Part A Regulatory Matters, 1 The Regulation of Deposit-Taking Business
- Bank supervision — Basel 3 — UK Prudential Regulation Authority (PRA)
1.01 The conduct of banking business is regulated in a variety of ways. At the most basic level, some form of licence or authorization will always be required before an entity can engage in banking at all.1 Thereafter, of course, there will be ongoing requirements as to competence of management, adequacy of capital, conduct of business and other matters. In a modern economy in which banking plays such a key role, the existence of these requirements needs no philosophical justification. Indeed, the depth of the financial crisis which gripped the world in the period beginning in 2008 meant that political pressure for further regulation of banks and financial institutions has intensified and is likely to continue to do so.
1.02 Yet matters are more complex than these broad statements may immediately suggest. For example, banking is now an undeniably international business, and the insolvency of an institution will invariably have repercussions beyond its own national boundaries.2 Yet the framework put in place for banking supervision is in many ways dependent upon purely national, legal structures. One only has to state this proposition to realize that there is in many ways a serious mismatch between the essentially territorial scope of the regulator’s powers and the international reach of many banks. Efforts are periodically (p. 4) made—and are currently being made—to bridge this gap. Inevitably, however, domestic political considerations may render this process difficult.
(a) the history of the regulation of banking business in the United Kingdom;
(b) deposit-taking as a regulated activity;
(c) the authorization procedure;
(d) the powers of the regulators; and
(e) finally, brief mention will be made of the position of banks incorporated in other parts of the European Economic Area (EEA) but carrying on business or providing services within the United Kingdom.
The History of Banking Regulation in the United Kingdom
1.04 Until 1979, there was no domestic legislation that regulated the conduct of banking business in the United Kingdom. Indeed, insofar as banking business comprises the making of loans and advances to customers, the absence of regulation remains a significant feature of the current legislation.3 Until 1979, the Bank of England operated an informal system of supervision which relied upon an expectation of compliance and the general influence of the central bank in the financial sphere.4 At that point, however, Parliament passed the Banking Act 1979, which required that the acceptance of deposits from the public should be subject to prior authorization by the Bank of England. The Act was passed in order to give effect to this country’s obligations under the First European Community (EC) Banking Directive, which required a formalized system of authorization and supervision for the banking sector.5 The regulatory framework was subsequently revised and extended by the Banking Act 1987. The main consequences of the 1987 Act were (i) a streamlining of the authorization process,6 (ii) the introduction of a ‘large exposures’ reporting system,7 and (iii) the Bank of England was given more ‘teeth’ in the sense that it had greater powers to demand information and to carry out investigations.
1.05 A notable feature of the 1987 Act—especially when compared with the current legislation—is that the Act regulated who could carry on a deposit-taking business but, (p. 5) subject to minor exceptions—it did not regulate how that business should be carried on, in the sense that there were very limited rules dealing with the conduct of business.
1.06 It was at this point of time that the incoming tide of European legislation began to become more evident. In 1989, the EC Council adopted its Second Council Directive on the coordination of laws, regulations and administrative provisions relating to the taking up and pursuit of the business of credit institutions,8 which was implemented in the United Kingdom by means of the Banking Coordination (Second Council Directive) Regulations 1992.9 These regulations gave effect to the Community’s ‘passporting’ scheme, under which it would no longer be necessary for an EC-based institution to be separately authorized in each of the EC Member States in which it had a branch or provided services. Instead, it would be permitted to establish a branch and undertake local activities in those other countries in reliance on its home State authorization. Although these particular regulations have now been repealed, the passporting system remains in effect through later directives and their implementing regulations, and this forms one of the key pillars of EU banking law.10 In addition, the Community began to introduce further directives intended to implement the capital adequacy and other prudential requirements laid down by the 1988 Capital Accord published by the Basel Committee on Banking Supervision (Basel I).11 The further initiatives included the Own Funds Directive,12 the Solvency Ratio Directive,13 and two directives dealing with capital adequacy issues.14 All of these directives have subsequently been consolidated and amended in the light of further recommendations by the Basel Committee in the field of capital adequacy.15 So it will be seen that the early 1990s saw a significant ‘Europeanization’ of banking law, mainly as a harmonizing measure with a view to completing the EC’s ‘single market’.16
1.07 More recently, however—and in a move which was not dictated by considerations of Community law—the government determined that the functions of the central bank should be separated from those of the market regulator17 and, in May 1997, the incoming Labour Government decided that the task of banking supervision should be transferred to the Financial Services Authority (FSA).18 The decision to transfer banking supervisory (p. 6) functions to the FSA was not, however, a ‘stand alone’ decision. It formed part of a larger plan to provide for unified supervision of the financial markets as a whole by a single regulator. Given the interdependence of the different segments of the financial markets (banking, insurance, fund management, and other businesses) it was argued that this was an appropriate step, although the wisdom of removing bank supervision from the Bank of England was questioned by some commentators in the wake of the recent financial crisis.
