The Banking Act 2009: Legislation for failing banks replaces emergency powers

The Banking Act 2009 (the “Banking Act” or the “Act”) was enacted on 12 February 2009, and its main provisions will come into force on 21 February 2009 when the Banking (Special Provisions) Act 2008 lapses. That Act gave the Treasury temporary powers to deal with banks in financial difficulties. The Banking Act gives the Bank of England, the FSA and the Treasury (the “Authorities”) permanent powers to deal with banks that are judged to be failing or likely to fail.

The Banking Act is divided into a number of parts, as follows:

• Part 1: Special resolution regime (the “SRR”) – this provides the Authorities with the tools to deal with banks in financial difficulties.
• Parts 2 and 3: Bank insolvency and bank administration – these establish a new bank insolvency procedure and a new bank administration procedure.
• Part 4: Financial Services Compensation Scheme (“FSCS”) – this provides the framework that will enable the FSA to overhaul the FSCS.
• Part 5: Inter-bank payment systems – this formalises the role of the Bank of England in overseeing certain systems for payments between banks and building societies.
• Part 6: Banknotes: Scotland and Ireland – this amends the framework under which certain banks in Scotland and Northern Ireland are permitted to issue banknotes.
• Parts 7 and 8: Miscellaneous and General – these contain a range of miscellaneous provisions, including new rules regarding the governance of the Bank of England and its ability to provide emergency liquidity, as well as power for the Government to introduce a new insolvency regime for investment banks.

The Act was developed by the Authorities by way of an initial discussion paper in October 2007, followed by three subsequent consultation papers (one in January 2008 and two in July 2008). The Act is largely consistent with these consultation papers.

The provisions of the Act have prompted considerable debate, and negotiations on amendments to it continued until shortly before it was finally approved on 11 February 2009. As a concession to this debate, the Act allows for the establishment of a specialist panel of experts – referred to in the Act as the “Banking Liaison Panel” – that will be drawn from the public and private sectors. The role of the Panel will be to advise the Treasury about the effect of the SRR on banks, persons with whom banks do business and the financial markets and, more generally, to advise the Treasury about the exercise of powers under the SRR.

The Core of the Banking Act – The SRR

At the core of the Banking Act is the SRR. This gives the Authorities various options and procedures to address the situation of a failing bank, including the following three “stabilisation options” (or “pre-insolvency options”):

• Private Sector Purchaser Transfer - Transferring all or part of the bank to a private sector purchaser – through a transfer of property or shares,
• Bridge Bank Transfer - Transferring all or part of the bank to a “bridge bank” (a new company wholly owned and controlled by the Bank of England) – through a transfer of property, and
• Temporary Public Ownership Transfer - Taking the bank into temporary public ownership – through a transfer of shares to the public sector.

The first and second options can be exercised by the Bank of England and the third option by the Treasury.

The development of the SRR has been a direct response to the collapse of Northern Rock and one aim of the new measures is to simplify the process of nationalising a stricken lender. However, the stabilisation options also give the Authorities permanent powers to facilitate continuity of banking services through a transfer of the valuable part of the bank’s business to a suitable third party purchaser which commands sufficient market confidence. To this end, the stabilisation options are complemented in the Act by a new bank administration procedure that will operate when there has been a partial transfer of business from a failing bank. If continuity of banking services is not possible, the Act introduces a new bank insolvency procedure. This is designed to facilitate a fast pay out for protected depositors or a transfer of their accounts.

The SRR will apply to “banks”, that is, UK incorporated entities that have permission to accept deposits. It does not apply to branches of either EEA, or other foreign incorporated, banks. The SRR also applies, subject to a number of necessary legal modifications, to building societies and (in the case of the power to take a bank into temporary public ownership) to UK bank holding companies. Credit unions are currently excluded, but the Act contains provisions enabling the Treasury to make an order to include credit unions at a later date. In this briefing, “bank” covers all entities now within the scope of the SRR.

In using, or considering the use of, the SRR, the Authorities are obliged to have regard to “the special resolution objectives”. These include UK financial systemic stability, public confidence in the UK banking systems and the protection of depositors and public funds. The Government is proposing a Code of Conduct to guide its use of the regime and to provide greater clarity on how the special resolution objectives can be achieved. The Authorities will be obliged to have regard to this Code, but the Code itself will not be binding and neither the Banking Act nor the Code, as currently drafted, provide specific guidance on how the objectives are to be balanced or weighed.

For background information on the development of the SRR, please click here.

The Role of the FSA in Triggering the Stabilisation Options

The FSA is responsible for triggering the stabilisation options. Under the Act, they cannot be used unless the FSA is satisfied that:

• First Condition - the relevant bank is failing, or is likely to fail, to satisfy the threshold conditions for carrying on regulated activities (the “threshold conditions”), and
• Second Condition - having regard to timing and other relevant circumstances, it is not reasonably likely that action will be taken by, or in respect of, the bank that will enable it to satisfy those threshold conditions.

