly’.

the Bank of england is not as such a banking regulator in the United Kingdom. Its role is currently largely confined to formulating and implementing monetary policy and maintaining monetary and financial stability in the United Kingdom. At the time of writing it is likely, however, that the Bank of england will assume certain responsibilities regarding ‘macro-prudential’ supervision following the arrangements agreed on the formation of the present coalition government in may 2010.

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Under the FSmA it is a criminal offence for a person to engage in ‘regulated activities’ by way of business in the United Kingdom unless he is authorised to do so (an ‘authorised person’) or exempt from the authorisation requirement. Regulated activities are described in secondary legislation made under the FSmA.1 Accepting deposits is such a regulated activity where such deposits are lent to third parties or where any other activity is financed wholly or to a material extent out of capital or interest on deposits. Banks therefore require FSA authorisation to carry on deposit-taking activities in the United Kingdom.

other regulated activities under the FSmA that may be relevant to banks include dealing in investments as principal, dealing in investments as agent, arranging deals in investments, advising on investments, managing investments, certain residential mortgage lending activities and safeguarding and administering investments (custody activities). the ‘investments’ to which these activities relate are set out in secondary legislation2 and include shares, debentures, public securities, warrants, futures, options, contracts for differences and units in collective investment schemes.

the FSA has a number of statutory objectives, which are:a maintaining confidence in the financial system;b promoting public understanding of the financial system;c securing the appropriate degree of protection for consumers;d the reduction of financial crime; ande contributing to the protection and enhancement of the stability of the UK

financial system.3

In discharging its functions the FSA is required to have regard to:a the need to use its resources in the most efficient and economic way;b the responsibilities of those who manage the affairs of FSA authorised persons;c the principle that a burden or restriction should be proportionate to the

benefits;d the desirability of facilitating innovation;e the international character of financial services and markets and the desirability

of maintaining the competitive position of the United Kingdom;f the need to minimise adverse effects on competition; andg the desirability of facilitating competition between those subject to regulation.

Consumer credit is regulated by the Office of Fair Trading (‘OFT’) under the Consumer Credit Act 1974 (as amended).

the Banking Act 2009 introduced a new ‘special resolution’ regime for banks and is intended to facilitate the orderly ‘resolution’ (i.e., wind down) of banks in financial

1 the Financial Services and markets Act 2000 (Regulated Activities) order 2001 (as amended) (Si 2001/544).

2 Ibid.� This last objective (referred to as the ‘financial stability objective’) was introduced by the

Financial Services Act 2010 with effect from 8 April 2010.

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difficulties. This legislation also established new insolvency proceedings for banks and formalised the Bank of england’s role regarding inter-bank payment systems.

the FSA carries out its supervisory powers through its ‘Advanced Risk-Responsive operating frameWork’ (referred to as ‘ARRoW’), which involves the FSA seeking to identify the risks that a firm poses to the FSA’s statutory objectives and then seeking to mitigate those risks. The FSA has extensive powers to investigate and to require information from regulated businesses and carries out regular ARROW visits to firms. The FSA allocates banks to one of three categories: ‘small firms’, ‘ARROW light’ and ‘full ARRoW’. An individual at the FSA (normally referred to as the ‘supervisor’) is assigned to banks in the latter two categories. that individual acts as the main point of contact between the FSA and the bank.

Management of banks

individuals performing management functions at FSA-regulated banks are subject to the FSA’s ‘approved persons’ regime under the FSmA. this section provides an overview of that regime and provides a summary of the liabilities of approved persons.

i Approved persons

Any individual carrying on a ‘controlled function’ in relation to an authorised firm’s performance of a regulated activity must be approved by the FSA (an ‘approved person’),4 whether the firm is carrying on the activity itself or through its contractors. Further details regarding the controlled functions are set out below.

ii The role of approved persons

the current controlled functions are listed in the Supervision manual of the FSA Handbook. There are currently a total of 15 controlled functions, not all of which are relevant to banks. Those that are relevant to banks include the director, chief executive, ‘apportionment and oversight’, money-laundering reporting, compliance oversight, systems and controls, significant management and customer functions.

the controlled functions are divided into broad categories, the most important of which are termed ‘significant influence functions’. These are functions that are likely to result in the person performing them exercising significant influence over the conduct of the firm’s regulatory affairs. This is a question of fact in every case and depends on the individual circumstances. Controlled functions may be combined in one or more individuals.

The ‘required functions’ are those of the controlled functions that the FSA expects every authorised firm (including every bank) to have where appropriate to its business. these include the apportionment and oversight function and the money-laundering reporting function.

The systems and control function is to ensure that an authorised firm has appropriate systems and controls in place in order to comply with Principle 3 of the FSA’s Principles for Businesses, which provides that a firm must take reasonable

4 FSmA, Section 59.

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care to organise and control its affairs responsibly and effectively, with adequate risk-management systems. the systems and controls function is the function of acting in the capacity of an employee of the firm (with the appropriate expertise and authority to carry out this function) with responsibility for reporting to the governing body of a firm, or the audit committee (or its equivalent) in relation to:a its financial affairs;b setting and controlling its risk exposure; andc adherence to internal systems and controls, procedures and policies.

The significant management function only applies to firms who apportion significant responsibility to a senior manager of a significant business unit. As such, this function generally only applies to the larger and more complex firms or groups. Whether someone falls within the significant management function will depend on a number of factors, such as the size of the firm, group and management structures and the size of international operations of the firm. Whether a business unit is ‘significant’ will also depend on factors such as the size of the unit, its contribution to capital or income of the firm and its risk profile.

the customer function covers activities under which a person deals with the firm’s clients in order to give advice on investments, manage investments or deal in investments.

iii Qualificationsof approvedpersons

Approval is only granted by the FSA if it is satisfied that the individual candidate is a fit and proper person to perform the controlled function for which an application for approval has been made. In accordance with the FSA Handbook’s ‘Fit and Proper test for Approved Persons’ Sourcebook, the FSA will have regard to a number of factors when assessing the fitness and propriety of an individual to perform a particular controlled function. the most important are concerned with the individual’s:a honesty, integrity and reputation; b competence and capability; and c financial soundness.