1.08 A further change in government in May 2010 eventually led to further changes in the regulatory structure, with the Prudential Regulation Authority (PRA) now operating alongside the Financial Conduct Authority (FCA).19
1.09 Notwithstanding these changes in the identity and structure of the regulators, the legal framework for bank regulation and supervision continues to be provided by the Financial Services and Markets Act 2000 (FSMA), although it has subsequently been subjected to extensive amendment. It has been pointed out elsewhere20 that the 2000 Act succeeded in being both a formidable, and yet at the same time inchoate, piece of legislation. It is formidable in the sense that it runs to some 433 sections and 22 schedules; yet it is inchoate in the sense that the Act itself answers few of the practical questions to which the scheme of regulation gives rise on a daily basis. Instead, it confers upon the regulators a broad rule-making power, and it will almost invariably be necessary to refer to those rules in order meaningfully to deal with any issues that may arise. As noted earlier, the legislation deals not merely with banking but also with other aspects of the financial markets. The present discussion will, however, naturally concentrate on issues relevant to the conduct of banking and associated business.
Deposit-taking as a Regulated Activity
1.10 Perhaps the two main activities usually associated with ‘banking’ are the acceptance of deposits and the lending of funds for business or other purposes.21 In spite of this general perception, the two aspects of the business are subjected to very different types and levels of supervision. It is thus necessary to examine these two aspects separately. The deposit side of the equation is considered here, whilst the lending side of the equation is considered at a later stage.22
Acceptance of Deposits
1.11 Reference has already been made to the broad and inchoate nature of the FSMA. The so-called ‘general prohibition’ contains an excellent illustration of that general proposition. Section 19 provides that ‘[n]o person may carry on a regulated activity in the United Kingdom, or purport to do so, unless he is…an authorised person…or an exempt person…’.
(p. 7) 1.12 It is immediately obvious that the meaning of ‘regulated activity’ is central to the whole scheme of the regulatory system created by the FSMA. This line of enquiry then leads to section 22 of the FSMA, which provides that a ‘regulated activity’ is ‘…an activity of a specified kind which is carried on by way of a business and…relates to an investment of a specified kind…or…in the case of an activity of a kind which is also specified for the purposes of this paragraph, is carried on in relation to property of any kind…’. At first sight, section 22 may not appear to advance matters in a particularly material way, but it does at least confirm that the Act only regulates activities which are carried on as a business; it does not apply to purely ‘one-off’ transactions or other dealings which cannot be said to be effected in the course of a business. The importance of this point will be discussed later.23
1.13 The FSMA further defines the activity of deposit-taking by a mere reference to ‘accepting deposits’.24 However, for real clarification of the nature of the general prohibition as it relates to deposit-taking, it is necessary to refer to the Regulated Activities Order.25 In its turn, article 5 of the Regulated Activities Order provides that:
(a) money received by way of deposit is lent to others; or
(b) any other activity of the person accepting the deposit is financed wholly or to a material extent out of the capital of or interest on the money received by way of deposit.
(2) In paragraph (1), ‘deposit’ means a sum of money, other than one excluded by any of articles 6 to 9A,26 paid on terms—
(a) under which it will be repaid, with or without interest or premium, and either on demand or at a time or in circumstances agreed by or on behalf of the person making the payment and the person receiving it; and
(b) which are not referable to the to the provision of property (other than currency) or services or the giving of security.
(a) it is paid by way of advance or part payment under a contract for the sale, hire or other provision of property or services, and is repayable only in the event that the property or services is or are not in fact sold, hired or otherwise provided;
(b) it is paid by way of security for the performance of a contract or by way of security in respect of loss which may result from the non-performance of a contract; or
(c) without prejudice to sub-paragraph (b), it is paid by way of security for the delivery up or return of any property, whether in a particular state of repair or otherwise.
(p. 8) Article 5, when read together with section 19 of the FSMA, thus raises four questions, namely, (i) is a particular sum of money a ‘deposit’, (ii) if so, is the person concerned ‘accepting’ deposits for the purposes of article 5, (iii) if so, is he carrying on that activity by way of business, and (iv) if so, is he carrying on that business in the United Kingdom? If all of these questions are answered in the positive, then the relevant activity will be unlawful, unless either the person concerned is authorized or exempt, or the transaction itself is in some way exempt.27 It is necessary to examine each of these issues in turn.
1.14 First of all, when does a payment or transfer of money amount to a ‘deposit’? In order to answer this question, it is necessary to examine the terms of the contract between the parties. If the deposit is to be repaid, either on demand or at a future date, with or without interest or premium, then on the face of it the relevant sum will be a ‘deposit’ for present purposes. A few points of interpretation flow from this apparently simple formulation:
(a) Article 5 requires that the relevant sum must be contractually repayable. It is submitted that this means that the deposit must be repayable in full, that is to say, without any deduction.28 This view is reinforced by the words ‘with or without interest or premium’, which suggest that the depositor may receive back more than the amount of his original deposit, but not less.
