Chapter 10 Regulatory and Other Changes in the U.K. Banking Market
- Robert Effros
- Published Date:
- June 1994
It has been emphasized by many commentators how the nature of banking has changed out of all recognition since the enactment of the Bills of Exchange Act in 1882. In this context it might be interesting to look back and see how the regulation of banking in the United Kingdom has developed over the last decade and to see what steps the Bank of England has taken to meet the needs of a marketplace that has seen many, sometimes dramatic, changes in that time. I will then touch briefly on the changes that have taken place in the London Eurocurrencies market in recent years. Finally, I will comment on the way in which the obligation of confidentiality has been eroded by statute in the interest of detecting and preventing crime.
Recent History of Banking Regulation
First, let me describe some of the legal changes that have taken place in the regulation of the London banking market. Until 1979, the United Kingdom, unlike most other major industrialized countries, had no statute law or statutory regulation that governed the establishment of a new bank or the conduct of banking business generally.
The Bank of England exercised its supervisory functions informally, monitoring each bank’s performance individually. When it wished to enforce a general policy throughout the banking community, the Bank would do so by a letter of request that asked each bank to conform to the new practice. Although the letter had no force of law and was not couched in legal language, the Bank expected it to be obeyed in the spirit as well as in the letter. When in 1973, Sir Leslie (now Lord) O’Brien, at that time the Governor of the Bank of England, addressed the Scottish Institute of Bankers, he said: “The supremacy of London as an international banking center is founded on a freedom from vexatious banking legislation equalled in few countries in the world.” That situation was soon to be changed.
Lifeboat Support Operation
The early 1970s saw a rapidly growing demand for credit in the United Kingdom, especially in the booming property market. This encouraged the development of what became known as “secondary” or “fringe” banks, which attracted depositors by offering high rates of interest. Many secondary banks were not regarded as banks by the Bank of England and were, therefore, not subject to its supervision. Some lent heavily to property companies and speculators, and when in 1973-74 the property market, and subsequently the stock market, suffered severe reversals, they found themselves in financial difficulties. The deposits placed with these secondary banks by the public were saved as a result of a voluntary support operation, known as the “lifeboat,” that was mounted by the Bank of England working with the clearing banks.
Banking Act 1979
As a result of the crisis, the Government produced a White Paper in 1976 entitled The Licensing and Supervision of Deposit-Taking Institutions. The changes in law proposed in this White Paper were enacted in the Banking Act 1979.1 The Act also met a requirement of the first Banking Directive issued by the European Community Commission in 1977 that banks and other financial institutions should be licensed. And so in 1979, banks in the United Kingdom found themselves subject to statutory regulation for the first time. The new Act regulated the carrying on of deposit-taking business in the United Kingdom by providing that such a business could be carried on only by two types of institutions: recognized banks and licensed deposit-takers authorized as such by the Bank of England.
To become a recognized bank, an institution had to satisfy the Bank of England (1) that it provided either a wide range of banking services or a highly specialized banking service; (2) that it enjoyed high reputation and standing in the financial community; and (3) that its business was carried on with integrity and prudence and with professional skills consistent with the range and scale of its activities. The requirements for recognition as a licensed deposit-taker were less stringent: its management had to consist of fit and proper persons and its business had to be conducted with financial prudence. Only recognized banks were allowed to use in their name the words “bank,” “banking,” and “banker.” The 1979 Act also established a deposit protection fund. This fund provided small depositors with some protection against the insolvency of a licensed institution. The protection continues in a modified form under the Banking Act 1987.2 The primary concern of the 1979 Act was to regulate deposit-taking in the United Kingdom: it did not contain provisions relating to the establishment of new banks or to the general supervision of banking business, which continued to be exercised by the Bank of England in the informal manner I have already described.
Collapse of Johnson Matthey Bankers and the Banking Act 1987
The next major event in the history of banking regulation was the collapse in October 1984 of Johnson Matthey Bankers.3 This led to a general review of the system of banking supervision in the United Kingdom. The Leigh-Pemberton Committee conducted this review and concluded that, although new legislation was needed, the existing system was in essence (if not necessarily in every detail) sound.