In addition, a firm must employ approved persons with the skills, knowledge and expertise necessary for the discharge of the responsibilities allocated to them (the ‘competent employees rule’). this also includes achieving a good standard of ethical behaviour. The FSA Handbook’s Training and Competence Sourcebook also provides guidance on the training and supervision that employees, including approved persons, will require in order to ensure that the competent employees rule is complied with.

The FSA is currently looking very carefully at the qualifications of prospective directors of banks and will now generally interview them before approving them as such.

iv Liabilities of approved persons

If the FSA considers that an approved person is no longer fit and proper to undertake their responsibilities, the FSA has the power under Section 63 of the FSmA to withdraw its approval of that person, taking into account any factor that it would take into account

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in relation to a grant of approval. the FSA will take into account, among other things, the criteria for fitness and propriety, failures to comply of the FSA’s Statements of Principle and Code of Practice for Approved Persons (‘APER’) and the qualifications and training of the approved person, before deciding whether to withdraw approval. in addition, the FSA may decide to use its powers under Section 56 of the FSmA to issue a prohibition order on the approved person, prohibiting him or her from carrying on any specified function in relation to regulated activities.

An approved person must also comply with APeR. APeR sets out a number of high-level statements of principle for approved persons including, for example, requirements that approved persons act with integrity, due skill, care and diligence. If an approved person fails to comply with these statements of principle (guidelines on which can be found in APeR 3), or is knowingly concerned in a contravention by the authorised firm of any requirement imposed on it by or under the FSMA, the FSA may fine the approved person and/or issue a public statement concerning the misconduct in accordance with Section 66 of the FSMA. In determining the level of the fine, the FSA will take into account a number of factors, including whether the approved person received a benefit from the breach and the resources available to the approved person. As mentioned above, the FSA may also issue a prohibition order against the approved person.

APeR makes clear that an approved person will only breach a statement of principle when he or she is personally culpable (i.e., where the approved person’s conduct was deliberate or his or her standard of conduct was below that which would be reasonable in all the circumstances). it is also important to note that disciplinary action will not necessarily be taken against an approved person performing a significant influence function simply because a regulatory failure has occurred in an area of business for which he or she is responsible.

Statement of Principle 4 in APeR states that an approved person must deal with the FSA and with other regulators in an open and cooperative way and must disclose appropriately any information of which the FSA would reasonably expect notice. This duty is fundamental and applies to all approved persons, regardless of seniority.

third parties (e.g., customers) do not have a general right of action against approved persons for breach of their regulatory obligations. Under Section 150 of the FSmA, third party rights of action can only be brought for contraventions by authorised firms of an FSA/FSMA rule, and may normally only be brought by a private person. However, third-party actions against approved persons under the common law (e.g., for breach of contract, torts or deceit) may still be possible if the requisite elements of the relevant common law claim are established.

Under Section 382 of the FSmA the FSA can apply to a court for a restitutionary action against an approved person to recover any profits made from a contravention of a regulatory requirement, such as a failure to comply with APER.

Authorised firms are prohibited from providing insurance policies that indemnify any person against any financial penalties imposed by the FSA under the FSMA, but this prohibition does not apply to certain contractual indemnities (for instance, as part of an employment contract with the authorised firm). However, an indemnity may fall foul of common law provisions rendering it void or unenforceable if it purports to indemnify against deliberate, fraudulent or criminal wrongs. In addition, extensive indemnities may be contrary to the FSA Principles for Businesses. if the indemnity is provided in respect

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of a director of a UK-incorporated company, the Companies Act 2006 imposes certain restrictions. in particular, that Act prohibits indemnities against any sums payable to a regulatory authority by way of penalty in respect of non-compliance with any requirement of a regulatory nature (however arising) and ‘any requirement of a regulatory nature’ would include for this purpose a requirement arising under FSA rules.

v Directors of parent undertakings

Additional FSA rules in force extend to directors and officers of parent undertakings of banks and other FSA authorised persons the requirements to be approved where their decisions or actions are regularly taken into account by the directors of the authorised person. This requirement extends to such directors and officers of non-UK parent undertakings.

II PRUDENTIAL REGULATION

i Regulatory capital

The EU Capital Requirements Directive5 has been implemented in the UK by the Capital Requirements Regulations 20066 and, more particularly, by FSA rules set out in the FSA’s Senior management Arrangements, Systems and Controls Sourcebook (‘SYSC’), general Prudential Sourcebook (‘genPRU’) and Prudential Sourcebook for Banks, Building Societies and investment Firms (‘BiPRU’).

The FSA requires UK banks to hold capital in respect of both credit risk and market risk. For these purposes, credit risk is, broadly, the risk that a debtor will not repay a loan at maturity, or that a counterparty will not perform an obligation due to the bank. market risk measures the risk of a bank suffering losses as a result of changes in market prices where it has invested in debt or equity securities, or in derivatives or physical commodities.