(b) If the contractual arrangements envisage situations in which the depositor may receive repayment of less than the original principal amount, then the arrangement does not amount to a deposit. In such cases, it must generally be assumed that the payer is assuming greater risk for greater reward, and that there is thus some form of risk or speculative element involved in the deal. Entities offering arrangements of this kind will often require authorization under other provisions of the FSMA,29 but the arrangement does not fall within the scope of the deposit-taking restriction in article 5.
(c) Similarly, the expression ‘repaid’ connotes that the deposit must be repaid in money. Consequently, payments made for stored value cards entitling the holder to the use of public transport or telephones do not amount to deposits, because the payer is not generally entitled to redeem the card for cash.30
(d) A sum of money thus only constitutes a deposit if its initial payment creates a debtor–creditor relationship between the parties, imposing upon the bank an obligation to repay the monies in full regardless of the success of any venture in which the (p. 9) bank may choose to invest those funds.31 This view is consistent with the general view of the banker–customer relationship.32
(e) the fact that a transaction is labelled as a ‘loan’ does not prevent it from being a ‘deposit’ if the ingredients of the statutory definition are met.33
(f) The exceptions from the definition of ‘deposit’ set out in article 5(2)(b) (read together with article 5(3)) of the Regulated Activities Order are of some importance in practice. In essence, these provisions exclude any payments which are referable to the provision of goods or services, or the taking of security. Thus, a landlord who takes a dilapidations deposit from his tenant is not accepting a ‘deposit’ for the purposes of the Regulated Activities Order.34 Likewise, a broker who accepts cash margin as security for dealings in commodities or financial futures is not accepting a ‘deposit’, since the payment is referable to the provision of dealing services and is intended as security for the customer’s obligations.35
(g) Certain payments of money are stated not to constitute deposits even though they might otherwise meet the definition of that term. The list of exempt payments36 includes:
(ii) sums paid by a person authorized under the FSMA to accept deposits or to carry out insurance business, or by a person whose business consists wholly or to a significant extent in lending money;37
(v) sums paid among close family members;38
(vii) sums paid by way of consideration for the issue of debentures or government securities;39 and
(viii) sums paid in consideration of an immediate provision of electronic money.40
1.15 If the transaction involving the payment of money does amount to a deposit, then it becomes necessary to determine whether the relevant entity is ‘accepting deposits’ for the purposes of the Regulated Activities Order. It will be recalled that the prohibition only applies where either (i) the monies so received by way of deposit are lent to others or (ii) the business of the person accepting the deposit is financed, wholly or to a material extent out of the capital of, or interest received on, those deposits.41 If the accepting entity is itself a money lender, then the first criterion will almost inevitably be met, with the result that the entity concerned will be ‘accepting deposits’ for these purposes. In other cases, it will be necessary to determine whether the second criterion is satisfied, and this may involve difficult assessments of a factual nature. It has to be borne in mind that not all funding received by an entity through the means of debt finance will necessarily constitute a deposit which falls to be taken into account for these purposes. For example, as has been seen,42 monies received from an authorized institution do not amount to the receipt of deposits by the borrowing entity. Consequently, they would not fall to be treated as deposits in making the necessary assessment.
Carrying on a Business
1.16 If the first two tests have been met, then it will finally be necessary to determine whether the relevant deposits were accepted in the course of a business since, as noted above, an activity is only subject to regulation if it is carried on by way of business.43 This can often be a delicate question in a number of contexts.44
1.17 In Financial Services Authority v Anderson45 the court considered the expression ‘business’ in this specific context and accurately described it as an ‘etymological chameleon’, in the sense that its meaning will depend upon the statutory background. Without attempting a definition, the court in the Anderson case held that deposits were being accepted by way of business because (i) sums running to into millions of pounds were accepted by the defendants for the purpose of on-lending to small businesses, (ii) this activity had continued over an extended period of time, (iii) the defendants had raised loans (deposits) from a wide range of individuals to fund this activity, and (iv) the object of the activity was to earn a profit by reference to the differential between borrowing and lending costs.46
(p. 11) 1.18 In the deposit taking context, it is specifically provided that a person should not be regarded as accepting deposits if (i) he does not hold himself out as accepting deposits on a day-to-day basis and (ii) any deposits which are accepted are taken only on particular occasions, whether or not involving the issue of securities.47 This clarification may be useful in various contexts. For example, a joint venture company which is owned in precisely equal shares48 may need to raise funds from time to time and will naturally approach its investors to make the necessary cash advances. This will not amount to an acceptance of deposits by the joint venture company, since it does not hold itself out as accepting deposits generally and only does so for the purpose of funding its particular activities.49 However, specific occasions aside, it should be appreciated that even very sporadic acceptance of deposits is likely to be treated as a business activity, especially where the profit motive is present.50
In the United Kingdom
1.19 If all of the above tests have been met, then it is necessary to ask whether the relevant business is being carried on ‘in the United Kingdom’. Quite apart from questions of UK statutes and their territoriality, it will be recalled that this requirement explicitly forms a part of the general prohibition.51
1.20 Once again, whether or not a particular business is being carried on in the United Kingdom can be a delicate question. For example, the mere fact that a foreign banker makes occasional trips to the United Kingdom to visit customers in the UK should not lead to the conclusion that his bank is carrying on business in the UK.52 A bank cannot be deemed to be carrying on business in every country in which it happens to have customers. There will, inevitably, be difficult questions of fact and degree.