As a result, it will require a judgment by the FSA in the first instance (as was the case in practice prior to the Bradford & Bingley rescue).

Both conditions must be satisfied before the stabilisation options can be used. It is clearly contemplated that a bank may be judged to be a failing bank before it has become technically insolvent.

The first condition is a regulatory matter for the FSA. A key threshold condition, in the context of the SRR, will no doubt be the FSA’s opinion on the adequacy of the bank’s resources in relation to its regulated activities, but the bank’s group ownership may also become relevant. The FSA has an obligation to consult with both the Treasury and the Bank of England in respect of the second condition. As a result, the FSA will have to involve those Authorities in any decision to trigger the SRR, although it is unclear whether the FSA will have to take the views of the Treasury and the Bank of England on board. There also exists the potential for confusion as a result of the three-way division of responsibilities between the Authorities.

The FSA is currently consulting (see Consultation Paper 08/23; Financial stability and depositor protection: FSA responsibilities) on how it will make its assessment under the second condition. The consultation period closes on 8 March 2009.

For further background information regarding the July consultation, please click here.

Further Specific Conditions for Use of Stabilisation Options

If the FSA determines that a bank has met the “trigger” conditions, certain further conditions must also be satisfied before the Treasury or the Bank of England can use a stabilisation option:

• The Treasury - For example, the Treasury may not transfer the failing bank into temporary public ownership unless, amongst other things, the exercise of the power is “necessary” to resolve or reduce a serious threat to the stability of the financial systems of the UK. This mirrors the threshold for the exercise of temporary powers under the Banking (Special Provisions) Act 2008.
• Bank of England - However, the transfer by the Bank of England of the business of a failing bank to a private sector purchaser or a bridge bank may be exercised if it is “necessary” to do so, having regard to the public interest in any of the following: the stability of UK financial systems, public confidence in the UK banking systems or the protection of depositors.

Guidance issued by the Treasury indicates that the test of “necessity” will be a high one. There is also an obligation on the Bank of England and the Treasury, as applicable, to consult with each other and the FSA before deciding that the conditions for exercise of their respective powers have been satisfied. In practice, though, it is hard to see how the “protection of depositors” condition would not be met when a bank that holds deposits is judged to be failing.

Effecting a Stabilisation Option – the Stabilisation Powers

In order to achieve a stabilisation option, the Banking Act gives the Authorities certain powers, known as “stabilisation powers”.

The Treasury will have the power to transfer the shares of a failing bank to a nominee of the Treasury or to a company wholly owned by the Treasury (as happened in the case of Northern Rock).

The Bank of England will have the power to transfer shares or property (being property, rights and liabilities) to a private sector purchaser (as happened in the case of Bradford & Bingley, Heritable and Kaupthing Singer and Friedlander) and the power to transfer property to a bridge bank.

These transfers will operate as a matter of law, notwithstanding any restrictions arising from contract, statute or incapacity and (in the case of shares) free of any trust, liability or other encumbrance.

The property transfer power can be applied in respect of property outside the UK, as well as to rights and liabilities under laws of jurisdictions outside the UK, although the effectiveness of these transfers may be questionable and could vary from jurisdiction to jurisdiction. In practice, parties are likely to need to take specific steps under local laws to ensure the effectiveness of a transfer and, consequently, those counterparties whose contracts are governed by foreign law may find themselves in a preferential position.

Finally, any property transfer made by the Bank of England may relate to the transfer of all or some of a failing bank’s property.

The Government has acknowledged that the comprehensive nature of the stabilisation powers could remove or adversely affect property, employment and other rights but believes that this intervention will be compatible with the UK’s EU legal obligations. However, to ensure full compliance with these obligations, the Banking Act provides a number of safeguards, including arrangements for compensating transferors for shares. The compensation mechanism involves the appointment of an independent valuer whose decision can be challenged. However, the valuation principles require the valuer to disregard any special financial assistance provided by the Bank of England or the Treasury. It is this assumption that caused the recent dispute over compensation for Northern Rock’ shareholders.

The Problem of Partial Transfers

The notion of partial transfers has become one of the most controversial aspects of the SRR. It means that the Bank of England has the ability to “split a bank”, that is, to transfer part only of a bank’s business, while leaving the remainder of the business with the “rump bank”. In practice, a partial transfer could be used to effect the disposal of an attractive part of the bank’s business (such as its deposit book) to a purchaser or bridge bank at a suitable price, while leaving behind the more troublesome assets (such as collateralised debt obligations or similar securities which the bank owns, and which could well be worth considerably less than their original values) pending the ultimate winding up of the insolvent residual bank under the new bank insolvency procedure.