Banking Act 1987
The Banking Act 1987, enacted as a result of this review, made no major reforms but did strengthen various parts of the legislative framework to deal with weaknesses identified by the Leigh-Pemberton Committee and the White Paper that followed its report. The 1987 Act abolished the two-tier system of recognized banks and licensed deposit-takers introduced by the 1979 Act. It replaced this two-tier system with a sole category of “authorized institution.” The distinction between the previous two categories of institutions had been confusing to the public and had required considerable supervisory resources to administer and maintain.
The 1987 Act does not set prudential standards or ratio requirements with which every institution must comply. The Bank of England continues to monitor each bank’s performance individually, assessing the strengths and weaknesses of its management team, its system of controls, and other relevant factors. The Act does, however, impose minimum capital requirements that are more stringent if the institution wishes to be known as a bank.
As a result of experience learnt from the Johnson Matthey collapse, the 1987 Banking Act introduced reporting thresholds for large exposures. Any transaction entered into by a bank with one person (or connected persons) that puts at risk more than 10 percent of the bank’s available capital resources must be reported to the Bank of England. Transactions involving a risk of more than 25 percent of available capital resources must be reported before they are made. The definition of “connected persons” treats persons as connected, notwithstanding that they had no link or relationship with each other, if among other things, their financial soundness might be affected by the same factors. Thus, the new reporting requirements give a measure of control over exposures to market sectors as well as to particular entities. Under the Act, the Bank has general power to require institutions to supply such information as it may reasonably require; there are criminal penalties for noncompliance.
Another important feature is the restrictions the Act places on the ownership of banks. Anyone who acquires 5 percent of the voting power of a bank must notify the Bank of England; the acquisition of 15 percent or more of the voting power requires the consent of the Bank. The Bank’s consent is also required if a shareholding stake of a bank is subsequently increased above 50 percent or above 75 percent. If the Bank is not satisfied that the existing or prospective controller is fit and proper, it can serve notice of its objections; this power is backed up by criminal sanctions. In some circumstances, the Bank may place restrictions on particular shares and apply to the courts for an order to sell or transfer them.
Financial Services Act 1986
In addition to regulation under the Banking Act, banks in the United Kingdom are, so far as investment business is concerned, now regulated by the Financial Services Act 1986.4 This Act provides a framework for investor protection and stipulates that persons carrying on investment business in the United Kingdom must either be specifically authorized to do so or be exempted from the need for authorization. Investment business includes dealing in investments, arranging deals in investments, managing investments, and advising on investments.
In most cases, authorization is obtained from one or more of the five Self-Regulating Organizations to which the Government, through the Securities and Investments Board, has delegated authority to administer the regulation of investment business. These Self-Regulating Organizations (SROs) are the Association of Futures Brokers and Dealers (AFBD), the Financial Intermediaries, Managers and Brokers Regulatory Association (FIMBRA), the Investment Management Regulatory Organization (IMRO), the Life Assurance and Unit Trust Regulatory Organization (LAUTRO), and The Securities Association (TSA).5 Each SRO has produced its own, extremely detailed, rule book with which its members must comply. Where a large bank has many subsidiaries engaged in a wide variety of investment business in the United Kingdom, the group will, with its subsidiaries, find itself a member of all five SROs. The group’s Chief Compliance Officer will then have to ensure that all five rule books are complied with; this is an administrative nightmare that I have experienced in advising one major banking client. The good news is that the Securities and Investments Board is now simplifying the rule books—a mammoth task.
The major mistake that the Government made in formulating the Act was failing to exclude from its provisions transactions between market professionals and transactions over a certain size (for example, £500,000). Market professionals are quite capable of looking after themselves: the Eurobond market in the United Kingdom was completely unregulated for very many years without adverse consequences to professional investors. It is the small, private individual investor who needs statutory protection. The complexity of investment business regulation and the consequent cost of compliance has meant that the cost of making an investment has increased out of all proportion to the protection afforded to the individual investor.