Whether a particular exposure is subject to the rules on credit risk or market risk normally depends on the bank’s intention in entering into the transaction. the rules on market risk apply to trading activity where the bank’s purpose is to make a profit, or avoid a loss, from short-term changes in market prices (i.e., proprietary trading). Such trading positions constitute the bank’s ‘trading book’. All other exposures and investments are treated under the credit risk framework. this includes ordinary bank lending. Investments made to generate an income stream, or to benefit from increases in their value over the medium to long term, are normally subject to the requirements in respect of credit risk.

in addition, banks must hold capital in respect of operational risk.in respect of credit risk, banks have a choice between a ‘standardised approach’

and ‘advanced approaches’. The standardised approach sets capital charges for exposures

5 The EU legislation commonly referred to as the ‘Capital Requirements Directive’ or ‘CRD’ in fact comprises two recast directives, the Banking Consolidation directive (2006/48/eC) and the Capital Adequacy Directive (2006/49/EC).

6 Si 2006/3221.

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to particular classes of counterparty (e.g., corporates, inter-bank, retail, mortgages, etc.). The capital charge generally depends on the external credit rating of the counterparty. The FSA requires capital to be held in respect of both assets and also off-balance sheet exposures. For the latter, a formula applies to convert off-balance sheet exposures into a notional on-balance sheet amount which is then subject to capital requirements.

Banks may obtain FSA approval to use internal models to calculate their capital requirements for credit risk. The FSA recognises two such ‘advanced approaches’: the foundation internal ratings-based approach (‘foundation iRB’) and the advanced internal ratings-based approach (‘advanced IRB’). Under foundation IRB, banks are required to determine the probability of default of exposures; the other risk factors are determined based on supervisory estimates, which are then fed into a formula to determine the capital charge for such exposures. Under advanced IRB, banks themselves determine all the risk factors based on their own internal estimates. Banks using their internal models may also use such models to calculate the capital requirements for off-balance sheet liabilities.

FSA requirements for market risk follow a ‘building block’ approach, identifying particular risks against which capital must be held. it follows that if a transaction gives rise to more than one type of risk it may trigger several different capital charges. Capital is required to be held in respect of position risk, counterparty risk, foreign exchange risk, commodities risk and large exposures risk. Banks can (with FSA approval) use an internal model to calculate their capital requirements for market risk. This is a different type of model to that used for determining capital charges for credit risk.

The FSA also imposes restrictions on certain large exposures of banks.

ii Types of capital

Under the FSA’s rules in GENPRU, bank regulatory capital is classified according to the broad scheme promulgated by the Basel Committee on Banking Supervision and implemented in the European Union pursuant to the Capital Requirements Directive. in summary:a Banks established in the UK are likely to require regulatory capital considerably

greater than the current minimum of 8 per cent of risk-weighted assets once the package of reforms to Basel that has been proposed (‘Basel 3’) is implemented. Current FSA supervisory policy already generally requires UK banks to hold considerably more capital than this minimum.

b At least half (possibly more) of this capital will need to be in the form of ‘core tier 1 capital’, that is, broadly, ordinary share capital and reserves (the Basel Committee proposes that this be the ‘predominant’ form of tier 1 capital). the remainder of the tier 1 capital could comprise other forms of tier 1 capital. While at present some forms of perpetual (i.e., undated) deeply subordinated debt can count as tier 1 capital, there is uncertainty as to whether or how, in the long term, any form of debt will count for this purpose.

c During the financial crisis, both investors and banking regulators have been focusing on how much tier one capital banks hold. there is currently no clear consensus on how much additional, non-tier one, capital banks should have in the future. Further guidance on expected ratios for core tier 1 capital, total tier 1 capital and total capital is expected to be published by the Basel Committee later in 2010. Non-tier 1 capital

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is likely to be limited in the future to tier 2 capital, which can include certain forms of perpetual and dated deeply subordinated debt.

d The actual amounts of capital that will be required will depend on the bank’s risk-weighted assets. there are various ways of calculating risk weighted assets. The FSA may require that a new bank start by using the ‘standardised approach’ mentioned above, which is the most formulaic method of calculating risk-weighted assets and is set out in the FSA’s rules. if a bank can convince the FSA that it has sufficiently sophisticated risk modelling methods itself then the FSA may then allow the bank to move to an iRB model that the FSA has approved.

iii Group supervision

The requirements for credit risk, market risk and operational risk apply to individual banks on a stand alone, or ‘solo’, basis. in addition, the FSA carries out consolidated supervision of banking groups. The relevant requirements are complex. However, the basic principle is that banking groups must hold sufficient capital, on a group-wide basis, to cover the assets and off-balance sheet liabilities of members of the group.

Consolidated supervision generally applies at the level of a parent undertaking incorporated in the european economic Area7 together with its subsidiary undertakings that are banks, investment firms, or which carry on broadly defined ‘financial’ activities. Subsidiary undertakings are consolidated in full. In addition, banks are required to include within the scope of consolidated supervision ‘participations’. A ‘participation’ is, broadly, a holding of 20 per cent or more of the share capital in another undertaking. Participations are consolidated on a proportionate basis.

iv Liquidity

The FSA has also made rules regarding the liquidity resources of banks. These, and other recent developments in the prudential regulation of banks in the areas of regulatory capital, remuneration and recovery and resolution plans, are considered in a little more detail in Section Vi, infra.

III CONDUCT OF BUSINESS

Until 2009, the conduct of business of banks in the context of deposit-taking activities was not subject to detailed regulation by the FSA, although consumer credit activities have long been regulated by the oFt under the Consumer Credit Act 1974 (as amended). the FSA regulates certain mortgage lending and related activities.

there are certain overarching legal and regulatory principles that UK banks must consider in the context of the conduct of their businesses. The FSA’s Principles for Businesses noted above, including in particular the principle that firms must treat their customers fairly (‘tCF’), apply to banks as they do to other FSA authorised persons. the tCF principle is primarily concerned with retail customers, although in principle

7 the european economic Area comprises the member States of the european Union together with iceland, Liechtenstein and norway.

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it can apply to the treatment of professional clients too. It extends beyond the direct treatment of those customers to all of the activities of an FSA-authorised person that affect customer outcomes.

