Banking & Finance Special Report: Bank checks

The recent turmoil in the banking sector has prompted a new regulatory regime aimed at reducing the impact of failed banks. By Nicola Evans

Banking & Finance Special Report: Bank checks Recent events have highlighted a ;number ;of ;serious ­weaknesses ;in ;the ;UK ­regulatory framework.

As a consequence, the Treasury, the Financial Services Authority (FSA) and the Bank of England (BoE) have produced a variety of proposals designed to strengthen and improve the current framework.

The key proposals can be divided into two main categories:
• those that seek to reduce the likelihood of a financial institution failing, for example through changes to the regulation of areas such as liquidity and capital; and
• those which seek to reduce the impact of a failing bank, building society or other financial institutions that holds client assets, for example by conferring greater powers on the authorities to deal with such banks in an orderly way.

As some of the proposals are still at the consultation stage and others have only been implemented recently, it remains to be seen how effective they will be in providing a ­stable regulatory framework and greater depositor protection. However, what is clear is that the new regulatory framework will be more onerous and the supervisory role of the FSA more stringent to minimise the risk of a repeat of recent market events.

Reducing the likelihood of a bank failingIn addition to proposing new rules relating to ­liquidity and stress testing, ;the ;FSA intends to focus on improving corporate governance arrangements ;of ;banks and other financial ­institutions.

Poor ;corporate ­governance is generally considered to have been a contributing factor to recent market events, particularly in the area of risk assessment and management. The FSA recently stated that it is “those [companies] which have the best corporate governance systems, overseen by those who are not afraid to ask the ­awkward questions, which are most likely to ride out difficult markets successfully”, and that it will take action against individuals who act dishonestly or incompetently when ­performing senior management functions.

Reducing the impact of a failing bank

A key plank in ensuring stability in the UK financial system is the new Banking Act 2009, which came into force on 21 February. The act is intended to provide a permanent ­framework for dealing with banks that fail or are likely to fail. It establishes a new special resolution regime (SRR) for UK banks, together with modified procedures for ­dealing with the insolvency of such banks. The provisions also apply, with certain modifications, to UK building societies. The provisions do not apply to credit unions, but the Treasury has the power to make provision for credit unions through secondary legislation.

Under the SRR, the authorities will be able to transfer: some or all of the shares or business of a failing bank to a private ­sector third party; some or all of the business of a failing bank to a publicly controlled ‘bridge bank’; or some or all of the shares of a ­failing bank into temporary public-sector ownership. In each case, the FSA must make a ­formal decision that the bank has failed or is likely to fail and, following that decision, the BoE will be responsible for the transfer.

The Banking Act provides for compensation to be paid to those who are affected by the exercise of powers under the SRR. ­During the consultation period, significant concern was raised regarding the possible effects of the ‘partial property transfers’ – transfers of part of the business of a bank. In particular, there were fears that such ­transfers could seriously undermine the ­certainty of netting, set-off and security arrangements. In recognition of these ­concerns, secondary legislation has been passed that restricts the terms of partial property transfers. In particular, where the bank is a party to a set-off, netting or title transfer financial collateral arrangement, it will not be possible to transfer only some of the rights and liabilities under the arrangement. Assets that are provided by way of security cannot be transferred unless the liability and the benefit of the security are also transferred. Further protection is ­provided in respect of capital market arrangements and the rules and contracts that apply to recognised investment exchanges and recognised clearing houses.

The act also modifies the insolvency rules that apply to UK banks. The modifications consist of two parts: ‘bank insolvency’, under which the court may appoint a ‘bank ­liquidator’; and ‘bank administration’, under which the court may appoint a ‘bank ­administrator’.

Under the bank insolvency process, the bank liquidator has responsibility for ­winding up the bank, but first they must cooperate with the Financial Services ­Compensation Scheme (FSCS) to ensure that the accounts of the bank’s eligible depositors are transferred to another bank or that those depositors receive ­compensation from the FSCS.

The bank administration process applies to the residual bank that remains following the transfer of part, but not all, of its business to a private sector purchaser or bridge bank. The bank administrator is responsible for the ‘normal’ administration procedure that applies under existing insolvency
law, but this is now overlaid by a primary ­objective of ensuring that the residual bank provides support for the transferred ­business through services and facilities that remain behind in the residual bank.

Nicola Evans is a partner at Lovells