1.21 The FSMA does provide a certain amount of guidance in this area, although it must be said that the effect of these provisions is to ‘import’ into the United Kingdom business which might otherwise be considered to be carried on outside of the UK. The provisions which are relevant to deposit-taking business are as follows:
(a) A UK company which is entitled to carry on deposit-taking business in another EEA State53 and which carries on that activity in such a State is deemed also to be carrying (p. 12) on that business in the United Kingdom.54 This slightly convoluted provision reflects the requirement that any entity carrying on activities covered by the Single Market Directives in relation to banking and financial services must be authorized for that purpose in its home State.55
(b) A UK company will be deemed to be carrying on business in the United Kingdom if it is carrying on a regulated activity whose day-to-day management is the responsibility of its registered office or an establishment in this country.56 Thus, even though a company may be offering deposit-taking services exclusively to persons outside the United Kingdom, it will still require authorization if its operations are ‘based’ in the UK.
(c) A foreign entity whose head office is abroad but which carries on a regulated activity through an establishment in the United Kingdom will be deemed to be carrying on that business in the United Kingdom even though it has no customers in the UK.57 In relation to foreign companies, this is essentially a mirror image of the provision described in (b) above.
For these purposes, it will not always be easy to say whether or not a particular entity has an ‘establishment’ in the UK. That issue is, however, discussed in another context.58
1.22 If deposits are being accepted in the course of a business carried on in the United Kingdom, then it becomes necessary to consider whether the person accepting the deposits is in some way exempted from the provisions of the FSMA. The Treasury has power to exempt persons (or specified classes of persons) from the scope of the general prohibition created by section 19(1) of the FSMA.59 The exemptions may be given generally or may relate only to specific transactions or circumstances. A number of institutions and organizations—including municipal banks, credit unions and industrial and provident societies—have been granted exempt status in relation to the prohibition against the acceptance of deposits.60
Consequences of Contravention
1.23 Apart from the criminal sanctions for breach of the general prohibition against the unauthorized acceptance of deposits,61 it should be noted that—under section 26 of the FSMA—an agreement entered into by a person in the course of carrying on a regulated business without the appropriate regulatory permission will be unenforceable against the other party.62 The other party will generally be entitled to recover both the funds paid by him and appropriate compensation.63 It should be noted that section 28 of the FSMA (p. 13) allows for an exception to these provisions, and allows the court to permit enforcement by an unauthorized person if it is just and equitable to do so in the circumstances of the case.64
1.24 However, whilst the criminal aspect of the above provisions applies to the unlawful acceptance of deposits, the civil consequences do not—section 26(4) states that ‘This section does not apply if the regulated activity is accepting deposits’. There is a logic to this position, in that it would be the borrower of the deposit who was acting unlawfully, and it would be unjust to deprive the lender—the innocent party—of his recourse on the basis of his borrower’s unlawful actions. It is not immediately clear why this should be the case. If a person places a deposit with an unauthorized person for a return which is below the market rate, he should be entitled to appropriate compensation as well as repayment. In addition, where deposits have been accepted unlawfully, the FSMA allows for an application to court for immediate repayment of the deposit regardless of its stated maturity date.65
The Authorization Procedure
1.25 If an entity wishes to accept deposits by way of business in the United Kingdom and none of the available exemptions apply, then it will be necessary to seek authorization for that purpose in order to avoid a contravention of the FSMA.66 The required authorization is frequently referred to as a ‘Part 4A permission’, since the details of the authorization process are set out in that Part of the FSMA.67 It is unsurprising that the main criteria to be taken into account in assessing such an application revolve around the financial soundness and managerial integrity of the entity concerned.
