Advantage - Retail Banking UK - ICB Issue

ICB Recommendations Explained

The ICB has released its final report, and the recommendations contained within have been strengthened since the Interim Report of April 2011. Responses from industry and stakeholders have followed thick and fast; a large number of which have focussed on the so-called delayed implementation timescales of 2019.

The recommendations represent a radical shakeup of the UK retail banking landscape which will necessitate lengthy project planning and complex delivery. With experience of delivering these kinds of major projects within Financial Services, Navigant summarises the key recommendations and clarifies those points which may not be clear upon first review. With the summary below, we hope to help you understand the potential impacts upon your organisation.

In This Issue

• Welcome
• ICB Recommendations Explained 
• Scope of the Recommendations
• What will be the true impact of the ICB?
  

Key Objectives of the Final ICB Report

The objectives of the report are to achieve financial stability and increased marketplace competition in the retail banking market. For the purposes of clarity, we have split out these two themes below, and have summarised the key recommendations contained within each.

Stability

It is the ICB’s objective to construct a regulatory focus so that systemic failure within banking organisations can be avoided. Where failure does occur, the ICB aims to ensure minimal interruption to the provision of essential services to retail and SME customers. The report recommends that this can be achieved by ring-fencing retail banking operations from wholesale and investment operations. The ICB also recommends that banks increase minimum capital ratios and holding of loss absorbing debt, thereby allowing them to become more capable of absorbing losses. These measures will isolate RFB activities from risks affecting other banking activities and remove the need for taxpayer support/government intervention. This will reduce the exposure of consumers and SMEs to the risks generated by failures within the banking industry. These two approaches contain a number of key recommendations, which are summarised below:

1. Increased Minimum Capital Ratios / Loss Absorbency – large retail banks are required to withhold a 10% minimum equity (equivalent to Basel III requirements) plus an additional 7-10% of loss absorbency through contingent convertible capital (CoCos) and ‘bail-in’ debt.
2. Ring-Fenced Mandated Services – only ring-fenced banks (RFBs) will be able to provide deposits, overdrafts and payments services.
3. Ring-Fenced Prohibited Services – amongst prohibited services are: lending to other financial institutions (with the exception of other RFBs); selling of investment products (with the exception of those which do not give rise to the RFB being required to hold regulatory capital against market risk); any services outside the European Economic Area, and; any services – other than deposit taking and payments services – to other financial institutions.
4. Ring-Fenced Ancillary Activities – RFBs must be able to manage their balance sheet against the variety of risks that arise in the course of their business, manage their liquidity and raise funding. For example, a ring-fenced bank would need to be able to hedge its own interest rate risk even if it should not be allowed to sell that hedge as a service. Backstop limits should be placed on the proportion of a ring-fenced bank’s funding which is permitted to be wholesale funding and on its total exposures, secured and unsecured, to non-ring-fenced banks and other non-bank financial companies.
5. Ring-Fenced Legal and Operational Links – as a minimum, RFBs must be separate legal entities. Where a RFB is part of a wider corporate group, it should be possible to be ‘isolated’ in a matter of days and continue the provision of its services without requiring solvency support. Therefore the RFB’s balance sheet should contain only assets and liabilities arising from these services and activities and it should have uninterrupted access to all of the operations, staff, data and services required to continue its activities irrespective of the financial health of the rest of the group. Further, the ring-fenced bank should either be a direct member of all the payments systems that it uses or should use another ring-fenced bank as an agent.
6. Ring-Fenced Economic Links – where a ring-fenced bank is part of a wider corporate group, its relationships with entities in that group should be conducted on a third party basis. It should not be dependent for its solvency or liquidity on the continued financial health of the rest of the group. This should be ensured through both regulation and sufficiently independent governance. In other words, relationships are to be conducted on an “arm’s length” basis. Furthermore, RFBs will be required to make all disclosures which are required by the regulator of the wider group and/or its other relevant substantial subsidiaries, and those which would be required if the RFB were independently listed on the LSE.