Another important point of concern to UK banks is that there is UK legislation that renders void or unenforceable certain unfair or unreasonable terms in consumer and certain other contracts. there are also restrictions in the FSA’s rules on an authorised person seeking to exclude or restrict, or to rely on any exclusion or restriction of, any duty or liability it may have to a customer unless it is reasonable to do so and the duty or liability does not arise under FSmA or FSA rules.

i Banking Conduct of Business Rules

the FSA’s Banking Conduct of Business Sourcebook (‘BCoBS’), which was introduced in 2009, contains rules on such matters as communications with customers and financial promotions, post-sale requirements and cancellation rights in relation to banking products. they represent a relatively ‘light-touch’ regime of conduct of business regulation when compared with the regimes that the FSA applies to insurers and investment firms in the United Kingdom. The BCOBS is the first set of conduct of business rules relating to deposit-taking that the FSA has promulgated. To a large extent these rules codify a former set of non-binding requirements that were set out in the Banking Code.

ii Mortgage regulation

The FSA’s Mortgage and Home Finance Conduct of Business Sourcebook (‘MCOB’) contains the FSA’s rules in respect of regulated activities associated with regulated mortgage contracts. these rules apply to persons (whether or not they are banks) carrying on the regulated activities associated with mortgages, including entering into regulated mortgage contracts as lender and administering, arranging and advising on such contracts. these contracts are broadly loans secured on first legal mortgages on land in the United Kingdom where at least 40 per cent of that land is used, or intended to be used, as or in connection with a dwelling by the borrower where the borrower is an individual or a trustee. the rules in mCoB relate to such matters as advising and selling standards, disclosure obligations, both at the pre-application and offer stages of the negotiation of a regulated mortgage contract, arrears and repossessions and equity release products.

HM Treasury announced in March 2010 that the regulation of second charge mortgages would be transferred to the FSA and that certain additional mortgage-related activities would become regulated activities for the purposes of FSmA.

iii Consumer Credit Act 1974 (as amended) (‘CCA’)

the CCA applies to most consumer lending in the United Kingdom, although notable exceptions include regulated mortgage contracts. The CCA applies to all persons engaging in the activities to which it relates, and not just to banks. in addition to lending itself, the CCA also regulates some related activities such as credit brokerage, debt collecting and the provision of some credit reference services. in addition to consumer credit activities, with which the CCA is principally concerned, it also regulates some business lending and hire purchase activities.

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Persons, including banks, carrying on activities to which the CCA relates may only do so if they have an appropriate consumer credit licence from the oFt. the oFt takes a number of factors into account when deciding whether to grant such a licence, including the fitness and properness of the applicant.

the CCA regulates credit agreements and renders them void (or enforceable only in the discretion of the court) if they do not comply with detailed prescribed requirements set out in extensive secondary legislation. The Consumer Credit Act 2006 amended the CCA and introduced an additional means by which the court may refuse to enforce credit agreements if it creates and ‘unfair relationship’ between the debtor and the creditor.

the CCA and related secondary legislation implement an eU directive in the United Kingdom,8 although the provisions of the CCA and that secondary legislation are much more detailed and extensive than the minimum requirements of that EU legislation.

iv Investment business

As previously noted, in addition to deposit-taking activities, the FSA also regulates a wide range of investment business carried on in the UK, including dealing in investments, managing investments and investment advice. Where a bank intends to carry on these regulated activities it must obtain prior authorisation to do so under FSmA. these activities are also subject to their own detailed conduct of business rules, including, most notably, the rules in the FSA’s Conduct of Business Sourcebook (‘CoBS’) as well as the Principles for Businesses referred to above.9

v Payment services

the United Kingdom has implemented the eU Payment Services directive10 (‘PSd’) substantially through the Payment Services Regulations 200911 (‘PSRs’). there are also a small number of payment services-related rules in the FSA Handbook. The PSRs came into force on 2 march 2009 for the purpose of allowing applications for authorisation as a payment institution to be made, and came into force in full on 1 november 2009.

the FSA is the ‘competent authority’ for most aspects of the PSd. two other authorities have been given responsibilities under the PSRs. The Office of Fair Trading (‘oFt’) deals with competition issues relating to access to payment systems and the Financial ombudsman Service (‘FoS’) provides a dispute resolution service. in addition, HM Revenue and Customs is responsible for supervising the anti-money-laundering compliance of money service businesses under the money Laundering Regulations 2007.

8 the Consumer Credit directive (87/102/eeC, as amended by 90/88/eC and 98/7/eeC), now replaced and extended by the 2008 Consumer Credit Directive (2008/48/EC).

9 the United Kingdom has implemented the eU markets in Financial instruments directive (‘miFid’) (2004/39/eC) and its eU implementing measures by means of legislation and FSA rules.

10 2007/64/eC.11 Si 2009/209, as amended by the Payment Services (Amendment) Regulations 2009 (Si

2009/2475).

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the PSRs:a introduced a new authorisation and prudential regime for payment service

providers that are not banks, building societies or e-money issuers (and so already authorised or certificated by the FSA); such businesses are known as ‘authorised payment institutions’ or ‘authorised Pis’ – authorised Pis are able to passport their services to other EEA states;

b allow payment service providers operating beneath a certain average monthly turnover threshold to be registered instead of obtaining authorisation; such ‘small payment institutions’ or ‘small PIs’ will be unable to passport;

c exempt certain payment service providers (for example, banks, and authorised and small e-money issuers) from the authorisation/registration requirements;

d set out conduct of business requirements; in this context, this means requirements for information to be provided to payment service users, and specific rules on the respective rights and obligations of payment service users and providers; these requirements are applicable to all payment service providers, whether they are payment institutions, banks, building societies, e-money issuers or any other category; and

e stipulate that rules governing access to payment systems should be non-discriminatory, subject to certain exemptions.