(a) an entity applying for permission to accept deposits must be a body corporate or a partnership;70
(b) the applicant must maintain its head office in the UK;71
(p. 14) (c) the applicant must demonstrate that its business will be conducted in a prudent manner and, in particular, that it will have adequate financial and non-financial resources;72
(d) the applicant must be a ‘fit and proper person’ for authorization bearing in mind the PRA’s objectives. In particular, the applicant’s management must have appropriate skills and experience;73 and
(e) if the applicant is a member of a group of companies or any person directly or indirectly controls more than 20 per cent of the voting rights or capital of the applicant—or the applicant controls 20 per cent of another entity—the PRA must be satisfied that those relationships are not likely to prevent the PRA from effective supervision.74
1.27 Compliance with the threshold conditions is a continuing requirement. Consequently, when deciding whether to grant an application for deposit-taking permission, the regulator must satisfy itself that the applicant meets the threshold conditions and will continue to do so.75 Assuming that the PRA is satisfied that the applicant meets the threshold conditions, it may grant the requested Part 4A permission to accept deposits. However, given that the FCA is also responsible for conduct regulation in relation to PRA-authorized entities, the PRA may only grant that permission with the consent of the FCA.76
1.28 As noted in para 1.27, continuing compliance with the threshold conditions is an important element of the authorization process. Consequently, the PRA may withdraw the permission to accept deposits77 if the relevant entity subsequently fails to meet those conditions or is likely to do so.78 Thus, for example, when the FSA determined that Kaupthing Singer & Friedlander—a UK authorized institution—no longer satisfied the ‘adequate resources’ test, it imposed upon that bank a requirement that it should cease to accept any further deposits.79
1.29 Likewise, continued compliance with the ‘fit and proper person’ test must to a large degree depend on the identity of those who can exercise a significant measure of control over the affairs of the institution, and this may obviously change over time. Accordingly, any person who proposes to acquire or to increase a significant shareholding over an authorized institution should notify the regulators in advance and obtain approval. If the acquisition occurs without prior notification to the regulator and it does not approve the new (p. 15) arrangements, then the regulator may bar the exercise of voting rights and apply to the court for an order that the relevant shares be sold.80
1.30 The above discussion has focused on authorization for the acceptance of deposits, since that is the key and distinguishing characteristic of banking business. It should, however, be appreciated that a bank would require further permissions for many of its other activities, including, to name but a few, (i) entering into regulated mortgage contracts,81 (ii) managing investments,82 and (iii) advising on investments.83 But the extent to which a UK entity with permission to accept deposits can carry on other forms of business activity is now to become the subject of a new layer of regulation, to which it is now necessary to turn.
Performance of Controlled Functions by Individuals
1.31 The above discussion has focused on the authorization of an institution to carry on the regulated activity of deposit-taking. But, of course, as with any corporation, such an institution can only act through human agency and some of the individuals concerned may be carrying out significant functions on its behalf.
1.32 Accordingly, section 59 of the FSMA requires that an authorized person must take reasonable care to ensure that ‘controlled functions’ are only carried out by a person who has been approved for that purpose by the PRA. ‘Controlled functions’ for these purposes are defined by the PRA Handbook84 and principally include the functions of directors, chief executives and persons in charge of systems and controls. The FCA is responsible for approval of persons carrying out certain other tasks within the institution, including compliance oversight and money laundering functions.
1.33 When the relevant provisions of the Financial Services (Banking Reform) Act 2013 are brought into force, additional approval requirements will apply to a person carrying out a ‘senior management function’—that is, a decision-making function in the affairs of the authorized person that may have serious consequences either for the institution itself or for wider business interests in the United Kingdom.85 The regulator must also be notified if the nature or scope of such a person’s role are varied at a later date,86 and the FCA may make rules about the conduct of such persons.87 The assessment process and the application of the ‘fit and proper’ test applied in relation to persons holding significant positions within banks is governed by the FIT Sourcebook in both the PRA and the FCA Handbooks.
1.34 New rules discussed above dealing with senior management functions and similar matters are, of course, a consequence of the financial crisis, where various individuals have been held to carry a degree of culpability for the failure of an institution. In an effort to reinforce (p. 16) the notion of personal responsibility for institutional failure—but without seeking to make too much of a dent in the notion of separate corporate personality—the decision was made to introduce a new criminal offence of participation in a decision that causes an institution to fail. Section 36 of the Financial Services (Banking Reform) Act 201388 creates an offence for a senior manager of a financial institution if:
(a) he takes or participates in a decision as to the conduct of a group company, or fails to take any step open to him to prevent that decision;
(b) he is aware that the implementation of that decision may cause the failure of the institution;
(c) his conduct in relation to that decision falls far below what could reasonably be expected of a person in that position; and
(d) the implementation of the decision causes the failure of the institution.
1.35 The elements of this offence may not be easy to prove beyond reasonable doubt. In many cases, senior managers may approve broad strategic policies, and it will not be a straightforward matter to link those decisions directly to the failure of the bank. In other cases, failure may result from a series of flawed decisions, and the defendant may have been party to some—but not all—of the fateful decisions. In any event, it is generally accepted that the purpose of the offence is to focus the minds of senior management on the importance and implications of their responsibilities, in the hope that this will prevent bank failures.