From the Authorities’ point of view, partial transfers offer the ability to intervene only to the extent necessary to achieve the SRR objectives in relation to the failing bank and, presumably, to do so on a less costly basis than would apply to “whole bank” intervention. However, as a consequence, the Act contains wide powers for partial transfer orders to override contractual rights of third parties, for example, by prohibiting the exercise of termination rights under a contract. This has generated considerable debate amongst various professionals and professional bodies who have expressed serious concerns that a partial transfer, under an SRR, might be made on terms (imposed by the Authorities) which:

• Netting and set-off - allow some but not all of a bank’s financial contracts to be transferred. This could result in related netting arrangements or set-off rights being overridden,
• Security interests - allow a bank’s liabilities to be transferred to a purchaser without a transfer of associated security for those liabilities,
• Structured finance - allow inter-connecting contracts constituting a structured finance transaction to be split between the new bank and the rump bank, or
• Residual creditors - allow assets of the failing bank to be “cherry-picked” so that good assets go to a bridge bank or a private sector purchaser leaving the counterparty with a claim on the residual and much weakened bank. As a result, creditors of a failed bank might find themselves worse off than they would have been had the whole bank gone into insolvency.

Outcomes such as these would cause great uncertainty in the markets. They would bring into question the effectiveness of arrangements, rights, interests and contracts, where they have previously been relied upon by market participants, and by law firms providing legal opinions to those market participants. This could lead to reduced confidence in the UK financial sector and to higher funding costs and higher regulatory capital requirements for UK banks, resulting ultimately in a loss of competitiveness for UK banks.

Safeguards for Partial Property Transfers

The Government has recognised these concerns and extensive work has been undertaken to put in place additional safeguards for partial property transfers – to be effected through secondary legislation and the Code of Practice - in order to reassure the markets that contractual rights and security interests will be adequately protected.
In October 2008, the Government established an expert liaison group (“ELG”) on banking, made up of legal, financial and insolvency experts from the banking sector, to advise the Government on the relevant secondary legislation. In November 2008, the Treasury issued a consultation paper, “Special resolution regime: safeguards for partial property transfers” setting out the Government’s initial proposals for delivering adequate safeguards, together with a draft safeguards order (the “Safeguards Order”) and the draft Code of Practice. The consultation period closed in January 2009. However, the Government has continued to work closely with the FSA, the Bank of England and the ELG in developing the following proposals:

• Safeguards for set-off and netting: rights and liabilities under set-off, netting or title transfer financial collateral arrangements (including bespoke agreements, as well as those made under industry standard forms, such as the ISDA master agreement) will be protected from disruption in a partial transfer (subject to certain limited exceptions). These provisions are perceived as being essential for the continued issuance of legal opinions on these arrangements.
• Safeguards for security interests: holders of security will be protected against partial transfers. A partial transfer may not separate property or rights against which a liability is secured from the liability itself and may not transfer a liability unless the property or rights against which that liability is secured are also transferred (subject, in each case, to certain limited exceptions).
• Safeguards for structured finance: because of their nature and importance, the integrity of these types of transactions will be protected from disruption by partial transfers. The latest proposal focuses on the exclusion from partial transfers of rights and liabilities which are or form part of a “capital market arrangement” to which the bank is a party, on the basis that this expression (as defined in the Insolvency Act 1986) is thought to be wide enough to cover most structures used in practice.
• Safeguards for residual creditors: a new third party compensation mechanism will be introduced to ensure that “pre-transfer creditors” left in a residual bank are no worse off than they would have been in a “whole bank” insolvency. The latest proposal is that the Treasury will have the power to make third party compensation orders in relation to partial property transfers, which will provide for the independent valuation of compensation amounts. The independent valuer will be required to assess the treatment which pre-transfer creditors would have receive had the bank entered insolvency immediately before the partial transfer. The relevant provisions will be set out in the “third party compensation arrangements for partial transfers” regulations (the “Third Party Compensation Regulations”), which will be made under the Act.

To coincide with the enactment of the Banking Act, the Government has published the latest draft versions of the Safeguards Order and the Third Party Compensation Regulations. These are expected to be finalised and come into effect on 21 February 2009 when the relevant parts of the Banking Act are commenced.

The objective of these instruments will be to provide adequate legal certainty to the financial markets, while delivering sufficient flexibility for the Authorities to execute partial transfers in the interests of financial stability. In practice, though, it remains doubtful whether the partial transfer mechanism will be workable for a complex bank, as opposed to a relatively simple transaction such as the transfer of the Bradford & Bingley deposit book. The third party compensation orders may also be problematic in practice since they will require hypothetical judgments as to recoveries that would have been achieved if the bank had been liquidated as a whole.