IV FUNDING

UK banks raise funding from a number of different sources. in addition to deposits, inter-bank lending and wholesale funding, it is expected that receipts from securitisations will become more important as the securitisation market recovers following the financial crisis.

the ability of FSA-authorised banks to rely on sources of funding from within their groups to meet liquidity requirements is limited under the FSA’s rules. This is only possible if the bank obtains a waiver from the FSA and the FSA is only likely to grant such a waiver if the liquidity is to be provided by another UK group company and the FSA is satisfied with the terms, the availability and the enforceability of the intra-group funding involved.

The Bank of England also makes available certain liquidity facilities to UK banks, in particular through its discount window facilities and open market operations.

V CONTROL OF BANKS AND TRANSFER OF BANKING BUSINESS

Control regime

i Outline of the UK regime

The UK has implemented the EU Acquisitions Directive,12 which concerns the prudential rules and evaluation criteria for the prudential assessment of acquisitions and increases

12 2007/44/eC.

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of holdings in the financial sector. Under the implementing provisions, which are set out in the FSMA, any person (whether acting alone or in concert) who decides to acquire or increase control of an entity which is authorised by the FSA must first obtain the approval of the FSA. Such entities include companies or partnerships that are authorised by the FSA to accept deposits in the United Kingdom and hence include all FSA-authorised UK banks. ‘Control’ for these purposes includes a shareholding or voting rights of 10 per cent or more in the bank or its parent undertaking. Completion of such an acquisition without prior FSA approval is a criminal offence, and may also result in the acquirer’s shareholding rights being restricted or a court ordering the sale of the shares.

An existing controller of an FSA-authorised entity that decides to reduce control over a bank, or cease to be its parent undertaking, or cease to be a controller of that bank, is required to give notice of such intention to the FSA, and commits a criminal offence if it fails to do so. There is, however, no requirement for FSA approval for such a transaction.

In addition, an FSA-authorised bank is required by FSA rules to take reasonable steps to keep itself informed about the identity of its controllers, and to notify the FSA as soon as it becomes aware that any person has decided to acquire control or to increase or reduce control of the bank.

ii Scope of the UK regime

the FSA’s change of control rules apply to all entities which carry on one or more ‘regulated activities’ in the UK. Thus, all banks, insurance companies and firms carrying on investment business (which includes dealing and arranging deals in investments, managing investments and providing investment advice) in the United Kingdom are prima facie within the scope of the regime, although overseas firms operating through branches in the UK are subject to different requirements.13

It should also be noted that, in addition to acquisitions or disposals of banks and their parent undertakings, the FSA’s change of control regime may also be relevant in relation to:a stakebuilding exercises in actual or potential public bid situations where the target

or one of its subsidiary undertakings is an FSA-authorised company;b joint ventures involving FSA-regulated business;c group reorganisations involving FSA-authorised companies (even where there is

no change in the ultimate parent company);d taking security over shares in FSA-authorised companies or shares in companies

which are controllers of such authorised entities; ande certain investment management, custody and stock lending agreements.

13 general insurance brokers and other insurance intermediaries, mortgage intermediaries, building societies, friendly societies and certain other businesses, are also subject to FSA regulation but are not covered by the Acquisitions Directive (‘non-directive firms’). Non-directive firms are subject to a slightly modified version of the change of control regime, which we do not consider further here.

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iii Meaning of ‘control’

For the purposes of the FSMA requirements and the FSA’s rules, ‘control’ is broadly defined. A person (‘A’) will have ‘control’ over a UK FSA-authorised bank (‘B’) for the purposes of the regime if that person:a holds 10 per cent or more of the shares in B or a parent undertaking (‘P’) of B;b holds 10 per cent or more of the voting power in B or P; orc holds shares or voting power in B or P as a result of which A is able to exercise

significant influence over the management of B.

A will be treated as increasing his or her control over B, and therefore requiring further approval from the FSA, if the level of shareholding or voting power in B or, as the case may be, P, increases by any threshold step. the threshold steps occur at 10 per cent, 20 per cent, 30 per cent and 50 per cent.14

in determining the level of a controller’s or potential controller’s shareholding or voting power for these purposes, the controller’s shareholdings or voting power are aggregated with those of any person with whom he or she is ‘acting in concert’. there is no statutory definition of ‘acting in concert’ for these purposes.15

iv The FSA’s approach

Following the implementation of the Acquisitions Directive, the FSA must:a consider the suitability of the acquirer and the financial soundness of the

acquisition in order to ensure the sound and prudent management of the UK-authorised person;

b have regard to the likely influence that the acquirer will have on the UK-authorised person; and

c disregard the economic needs of the market.

If there are any supervised institutions within the acquiring group, the FSA must consult any appropriate home state regulator before completing its assessment. the FSA may only object to an acquisition if there are reasonable grounds for doing so on

14 Certain shareholdings may be disregarded in certain circumstances. most of these disregarded holdings apply where the acquirer is a credit institution, an investment firm (or its parent), a UCitS management company (or its parent), a custodian or its nominee or an underwriter of a securities offering (in each case acting in its capacity as such).

15 the Committee of european Banking Supervisors (‘CeBS’), the Committee of european Securities Regulators (‘CeSR’) and the Committee of european insurance and occupational Pensions Supervisors (‘CeioPS’) have issued ‘guidelines for the Prudential Assessment of Acquisitions and Increases in Holdings in the Financial Sector’ (‘�L� Guidelines’) aimed at setting out a standardised approach across the eU. these provide that: ‘persons are ‘acting in concert’ when each of them decides to exercise his rights linked to the shares he acquires in accordance with an explicit or implicit agreement made between them’, but some uncertainty still remains. in addition, in April 2010 the FSA launched a consultation on new guidance for the FSA Handbook on the meaning of ‘acting in concert’ for these purposes.