Improved Competition

The final ICB report recommends a number of measures to improve competition and for the consideration of further enhancements to be decided at a later date. A checkpoint is scheduled for 2015 to refer to the Competition Commission if sufficient conditions or progress haven’t been met (i.e. ease of switching, a strong and competitive challenger, strongly pro-competitive FCA). The five key recommendations are summarised below:

1. Switching – the introduction of a Current Account redirection service by September 2013 whereby the processes of switching will be made easier.
2. Transparency – a focus on consumer choice through the provision of data and increased transparency. Banks are to provide information on the price of services for a sample of representative customers and potentially also the cost of these services. The report is ambiguous around cost and pricing and we are clarifying this with the ICB. Furthermore, it has been recommended that foregone interest should appear on annual statements by January 2013.
3. Market Structure – a sizeable challenger is to be created through the planned divesture of Lloyds Banking Group assets with the primary focus of Project Verde now on creating this challenger (i.e. current account market share to be >6% & improved funding position) rather than reducing market concentration.
4. Financial Conduct Authority (FCA) – the FCA should have a clear mandate to promote effective competition in the retail banking marketplace.
5. Barriers to Entry – requires the Prudential Regulatory Authority to work with the OFT to reduce barriers to entry. However there are no recommendations on access to payment systems or branches for smaller banks.

Having analysed the interim and final ICB reports, Navigant is concerned that neither the ICB nor individual banks have undertaken a rigorous or sufficiently systematic analysis to determine the extent of the impact of the ICB recommendations. There will be extensive disruption to business, not least given the other significant change programmes running in parallel. The two other articles contained within the Advantage Newsletter (‘ICB recommendations will affect the entire banking sector’ and ‘What will be the true impact of the ICB’) provide further insight into the implications and associated timescales attached to the ICB recommendations.

For further information, please contact Christopher Hogg. 

ICB Scope of the Recommendations

One of the key implications of the ICB’s final report is that it will affect all types of banks and building societies - large and small, new and established, complex diversified banks, and “simple” retail only building societies. All banks affected by the new requirements need to develop capital raising strategies and take account of capital, liquidity and funding in their analysis of dividing activities between the ring-fenced and non ring-fenced parts of their organisation. It is clear that all financial institutions with retail banking assets need to start thinking about the implications for their organisations now.

The recommendations aimed at increasing competition will affect the industry as a whole, but what has been reported to a lesser extent is that relatively mainstream retail banking activities, such as provision of investment products to retail customers, fall outside of the ring fence. A good example here is Equity ISA sales which are prohibited to be sold by a ring fenced organisation, except through a “third party” style relationship.

The impact on sales processes and customer journeys could be significant and the complexities of the recommendations themselves mean that the specific implications will vary from one bank to the next. The diagram below outlines the impacts for different types of organisations within the market:

In This Issue

• Welcome
• ICB Recommendations Explained 
• Scope of the Recommendations
• What will be the true impact of the ICB?
  

Some of the finer points of the final report are, in our view, ambiguous and potentially significant. What is the detail and intent behind proposed changes to intra-group VAT rules? To what extent is transparency on cost (as opposed to price) really required? No-one is unaffected, so here is what you need to do and when:

TIMESCALES OF THE RECOMMENDATIONS

If the recommended timescales proceed, the milestones come thick and fast, as displayed in the timeline below. The recommendations around competition, and in particular switching, require immediate attention. Banks must also act play an active role in the development of practical legislation. Whilst the planned ring-fencing implementation date of 2019 seems like a lifetime away, banks will still need to fundamentally reassess their organisation’s existing change portfolio and undertake an analysis of the impacts of a more competitive environment on their business and customers.

TIMELINE

We recommend all banks map out a journey to 2019 which starts with an understanding of the impacts and options for the business. This will help you to steer your current projects and initiatives so that they support the long term objectives of the regulation. In the following table we demonstrate some of the activities that need to be considered.

In summary, it would be wrong to assume that a complete redesign of the business needs to happen now - it’s too early - but there are activities that you should be prioritising which will make any future transition much easier to achieve.