Changes in the London Eurocurrencies Market
I now turn to the changes in the London Eurocurrencies market over the last few years. The most significant change is securitization where, instead of providing money by single-bank or syndicated loans, banks have acted as intermediaries in finding investors who will purchase short-term or medium-term notes from a corporation or sovereign entity wishing to raise money in the London Eurocurrencies market.
In recent years, there has been an ever-increasing number of note issuance facilities, commercial paper programs, and medium-term note programs. Where loans have been made, particularly in syndicated form, there has been an increasing tendency for the loan agreement to provide for each lending bank’s rights and obligations to be freely transferable to other financial institutions. This has, of course, led to an increasing secondary market in loan participations. The reasons for these changes are not hard to find:
The trend toward stricter capital requirements has led to a concentrated effort to reverse—or at least halt—the downward trend in banks’ capital ratios by the sale of loan assets.
Banks have been increasingly attracted by fee-earning (as opposed to asset-creating) business and by business that does not appear on their balance sheets.
Because of the rigidities imposed on parts of their balance sheets by country debt reschedulings, banks have kept their remaining assets as liquid as possible.
There has also been a great deal of financial innovation or financial engineering, as it is often called. Interest rate swaps (where a fixed-rate stream of interest is exchanged for a floating-rate stream of interest) were invented by an engineer who became a banker and decided to apply his engineering skills to that field.
A recently observed form of financial innovation is the securitization of mortgages, where a portfolio of residential mortgage loans is offered to investors through the medium of a special purpose vehicle. That is going to develop in other fields; other types of assets are going to be packaged together. In 1989 also there was intense activity in leveraged and management buy-outs, which led to many complicated and innovative forms of debt structuring. Finally, aircraft finance, too, has become highly sophisticated. This has in part been due to the desire of aircraft manufacturers to offer financial inducements to encourage airlines to purchase their aircraft, and in part to the opportunities that have been available to lenders to offer borrowers a financial structure that takes the maximum advantage of tax-saving devices.
Underpricing of Financial Risks
In 1985 a study was set up by the central banks of the Group of Ten countries under the auspices of the Bank for International Settlements to examine recent innovations in the conduct of international banking.6 It concluded that innovation has been a product of, and contributed to, the continuous and intense pressure of competition in the international financial markets. It also concluded that financial risks may go through extended phases of underpricing because of the combination of an inability to foresee long-term events and the pressures of competition in the short term.
By way of example the report stated that in pricing sovereign and other loans, banks made long-term economic assumptions derived from short-term trends. The underlying assumptions turned out to be incorrect, mainly because of the deceleration of inflation and the resulting rise in real interest rates in the 1980s. If history is anything to go by, it seems likely that this trend will continue and that financial risks will be priced according to current perceptions of risk and immediate pressures of supply and demand with the result that, as economic conditions change, the risks may turn out to be underpriced.
Erosion of Banker’s Duty of Confidentiality
Let us turn to the erosion through statute law of the banker’s duty of confidentiality. I find it difficult to understand why the U.K. Government was unable to accept the view of Professor R. B. Jack’s committee7 that there has been a “massive” erosion of the banker’s duty of confidentiality over recent years. The committee’s report lists about 20 statutes that provide for compulsory disclosure by banks of confidential information. Of these, 11 have been enacted since 1983. Two of these statutes are of particular concern to bankers: the Drug Trafficking Offenses Act 19868 and the Prevention of Terrorism (Temporary Provisions) Act 1989.9
Drug Trafficking Offenses Act
Section 24 of the Drug Trafficking Offenses Act makes it an offense if a person, knowing or suspecting that another person is trafficking in drugs, (1) holds or controls the proceeds of drug trafficking; or (2) puts funds at a person’s disposal secured by the proceeds of drug trafficking; or (3) gives any assistance in investing such proceeds.10 It is a defense under Section 24(4) to show that it was not known or suspected that trafficking in drugs was involved, or that the relevant authorities had been informed once suspicion had been aroused.11 The most important difficulty facing banks in complying with Section 24 is identifying what type of transactions to report to the authorities. The Act gives little practical guidance on this point.