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the basis of the assessment criteria listed below, or if the information provided by the applicant is incomplete. if contemplating raising an objection, the FSA may also take into account whether the applicant has cooperated with any information requests made or requirements imposed by the FSA.

the assessment criteria are:a the reputation of the acquirer;b the reputation and experience of any person who will direct the business of the

UK-authorised person as a result of the proposed acquisition;c the financial soundness of the acquirer, in particular in relation to the type of

business that the UK-authorised person pursues or envisages pursuing;d whether the UK-authorised person will be able to comply with its prudential

requirements (including the threshold conditions in relation to all of the regulated activities for which it has or will have permission);

e if the UK-authorised person is to become part of a group as a result of the acquisition, whether that group has a structure which makes it possible to:• exercise effective supervision;• exchange information among regulators; and• determine the allocation of responsibility among regulators; and

f whether there are reasonable grounds to suspect that, in connection with the proposed acquisition:• money laundering or terrorist financing is being or has been committed or

attempted; or• the risk of such activity could increase.

the FSA may impose conditions on its approval where it would otherwise object to the acquisition. However, it may not impose conditions requiring a particular level of holding to be acquired.

v The FSA’s change of control regime in practice

the FSA has an ‘assessment period’ of 60 working days (plus any permitted interruption period) from the date upon which it acknowledges receipt of the application for approval to decide whether or not to approve a change of control. the FSA may, no later than the 50th working day of the assessment period, ask for further information to complete its assessment, and may interrupt the assessment period no more than once for up to 20 working days while this information is provided (30 working days if the notice-giver is situated or regulated outside the european Union, or is not subject to supervision under certain financial services directives).

If there are any supervised institutions within the acquiring group, the FSA must also consult any appropriate home state regulator before completing its assessment, and this may have an impact on the timetable.

Although, in many cases, the process can be completed well within the maximum time allowed, it can never be assumed that this will be possible.

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vi Further reform

The European Commission is committed to reviewing the application of the Acquisitions directive, and to submitting a report to the european Parliament and to the Council (together with any appropriate proposals) by 21 march 2011.

A recent Communication by the european Commission on reform has indicated that three new european Supervisory Authorities (a european Banking Authority, a european insurance and occupational Pensions Authority and a european Securities Authority) ‘could’ be involved in the prudential assessment of european mergers and acquisitions in the future.

vii Other UK issues

the description above deals only with certain issues arising under the FSmA. it should be noted that, in addition to the FSMA requirements, change of control in a UK bank may also give rise, among other things, to issues under the City Code on takeovers and mergers, the data Protection Act 1998, the CCA, the Pensions Act 2004 and the rules of any exchange of which the bank is a member.

it will also be necessary in some cases to consider other aspects of the FSmA, in particular the requirements for individuals performing controlled functions within an authorised firm to be approved in advance by the FSA, and regulatory capital requirements.

Transfers of banking business

it is possible to transfer a banking business in the UK by way of a court-sanctioned banking business transfer scheme under Part Vii of the FSmA (a ‘Part Vii transfer’). this does not, however, prevent the use of other mechanisms for the transfer or assumption of assets and liabilities relating to banking businesses by other means, such as assignments or novations.

i Part VII transfers

A Part Vii transfer of banking business is referred to as a ‘banking business transfer scheme’ in Part VII of FSMA, and is defined as a scheme that:a satisfies one of the conditions in Section 106(2) of the FSMA. The conditions

in section 106(2) include a condition that ‘the whole or part of the business carried on by a UK authorised person who has permission to accept deposits… is to be transferred to another body…’; it is also possible to undertake a Part VII transfer under which ‘the whole or part of the business carried on in the United Kingdom by an authorised person who is not a UK authorised person but who has permission to accept deposits… is to be transferred to another body which will carry it on in the United Kingdom…’;

b is one under which the whole or part of the business to be transferred includes the accepting of deposits; and

c is not an excluded scheme as defined by the FSMA.

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the business to be transferred must include deposit-taking activities carried on in the United Kingdom. these activities must form an integral part of that business, but need not be the sole or predominant business carried on.

A banking business transfer scheme takes effect without the consent of the depositors or other counterparties, although any person who alleges that he would be adversely affected by the carrying out of the scheme may be heard in the court proceedings which are required to sanction the scheme (Section 110 of FSMA) and the court may require assurances that such persons have been fairly treated. The FSA is also entitled to be heard in the proceedings.

ii Implementation procedure

the following procedure needs to be undertaken in order to implement a Part Vii transfer.a the Part Vii transfer process is initiated by the submission of an application to the

High Court. Under Section 107(2) of the FSMA, the application can be made by the transferor, the transferee or both. the court procedure involves two hearings.

b At a preliminary hearing, typically before a registrar, the court is requested to grant a preliminary order sanctioning the publication of notices (see infra) and setting a date for the final hearing. Once the application for the Part VII transfer has been made to the court, notices (approved by the FSA) stating that fact (and containing the address from which the statement mentioned infra may be obtained) must be published in the London, edinburgh and Belfast gazettes, as well as in two national newspapers in the UK.

c the terms of the Part Vii transfer are documented in a scheme of transfer (‘the scheme document’), which must be lodged in support of the application to court. the scheme document must include details of the transfer itself and any specific provisions in relation to particular categories of asset or liability being transferred, together with provisions setting out the precise nature of what is (and is not) to be transferred pursuant to the scheme document.

d A statement explaining, and setting out the terms of, the scheme document (‘the statement’) should be prepared, and must be given free of charge to anyone who requests it. A copy of the court application and the statement must be provided to the FSA.

