United Kingdom

Is there any legislation or proposed legislation in your jurisdiction under which financial institutions are prohibited from dealing in investments as a principal?

The Financial Services (Banking Reform) Act (the Banking ReformAct) was passed by Parliament in December, 2013. It requires the ring-fencing of certain retail banking activities into separate entities within the corporate group. These ring-fenced bodies are then prohibited from carrying on certain activities, including that of dealing in investments as principal.

To which financial institutions do the prohibitions relate?

Section 4 of the Act provides that a ring-fenced body is a “UK Institution” (that is a body corporate incorporated in the United Kingdom) which carries on the regulated activity of accepting deposits.  Consequently, the ring-fencing provisions of the Act do not apply to branches of foreign banks located in the United Kingdom.

A building society (within the meaning of the Building Societies Act 1986) is expressly excluded from the requirement to ring-fence. In addition there is draft secondary legislation which sets out further the UK institutions which HM Treasury intends to exempt from the ring-fencing requirements of the Act. These Orders include:

  • the Financial Services and Markets Act 2000 (Ring-fenced Bodies and Core Activities) Order (the Core Activities Order); and
  • the Financial Services and Markets Act 2000 (Excluded Activities and Prohibitions) Order (the Excluded Activities Order).

It should be noted that the secondary legislation is currently in draft and subject to amendment at the time of writing. The Core Activities Order currently provides that small banks, regulated insurance companies, credit unions and industrial and provident societies should be exempted.

A small bank is one whose core deposits, averaged over a three year period, do not exceed £25 billion. To prevent a bank avoiding the ring fencing requirements by splitting its deposits across different companies within a group, the £25 billion benchmark will be calculated in respect of all the core deposits held by companies in the group.

The Act is therefore likely to apply to HSBC Holdings PLC, Barclays PLC, The Royal Bank of Scotland plc, Lloyds Banking Group PLC and Santander UK plc.

What exceptions to the ban on proprietary trading are contemplated by the legislation?

The current proposals for the circumstances in which a ring-fenced bank will be permitted to engage in dealing in investments as principal, are set out in the Excluded Activities Order. As mentioned above the Excluded Activities Order is in draft form and this update addresses it in its current draft.

The current exceptions to the prohibition are:

  1. hedging by the ring-fenced body of its exposure to changes in interest rates, exchange rates or commodity prices, default risk and liquidity risk;
  2. dealing with investments as principal as required for compliance with liquidity ratios under capital adequacy legislation;
  3. dealing in the shares of a company acquired as part of a debt for equity swap;
  4. entering into certain transactions in connection with the securitisation of its own assets;
  5. entering into certain transactions with a central bank (or with a subsidiary of the central bank); and
  6. entering into transactions involving the sale of “simple derivatives” to its account holders.

Can any other entity within the relevant financial institution’s group of companies carry on the prohibited activity?

Initially, the ring-fenced body and the bank conducting the investment business may have common ownership, or one may be the subsidiary of the other. It is therefore possible, at this stage, for the ring-fenced body to market, as agent for its parent or sister investment bank, products which the ring-fenced body itself is prohibited from supplying. Any agency will, however, need to be negotiated at arm’s length.

There are a number of circumstances in which the ring-fence can be “electrified” by the regulator, so that the ownership of the retail bank and the investment bank are fully separated. These are broadly where the initial, unelectrified ring fence is not achieving the aims of the Act. In these circumstances, the prohibited activities would not be able to be carried out within the ring-fenced body’s group of companies.

When will the proposed legislation come into effect?

Although the Act was passed into law in December 2013, it will not come into force until such day as the Government may by order specify. Before that happens, the accompanying secondary legislation (including the Core Activities Order and the Excluded Activities Order) will need to be finalised. It is anticipated that this will occur before the next general election due in the United Kingdom, in May 2015.