1.36 When banks trade in investments, derivatives, and similar instruments (so-called ‘proprietary trading’), they are in practice taking risks that affect the bank’s deposit base and potentially affect its solvency. This, in turn, has serious consequences for the financial system as a whole and for the continuity of financial services. The UK Government commissioned an examination of this particular problem, and the result was the Vickers Report.89 The main recommendation of that Report was that deposit-taking and certain other activities should be segregated (or ‘ring-fenced’) from proprietary trading and other activities of a risky nature.90
1.37 The implementation of this aspect of the Vickers Report is achieved by section 4 of the Financial Services (Banking Reform) Act 2013, which inserts a new Part 9B into the FSMA.91 The wounds inflicted by the financial crisis mean that the reforms to be effected by the 2013 Act enjoy broad support across all political parties and they are likely to proceed according to plan. An examination of these reforms is thus clearly appropriate in the present context.
1.38 In terms of its scope, Part 9B of the FSMA will apply to a UK-incorporated institution that carries on a so-called ‘core activity’. That expression will include (i) the regulated activity of (p. 17) accepting deposits, whether in the UK or elsewhere, and (ii) any other activity designated as such by the Treasury.92 The section allows the Treasury to exclude certain types of deposits from the ‘core activities’ that must be within the ring-fence. The result of the secondary legislation on this subject93 is that deposits fall outside the scope of the ring-fencing requirement if they are accepted from (i) certain financial institutions (including banks and investment firms), (ii) organizations that meet stated balance sheet or other size requirements, or (iii) an individual holding assets in excess of £250,000. Depositors who may be regarded as ‘sophisticated’ in line with these tests may thus place their money with entities that are not ring-fenced. Given that the rules now under discussion are directed towards the stability of the financial system as a whole, institutions with a deposit base of less than £25 billion are exempted from ring-fencing.
1.39 As already noted, part of the purpose of the ‘ring-fencing’ rules is to ensure that ‘core services’ will continue to be available on an uninterrupted basis. When certain major UK institutions were found to be on the verge of collapse in October 2008, this threatened depositors’ access to their funds, and to the payment of direct debits/standing orders. This would have caused great difficulty and inconvenience, both for depositors and their creditors. It is thus perhaps unsurprising that ‘core services’ are defined to include:
(a) facilities for accepting deposits or other payments into a bank account;
(b) facilities for withdrawing money or making payments from such an account; and
(c) the provision of overdraft facilities on such an account.94
1.41 First of all, a ring-fenced entity is prohibited from carrying out certain types of activities. Given that proprietary trading95 was seen as one of the causes of the financial crisis, the regulated activity of ‘dealing in investments as principal’ necessarily falls to be treated as an excluded activity.96 As in the case of ‘core activities’ and ‘core services’, the Treasury has power to add to the list of ‘excluded activities’ which are foreclosed to a ring-fenced entity.97 These rules are refined by secondary legislation, which allows ring-fenced entities to enter into swap and derivative contracts that are designed to protect it against fluctuations in (p. 18) interest or exchange rates, or various indices. Derivatives trading as a self-standing business thus remains off-limits for such an entity.98
1.42 Secondly, the Treasury may impose prohibitions against other forms of activities or may restrict the conduct of business of ring-fenced entities in particular jurisdictions.99 In an effort to ensure that a bank’s capital base can absorb losses, the PRA may require an institution to issue debt instruments consisting of Tier One or Tier Two capital; up to a specified level.100
1.43 In view of the importance attached to the ring-fencing mechanism in the wake of the financial crisis, it is perhaps surprising that a contravention of the above rules will not constitute a criminal offence or give rise to any right of action in respect of any breach of statutory duty.101 Instead, the ring-fenced body will be taken to have infringed a requirement imposed by the PRA or the FCA, and will be liable to a disciplinary penalty accordingly.102
1.44 Perhaps to the relief of third parties dealing with a ring-fenced entity, it is specifically confirmed that the ring-fencing provisions will not render illegal or unenforceable any contract entered into by the ring-fenced entity in contravention of the rules described above.103
1.45 As will be apparent from the above discussion, the purpose of the ring-fencing rules is to insulate a ring-fenced entity from the losses that might otherwise accrue as a result of ‘own account’ or proprietary trading, or other ‘non-core’ activities. Whilst this is satisfactory as far as it goes, it must be borne in mind that (i) a ring-fenced entity may be part of a wider corporate group and (ii) the financial position of the ring-fenced entity may be adversely affected by difficulties afflicting its holding company or other members of the group. It was therefore to be expected that the new Part 9B of the FSMA would contain additional provisions to regulate this type of situation. For these purposes, the PRA has power to give instructions for the disposal of assets or the initiation of steps to relieve the ring-fenced entity of specified liabilities.104 The underlying objective is to ‘insulate’ the ring-fenced entity from problems that arise elsewhere in the group structure.