e Although not a legal requirement, as a practical matter the FSA’s approval to the Part Vii transfer will need to be sought before it may proceed.

f At the final hearing, typically before a High Court judge, persons who allege that they would be adversely affected by the carrying out of the Part Vii transfer are given the right to raise objections and, if the court is so minded, the Part Vii transfer will be sanctioned by a final court order. The FSA also has the right to attend that court hearing, and now typically does so.

g The court may sanction the Part VII transfer by the final court order if:• appropriate certificates have been provided by the FSA certifying that the

transferee possesses (or will possess before the Part Vii transfer takes effect) adequate financial resources, taking the Part VII transfer into account;

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• the transferee has the necessary authorisation to carry on the business being transferred in the UK;

• at least 21 days have elapsed since the FSA was given copies of the application and the statement; and

• the court is satisfied that, in all the circumstances of the case, it is appropriate to sanction the Part Vii transfer.

h the court has wide-ranging powers to make the transfer effective, including providing for the transfer to the transferee of the whole or any part of the undertaking concerned and of any right, property or liability of the transferor (whether or not the transferor has the capacity to effect the transfer in question).

i Where any property or liability included in the order is governed by the law of a country or territory outside the UK, the final court order may require the transferor, if the transferee so requires, to take all necessary steps for securing that the transfer of that property or liability is fully effective under the law of that country or territory.

j the Part Vii transfer takes effect as provided in the scheme document and this normally happens very shortly after the final court order is made.

VI THE YEAR IN REVIEW

the year prior to the publication of this chapter has been dominated in the UK by measures taken by the FSA and the government to address various perceived shortcomings in the UK’s bank regulation regime arising out of the financial crisis, principally (as far as UK banks are concerned) in the areas of regulatory capital, the regulation of liquidity, remuneration, senior management responsibility and recovery and resolution plans (‘living wills’). Some of these measures are set out in, or enabled by, the Financial Services Act 2010 (‘the FSAct’).

i Capital

in december 2009 the FSA published a consultation paper16 making proposals for the implementation of changes to the Capital Requirements Directive17 in the United Kingdom. the consultation period closed on 10 march 2010. this was the third in a series of consultation papers that the FSA has published since 2005 on the implementation of the Capital Requirements Directive in the United Kingdom. Further FSA consultations are likely to be required on certain aspects of the changes proposed. In its December 2009 consultation paper the FSA set out its approach to implementing the changes, commenting that it would do so in a ‘pragmatic and proportionate’ way on an ‘intelligent copy-out’ basis (meaning that new FSA rules resulting from the changes will generally be based on the text of the amended Directives). The FSA has added that it will only impose measures that go beyond Directive requirements where that is justified in its own

16 CP09/29 (‘Strengthening Capital Standards 3’, december 2009).17 2006/48/eC and 2006/49/eC.

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right and is consistent with the directive provisions. the FSA will also take into account the work of the Committee of european Banking Supervisors (‘CeBS’) when drafting its new rules and guidance to implement the changes.

The changes to the Capital Requirements Directive to which this FSA consultation related are those known as ‘CRD II’ (which was published in the EU Official Journal on 17 november 2009 and must be implemented in member states by 31 december 2010) and ‘CRD III’ (which, barring delays, is expected to take effect by 1 January 2011). The changes associated with CRD II and CRD III are described briefly in the European Union chapter.

ii Liquidity

One of the principal legacies of the financial crisis has been that the importance of liquidity, as well as capital, in banks has finally been accorded the priority that it deserves. Ahead of international initiatives on liquidity, the FSA introduced its own rules in December 2009, although transitional arrangements apply in respect of quantitative liquidity standards and, at the time of writing, the FSA has not yet calibrated those standards fully. these rules broadly require banks regulated by the FSA to be self sufficient for liquidity purposes, only being able to rely on other members of their group if they apply for and obtain a waiver from the FSA and comply with stringent requirements. The FSA is unlikely to grant this waiver to a UK bank that is seeking to rely on liquidity from non-UK companies in its group. The liquidity standards in the new rules require that banks have adequate liquidity resources in certain specified stressed scenarios.

iii Remuneration

In March 2009 the FSA first proposed a remuneration code to regulate the structure of remuneration arrangements in banks. The FSA’s Remuneration Code was confirmed in August 2009. it came into force on 1st January 2010 and applied to new employment contracts from that date. nevertheless, a number of major banks operating in London committed publicly in october 2009 to observing the Code for the 2009 bonus season. Firms to which the Code applies have until the end of 2010 to bring existing employment contracts into line with its requirements. Among other matters, the Code focuses on the contracts of individuals who perform ‘significant influence functions’ within firms and whose activities have, or could have, a material impact on the firm’s risk profile.

the FSAct contains four linked powers for the FSA over remuneration:a A power, which the FSA must exercise, to require authorised persons (including

banks) to have, and act in accordance with, a ‘remuneration policy’. the rules must secure that any such remuneration policy is consistent with the effective management of risks and the implementation Standards for Principles for Sound Compensation Practices issued by the Financial Stability Board on 25 September 2009.

b A discretionary power for the FSA to make rules that ‘prohibit persons… from being remunerated in a specified way’ (with the FSA to determine the types of remuneration to be specified for this purpose).

c A discretionary power to make rules that provide that ‘any provision of an agreement that contravenes such a prohibition is void’.

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d A discretionary power to make rules which provide for the clawing back of any payment made, or property transferred, under a void provision.