For further information, please contact Darren Peel.

What will be the true impact of the ICB?

The changes outlined in the ICB report are significant and will have a profound impact on the banking industry in the UK. However, whether these changes will achieve the end state that the ICB envisage, particularly around competition in the market, is debatable. The aims of the ICB are to reduce risk and to increase competition. These objectives counter balance each other and, with the exception of establishing a new player from the Lloyds Banking Group divestment, they are unlikely to benefit anyone other than organisations which supply capital and services to the industry.

In This Issue

• Welcome
• ICB Recommendations Explained 
• Scope of the Recommendations
• What will be the true impact of the ICB?
  

Being able to envisage what the Financial Services world will look like post ICB implementation is clearly impossible to do accurately at this stage. However, based upon our analysis of the report over the last week, we have in this article set out our view of the impact on; Industry Competition, New Entrants, Suppliers, and Customers, post ICB implementation - and pose some related questions to help our clients think through the implications on their businesses. The following picture represents Navigant’s view of the post-ICB marketplace on ringfenced financial institutions using Porter’s Five Forces Model.

Summary of Implications of ICB on Ring Fenced Banks

New Entrants and Industry Competitors

When we consider what the UK banking market might look like following ICB implementation, a legacy from the Commission of increasing competition within the market actually seems unlikely to be achieved.

The report itself sets out some of the reasons new entrants find it difficult to achieve traction within the market, in particular due to customers’ preference for banks with a large branch footprint. The higher cost of capital introduced through this review, along with an increased cost of compliance makes it less likely, not more, that new organisations will decide to enter the market, the successful purchaser of Verde perhaps being the only exception here. However, there may be an unintended consequence, because Verde will likely threaten smaller institutions and building societies rather than banking groups with larger market share.

The impacts may go further if any of the existing Universal Banks decide to exit the market due to severely reduced economics for operating in the UK market. We discuss this in more detail in the article Exploding the myths.

Having said all this though, for those organisations that do remain, the market will be a very different place, with a clear focus by the regulator on driving and monitoring competition and a customer base more able to switch products quickly and easily.

Buyers

So will the recommendations benefit the buyers of banking services, our customers? The ICB recommendations are not themselves aimed at benefiting customers. Indeed, all customers are likely to face increased cost, and customers with more sophisticated needs, including SMEs and Corporates, are likely to face increased confusion and bureaucracy. There remains a need for clarity over mandated and prohibited services, and the impact of customer choice in interfacing with post ring-fenced organisations. The future of free banking must now be considered in doubt given the transparency, cross subsidisation and cost issues which will face our banks.

Suppliers and Substitutes

The ICB will greatly affect banks’ aggregate risk and funding positions, giving rise to increased cost for the supply of capital. Additional regulatory capital requirements, implications on capital buffers, and potential mismatch of funding requirements for different businesses within the same group make the supply of capital a particularly important issue. Furthermore, the removal of the implicit deposit subsidy and reduced diversification outside of the ring-fence gives rise to a higher risk rating and greater difficulty in attracting capital at a reasonable cost.

Ironically, the biggest beneficiaries of the ring fencing proposals appear to be suppliers to the industry, where the demand for skills in key areas such as compliance, legal and corporate finance looks likely to outstrip supply: and where a relatively under-developed outsourcing market will now be in need to step up to provide the response that the industry will need as it changes.

We also expect to see increased innovation in the non-ring-fenced part of businesses. These will have significantly more freedom, which may lead to the further disintermediation of banks themselves; as non-bank institutions are able to take advantage by offering small businesses and corporates the opportunity to go directly to the capital markets, for example.

In summary, the adoption of the ICB’s recommendations will create significant external market disruption and will redefine the shape of the banking industry for years to come.

Banks must assess the consequences of these external changes on their business to ensure they are effectively prepared for a challengingly altered environment. Immediate priorities will be to model capital / funding requirements and operating model implications for ringfenced businesses.

For further information, please contact Peter Hewlett.