Finally, one of the most controversial elements of the SRR has been the inclusion in the Act of a power for the Treasury to amend the law with retrospective effect through regulations, which can (if the Treasury so decides) be effected without the prior approval of Parliament, “for the purpose of enabling the stabilisation powers to be used effectively”. Although the Government has narrowed the scope of this power, it is still available in relation to any particular exercise of the stabilisation powers if “the Treasury consider it necessary or desirable”. It is possible that the inclusion of this power may have been influenced by the Bradford & Bingley experience, where it seems that the Government accidentally omitted to provide for interest on the FSCS/Treasury exposure in that case.

New Bank Insolvency and Administration Procedures

The stabilisation powers are designed to allow the Authorities to take action before a bank actually fails. At the same time, the Banking Act introduces two new regimes for banks which have failed: a bank insolvency procedure and a bank administration procedure.

The new insolvency procedure puts pay-out of compensation to the retail depositor base as the primary objective, with achieving the best result for the creditors as secondary. Under the Act, the bank liquidator is obliged to begin working towards both objectives immediately upon its appointment, although it remains to be seen whether these objectives can be reconciled in practice. The insolvency procedure is designed to facilitate an orderly winding-up of the failing bank and a fast pay out for protected depositors or a transfer of their accounts. As a result, it is only available when a bank has depositors who are eligible for compensation under the FSCS. It is a stand-alone procedure which can be used once the FSA has determined that the “trigger conditions” for use of the SRR have been met.

Bank administration is an even more radical departure. The primary objective of the bank administrator is to support the bridge bank or private sector purchaser, following a transfer of the bank’s property, and only secondarily to pursue the ordinary aims of a “normal” administration, such as rescuing the bank as a going concern or achieving a better result for the bank’s creditors than an immediate liquidation. Again, the administrator is obliged under the Act to begin working towards both objectives immediately upon its appointment, although it is unclear how this would work in practice. The administration procedure is designed to ensure that key services and facilities that cannot be immediately transferred from the failing bank to the bridge bank or private purchaser continue to be provided by the bank for a period of time to ensure that the property transfer works effectively (as was the case when Abbey acquired the deposit base and the branch network of Bradford & Bingley and required access to the bank’s head office functions for a limited time). As a result, the administration procedure can only be used when the Bank of England has made, or intends to make, a property transfer.

Both of the new insolvency processes are based largely on existing provisions of the Insolvency Act 1986 and can only be commenced by way of a court order made on the application of the relevant Authorities or the Secretary of State.

Changes to the Financial Services Compensation Scheme

The other key part of the Banking Act deals with changes to the FSCS. The run on Northern Rock, and the subsequent rescue of Bradford & Bingley among others, shone a spotlight on the FSCS and it became clear that it was not fit for purpose.

Broadly, the Government’s proposals are designed to achieve greater consumer awareness of, and confidence in, the FSCS, the ability to achieve a faster pay-out (with a target of making payment within seven days of a bank failing), and an overhaul of the mechanics of the Scheme, including the potential to introduce pre-funding.

The legislative framework for these changes is included in the Banking Act, which will amend existing legislation, as follows:

• Pre-funding - the Government will be able to introduce regulations to provide for pre-funding of the Scheme. At present, the Scheme is funded on a “current pay” basis. However, pre-funding does not appear to be an immediate priority of the Government, and is not covered by the latest FSA consultation documents. In practice, the costs of meeting the existing FSCS bill are significant, and there is little scope to increase this burden through additional pre-funding in the short to medium term.
• Contribution to the costs of the SRR – some of the stabilisation powers may prevent a bank from failing, but there will nevertheless be a cost involved. The Government would like the FSCS to contribute to such costs, provided that the cost to the FSCS does not exceed the costs it would have incurred if the bank had failed. This is controversial as it expands the responsibilities of the FSCS. It will also involve some difficult, hypothetical calculations in order to determine the maximum contribution by the FSCS, for which purpose an independent valuer will be appointed. The detail of these arrangements will be contained in regulations which have not yet been published.
• Management of funds – the Act specifically addresses the funding of the FSCS, placing on a statutory footing its power to borrow from the Government (and thereby obtain bridge funding of the type used for the Bradford & Bingley rescue) and its power to lend surplus funds to the Treasury.
• Claims procedure – the Act will allow claims to be paid automatically, without the need for each depositor to actually lodge a formal request for payment. This is seen as a key element of moving to swifter settlement, but raises a number of practical difficulties.

For background information on recent developments in relation to the FSCS, click here and click here.

Insolvency Regime for Investment Banks

Finally, the Act permits the Government to introduce regulations amending the insolvency regime for investment banks (defined in this context as banks that hold client assets, or deal as principal or agent). The Lehman experience has shown that current rules do not properly protect client money, nor do they adequately cater for trades that remain unsettled at the date of the insolvency. The Government intends to complete a review of insolvency procedures for investment banks by summer 2009 and then undertake a full consultation on the draft secondary legislation.