The FSAct confers powers on HM Treasury to make regulations requiring ‘remuneration reports’ concerning ‘executives’ of FSA-authorised persons, including anonymous disclosure of levels of remuneration within specified ranges.

iv Recovery and resolution plans (‘living wills’)

Under the FSAct the FSA is required to make rules applying to some or all FSA-authorised persons (including all FSA-authorised banks) that mandate each such authorised person to maintain a ‘recovery plan’ and a ‘resolution plan’. A recovery plan will describe the action which could be taken to ensure the continuity of all or part of the business of a firm (or of another member of its group) in prescribed circumstances. it will be for the FSA to specify in its rules what those circumstances are, but they will include circumstances that threaten the viability of the firm or its group. By contrast, a resolution plan must relate to action to be taken in circumstances in which it is likely that all or part of the business of an authorised person (or of another member of its group) will fail or in circumstances in which that business does in fact fail. ‘Failure’ for these purposes includes insolvency, bankruptcy or administration of the firm concerned or the exercise of a resolution power under Part I of the Banking Act 2009 in relation to that firm.

v Bank charges

in 2009 the United Kingdom Supreme Court heard a landmark test case on the fairness of bank charges.18 the case concerned the system of ‘free if in credit’ banking operated by the six banks and one building society (together referred to as ‘banks’) that were the appellants before the court. The banks accepted that the system involves a significant cross-subsidy provided by those customers who regularly incur charges for unauthorised overdrafts to the very significantly greater number of customers who never, or rarely, incur such charges. the bank charges in issue in the case were charges levied on personal current account customers in respect of unauthorised overdrafts, including unpaid item charges and other related charges. The question to be addressed was whether the fairness of these charges could be challenged on the basis that they were excessive.

The Office of Fair Trading (‘OFT’) challenged these charges under the Unfair terms in Consumer Contracts Regulations 1999 (‘UtCCR 1999’)19 on the ground that they were unfair. UtCCR 1999 transpose into UK law the eU Unfair terms in Consumer Contracts directive.20

the basic test of fairness is in Regulation 5(1) of UtCCR 1999, which provides that ‘a contractual term which has not been individually negotiated shall be regarded as unfair if, contrary to the requirement of good faith, it causes a significant imbalance

18 Officeof FairTradingv.AbbeyNationalplc [2009] UKSC 6 [2009] All eR (d) 271.19 Si 1999/2083.20 93/13/eeC.

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in the parties’ rights and obligations arising under the contract, to the detriment of the consumer’.

the banks contended that any such challenge would be circumscribed by the provisions of Regulation 6(2) of UtCCR 1999, which provides that:

‘In so far as it is in plain intelligible language, the assessment of fairness of a term shall not relate –

a tothedefinitionof themainsubjectmatterof thecontract;or

b to the adequacy of the price or remuneration, as against the goods or services supplied in

exchange.’

In this context, ‘adequacy’ is required to be read in the sense of ‘appropriateness’.21

The question for the Supreme Court was, therefore, whether as a matter of law the fairness of the relevant charges could be challenged as excessive in relation to the services supplied to the customers. That question depended on the correct interpretation, in its EU context, of UTCCR 1999.

in a judgment handed down on 25 november 2009 the Supreme Court decided that the relevant charges are part of the price or remuneration for the banking services provided and, insofar as the terms giving rise to the charges are in plain intelligible language, no assessment under UtCCR 1999 of the fairness of those terms may relate to the adequacy of the price provided as against the services supplied. The Supreme Court made it clear that the Regulation 6(2) exclusion is not limited to ‘essential’ prices (as the Court of Appeal had previously found) and that any monetary price or remuneration payable under the contract in exchange for the goods or services (rather than, for example, on default) would naturally fall within the meaning of the provision.22 the Supreme Court declined to refer the issue to the european Court of Justice under Article 234 of the eC treaty.

vi Future regulatory architecture

institutional uncertainty has continued over the future of the FSA for some time, with the Conservative Party pledging to transfer the FSA’s powers over prudential regulation to the Bank of england if it gained power at the general election on 6 may 2010. At the time of writing, a coalition government has been formed and it appears that this policy will not now be carried out in full.

21 DirectorGeneralof FairTradingv.FirstNationalBankplc [2001] UKHL 52, [2002] 1 AC 481.22 Although the issue before the Supreme Court was such that they were not asked to consider

the fairness of the charges, Lord Walker, with whom several of the justices agreed, stated that parliament had decided to implement the Unfair terms in Consumer Contracts directive precisely and to provide no greater consumer protection, as was provided in other member states. It could decide to reconsider this restraint. Lady Hale questioned whether the real problem was not the charging model, but the lack of competition between the banks. Lord Phillips, while noting the consequences for free banking if such charges were not made, said it was open to question whether it was fair to subsidise some customers whose accounts always remain in credit by levies on others.

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VII OUTLOOK AND CONCLUSIONS

At the time of writing the outlook for UK regulation of banks is highly uncertain. in addition to the institutional uncertainty referred to above surrounding the future of the FSA, uncertainty persists over the future shape of the UK banking industry itself.

the new coalition government accepts that it will take some time to reach a view on what that shape might most appropriately be and whether, for example, certain activities, such as proprietary trading, should not be carried on by banks that accept retail deposits. While politically emotive, the true analysis of the position is certainly more complex and will take longer to resolve than the mass media usually suggests.

About the authors

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JAN PUTNIS

Slaughter and May

Jan Putnis is a partner at Slaughter and May in London. He qualified as a solicitor in England and Wales in 1996. Before deciding to become a lawyer, he graduated with a degree in physics from Oxford University. His principal areas of practice now include the regulation of banks, insurance companies and investment firms and he advises these institutions on cross-border mergers, acquisitions, joint ventures and the establishment of new businesses, as well as on disputes with regulators and enforcement cases.

SlAUghTer ANd mAyOne Bunhill RowLondonEC1Y 8YYUnited KingdomTel: +44 20 7600 1200Fax: +44 20 7090 [email protected]

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