(a) the EU has also brought forward legislation designed to deal with the same issue. That legislation is considered in an EU banking law context;105 and
(b) in the United States, the issue was addressed by Paul Volcker, a former chairman of the Federal Reserve System, following his appointment as chairman of the President’s Economic Recovery Advisory Board in 2009. Although there may be differences of emphasis, approach, and style, Volcker likewise concluded that proprietary trading and the extensive use of derivatives involved a degree of speculation that created systemic (p. 19) risk that was inconsistent with the normal functions of an ordinary commercial bank. Subject to a number of exceptions and an arduous legislative process, the ‘Volcker Rule’ is now enshrined in section 619 of the Dodd–Frank Wall Street Reform and Consumer Protection Act. This operates as an amendment to the US Bank Holding Company Act of 1956, and provides that: ‘Unless otherwise provided in this section…a banking entity shall not…engage in any proprietary trading or…acquire or retain any equity, partnership or other ownership interest in or sponsor a hedge fund or a private equity fund.’ There are a number of exceptions to this basic rule and there is a vast body of implementing regulations. But it will be apparent from this brief description that, in very broad terms, the regulatory wind is blowing in the same direction.
Powers of the Regulators
1.47 Reference has already been made to some of the powers of the FSA in the context of the initial authorization of a credit institution, the threshold conditions and the ‘fit and proper person’ test. However, regulation and supervision are ongoing processes and it is therefore unsurprising that the PRA and the FCA also enjoy extensive information-gathering and investigatory powers. These are set out in Part XI (sections 165–177) of the FSMA and include the following:
(a) Power to require an authorized person to produce information and/or documents specified by the PRA or the FCA,106 but the power is limited to material reasonably required by the relevant regulator for the purpose of exercising its respective functions.107 The power extends to other entities which are in the same group as the authorized institution. In a wider context, the PRA has power to require the production of documentation where it considers that the requested material may be relevant to the stability of any part of the UK financial system.108
(b) Power to require an authorized person (or any member of the same group) to provide to the regulator a ‘skilled person’s’ report109 on any documents produced or required to be produced pursuant to the provisions described in (a) above. It may be noted that it is the duty of any person who has provided services to the relevant authorized person to provide such assistance as the skilled person may reasonably require.110 This would presumably include accountants, lawyers, and others who may have advised the bank on matters connected with the subject matter of the proposed report. However, it would seem that the skilled person could not require the disclosure of any information which is subject to legal professional privilege.111
(c) The regulator may appoint one or more competent persons to investigate the nature, conduct, or state of the business conducted by an authorized person, a particular aspect (p. 20) of that business or its ownership or control.112 The investigatory powers of the competent person extend to group members and to entities which were formerly authorized.113 Since they may have an impact on the financial health of the authorized person, the investigatory power also extends to any non-regulated business carried on by the authorized person concerned.114
(d) The regulators also have a more specific power to appoint a person to carry out an investigation on its behalf if it has grounds for believing that particular criminal offences (including offences such as market abuse or insider trading) may have been committed or if there has been any contravention of certain other rules.115
(e) In view of the international nature of the financial markets and the fact that suspected wrongdoing will frequently involve conduct in more than one jurisdiction, each regulator has power to assist an investigation by an overseas regulator116 by initiating its own investigation in line with the powers described above.117 Where the request comes from a regulator in another Member State, there may in some cases be an EU law obligation to provide the requested assistance.118 Subject to that, however, and in deciding whether to provide assistance in this way, the FSA must take into account (i) whether reciprocal assistance would be forthcoming, if requested, (ii) whether the investigation involves activities which would be unlawful or would contravene regulatory requirements in the United Kingdom, (iii) the seriousness of the case and any relevance to the United Kingdom, and (iv) whether it is otherwise in the public interest to provide the requested assistance.119 The discretion to assist overseas regulators has been the subject of judicial consideration. In R (on the application of Amro International SA) v Financial Services Authority,120 the FSA was asked to assist the US Securities and Exchange Commission (SEC) in an ongoing civil action involving fraudulent trading in company stock. The SEC requested documentation from a UK firm of accountants in relation to two entities which were not the target of the SEC allegations, on the basis that this information was required to assist in explaining the relationship between some of the entities which were under investigation. At first instance, the court held that there had been no assertion that the two entities concerned were knowingly involved in share manipulation, nor had it been suggested that the main target of the investigation had any interest in either of these two entities. As a result, the court granted judicial review of the decision to appoint the investigator insofar as it related to these two, specific entities. However, the judgment was reversed on appeal, on the basis that the FSA had properly exercised its powers and was not required to second guess the motives or objectives of the overseas regulator.121
(p. 21) (f) Various notice and other procedural requirements apply in relation to the instigation and conduct of the investigations described above.122 The investigator has power to require the person under investigation to answer questions, to provide information, and to produce documents.123 As a general rule, statements made to an investigator are admissible in court proceedings but this is strictly limited where the target of the investigation is subsequently charged with a criminal offence.124
(g) Unsurprisingly, a person who fails to comply with a documentation or information request made for the purposes of an investigation, or who destroys or falsifies any relevant material, may be guilty of an offence, unless he has a reasonable excuse.125
1.48 In accordance with the terms of EU legislation in this sphere, a credit institution126 established in another EEA State127 and which is authorized by its home State regulator is entitled to be treated as authorized in the United Kingdom to the same extent. The whole subject is dealt with in more detail at a later stage.128 But, in essence, an EEA firm authorized in another Member State must notify its home State regulator that it wishes to establish a branch or to provide services in another Member State. The home State regulator must notify the host State regulator accordingly. The host State generally has no right to prevent the relevant firm from pursuing its passported activities in the United Kingdom.129(p. 22)
2 Again, this statement requires no justification but the aspects of the crisis relating to certain Icelandic banks provide an obvious illustration: see the discussion at paras 13.17–13.29 below.