The Customs and Excise Authorities have indicated they would be interested in transactions such as large deposits of cash or other financial papers (e.g., traveler’s checks) or a rapid buildup to a substantial balance of an account from a small or nil balance followed by a withdrawal or transfer of funds, especially overseas.
The British Bankers Association issued the following guideline: “Banks should in future when monitoring accounts, be on guard against any suspicious activity which is out of character with the normal operation of the account, such as new unexplained series of credits or an unexplained increase in the total value of existing regular credits.” As one commentator on the Act remarked, from the banker’s point of view, not only is the Act another inroad into a banker’s duty of confidentiality but it also makes the banker put on a police officer’s hat—something a banker is neither trained nor paid to do.
European Commission Measures Against Money Laundering
In mid-February 1990, the European Commission approved a set of measures aimed at making money laundering in Europe a criminal offense and obliging banks to report suspicious transactions. The Commission would require all financial institutions to obtain the identification of all clients with whom they do business (including ultimate account holders). Special attention would have to be paid to transactions with no apparent economic or visible lawful purpose. Staff should be trained to recognize suspicious transactions. Finally, member states would have to protect banks from alleged breaches of banking secrecy laws when the banks report their suspicions to the authorities.
Report by Leading Industrialized Countries
These moves by the European Commission are mirrored by a report released on April 19, 1990 by 15 of the world’s leading industrialized countries.12 The report contains about 40 proposals for curbing money laundering by drug dealers, including limitations on bank secrecy, closer international cooperation, and better monitoring of movements of cash.
First, banks and other types of depositoty institutions, such as savings banks and building societies, would be obliged to improve their monitoring of money transactions. The report says that this can best be done by a “suspicion-based” system by which banks are required to report cash movements they suspect may be drug-related. The report, however, is against widening the U.S. practice of mandatory reporting of all cash movements above $10,000. This was thought to be too cumbersome.
Second, the banks must take better steps to identify their customers. The report admits that this is not easy because drug dealers can conceal their identities behind nominees. But there is scope for closer scrutiny of unfamiliar clients.
Third, the report urges ratification of the 1988 Vienna Convention against drug trafficking,13 which commits signatory countries to making money laundering criminal. One key aim of the convention is to lift the confidentiality restraint from banks in cases of suspected drug money laundering. The Criminal Justice (International Cooperation) Act 1990 enabled the United Kingdom to ratify the Vienna Convention.
Prevention of Terrorism (Temporary Provisions) Act
Finally, I turn briefly to the Prevention of Terrorism (Temporary Provisions) Act 1989.14 Under this Act a banker must not deal in funds that are known or suspected to come from a doubtful source. Unlike under the Drug Trafficking Offenses Act,15 a banker is under no duty to report his or her suspicions to the authorities but he or she commits an offense (which is imprisonable for up to 14 years) if he or she enters into or is otherwise concerned in an arrangement whereby the retention of, or control by or on behalf of another person of, terrorist funds is facilitated, whether by concealment, removal from the jurisdiction, transfer to nominees, or otherwise. If the bank official can prove that he or she did not know and had no reasonable cause to suspect that the arrangement related to terrorist funds, that constitutes a defense. The Act provides more problems for the bank manager. Section 12 of the Act relaxes the duty of confidentiality and allows a bank to disclose information to the police.16 The Section provides that a person such as a banker does not commit an offense if, among other things, the banking official discloses such suspicions to a constable.
All these changes have provided great challenges for English banking lawyers. But I am not sure that our reputation generally has much improved since Dr. Samuel Johnson observed that “he did not care to speak ill of any man behind his back, but he believed the gentleman was an attorney.”