The reforms contemplated by the Financial Services (Banking Reform) Bill (the Bill) set out activities that ring-fenced banks (RFBs) will not be permitted to engage in (the Excluded Activities). In particular, the Bill provides that RFBs will be prevented from dealing in investments as principal. In addition, the Bill allows the Treasury to designate other activities which the RFB may not engage in and to prohibit RFBs from entering into transactions of a specified kind or with particular counterparties.
The proposed Financial Services and Markets Act 2000 (Excluded Activities and Prohibitions) Order 201* (the Order) extends the scope of these Excluded Activities to commodities trading and prohibits RFBs from incurring exposures to other financial institutions. The Order also sets out a number of exceptions to these exclusions and prohibitions, recognising that, without them, there would be some disproportionately negative consequences to participants in the trade finance market.
The exceptions contained in the Order do not extend to the full range of trade finance products, and create, in some instances, ambiguity. This updater examines some of the issues involved and explores the range of products that RFBs are able to continue to offer to their customers.
Drawing the “line”
The Independent Commission on Banking (ICB) recommended in its report of September 2011 that RFBs should be prevented from dealing in investments as principal and activities that expose them to market risk. Accordingly the draft Order provides that RFBs should, in general, be prohibited from trading in physical commodities too, as these could expose them to fluctuations in global market prices.
The ICB also recommended that RFBs be permitted to offer trade finance services, and in line with the recent recommendations of the Parliamentary Commission on Banking Standards, the Order permits RFBs to sell simple derivatives products to their customers, subject to safeguards.
The limited nature of the trade finance exception and the restrictive definition of what products constitute simple derivatives would, if passed into law, create significant disruption in the trade finance market.
Exceptions to the Excluded Activities – Trade Finance
The Order permits RFBs to offer trade finance services consisting of the issue or confirmation of a documentary credit or of a guarantee for the benefit of its customers.
standby letters of credit, third party bonds or other common and useful trade finance products do not appear to fall within the exception, as they are not usually seen to be “documentary credits” or “guarantees”;
documentary credits and guarantees need to be subject to standard ICC rules (UCP 600 for the documentary credits, and URDG 758 for the guarantees) to comply with the Order – anything else does not fall within the exception.
In addition, the Order provides that an RFB’s exposure to other financial institutions must be limited to 10% of its capital, with no more than 5% of its capital exposed to any one other financial institution. This is apparently consistent with historical trends, but may prove constricting to some RFBs.
It is unduly restrictive to stop RFBs from offering some of the commonest trade finance instruments. In addition, the ICC rules referred to are not universally adopted - alternatives are often perfectly acceptable.
Exceptions to the Excluded Activities - Derivatives
The Order does allow RFBs to provide some derivative products to its customers, but these are limited to straightforward interest rate, currency and commodity swap, forward and future contracts.
In addition, the price of these products or the prices used to value the product must be observable in the market – in other words they must be liquid products that are commonly traded. There are also caps on the volume of the derivatives an RFB can offer (in relation to its own funds and its credit risk capital requirement).
While allowing RFBs to offer simple derivative products is welcome, the definition of what constitutes these is too limited. An RFB may well wish to offer many other common, well-understood and popular derivative products – swaps with break clauses, options and participating forwards, for example - to its retail customers in the normal course of its business.
What impact will this have ?
Businesses banking with an RFB face the prospect of being unable to use a single bank for all of their trade finance needs. Customers involved in anything other than the most straightforward transactions will need to maintain a relationship with at least one non-RFB, with the inefficiencies and duplication of effort that that involves, as well as the impact on the pricing and other costs.
Furthermore, as all dealings between RFBs and non-RFBs need to be on an arm’s length basis (even if they are within the same corporate group), time, effort and cost will be diverted to document security-sharing arrangements and other inter-creditor issues which are not needed with a “one-stop shop”.
While the Order has introduced some useful exceptions to the Excluded Activities regime created by the Bill, it does not go far enough.
The trade finance market, and the financial products used in it, did not cause the financial crisis and yet it has been caught in the cross-fire. The Government is seeking to encourage an export-led recovery: yet the Bill and the Order in their current guise will make finance more difficult to come by for exporters.
We and other industry bodies (such as the BBA and the CBI) have written to the Government suggesting desirable changes to the Order with a view to minimising the inconvenience and disruption that will otherwise affect the increasingly important trade and export finance market. The Government is intending to legislate early in 2014: changes to the Order need to be monitored carefully.