3 The exceptions to this statement relate principally to mortgage lending and consumer credit, where regulation seeks to compensate for a lack of bargaining power. These aspects will be discussed at paras 4.02–4.61 below. It should be added that, whilst a bank’s lending activities are not directly regulated, they are indirectly regulated by a number of means, for example through the rules requiring an institution to hold sufficient capital to meet its risks, rules governing large exposures and similar measures: see generally the discussion in Chapter 6 below.
5 The scope and effect of the First Banking Directive was one of the issues which arose for debate in the Three Rivers litigation, and is accordingly discussed in Chapter 14 below.
6 An institution which wished to accept deposits would henceforth have to be an ‘authorized institution’. This replaced the earlier system under the 1979 Act, which provided for a two-tier structure of ‘recognized banks’ and ‘licensed deposit takers’.
7 On this subject, see paras 6.84–6.89 below.
10 For further discussion of this subject, see paras 2.17–2.22 below.
11 The Basel Committee on Banking Supervision was originally established in 1974. It consisted of the governors of the central banks of the G10 States, but its membership has recently been expanded. It has no treaty or other formal, legal basis, but its recommendations have tended to be adopted as minimum standards for banks which are active in international business.
15 The later (and current) structure is known as ‘Basel II’. On this subject, see generally Chapter 6 below.
16 The whole subject of EU banking law is considered in more depth in Chapter 2 below. The same ‘Europeanization’ has also been apparent in the field of investment services: see in particular the Markets in Financial Instruments Directive which, so far as relevant to banks, is considered at paras 3.26–3.57 below.
18 The transfer was effected by s 21 of the Bank of England Act 1998. The same Act also conferred independence upon the Bank of England in determining monetary policy, and established the Monetary Policy Committee for that purpose. Once again, this decision reflected a growing international trend and is consistent with the requirement for central bank independence for institutions forming a part of the European System of Central Banks.
19 On these developments and for a discussion of the PRA and FCA, see Chapter 8, below.
21 Of course, matters are much more complex than this in practice. See, for example, the discussion on payment services in Chapter 5 below and relevant aspects of the Markets In Financial Instruments Directive at paras 3.26–3.57 below.
22 See Chapter 4 below.
23 On the expression ‘by way of business’, see the Financial Services and Markets Act 2000 (Carrying on Regulated Activities by Way of Business) Order 2001 (SI 2001/1177), as amended. This Order is considered at para 1.15 below.
25 To provide its full title, the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544). As will be apparent from the present discussion, numerous orders have been made in reliance upon the powers delegated to the FSA under the 2000 Act. The Regulated Activities Order may, however, be regarded as the main source of law in the area now under consideration.
26 The various exceptions and exclusions are discussed at para 1.14 below.
27 On exempt persons, see para 1.22 below.
28 This requirement may have to be subject to the minor exception that deductions can be made on account of normal bank charges but, nevertheless, the deposit is still repaid in full in the sense that the customer receives a discharge for liabilities which he would otherwise have to pay directly. Sums deposited with a bank may become subject to a right of set-off in the hands of the bank but, again, it is submitted that this does not alter the fundamental nature of the transaction as a deposit; the customer will still receive full credit for the amounts deposited with the bank, even though it may have the right to refuse their subsequent re-transfer or repayment to the customer. The requirement that a deposit must be repaid in full has caused some difficulty in the authorization of institutions wishing to offer Islamic-compliant products: see the discussion at paras 51.17–51.19 below.
30 It should however be noted that issue of e-money is a regulated activity: see the discussion in n 40 below.
31 Since money is fungible in any event, it is difficult to see how the customer’s right to repayment could be linked in this way. It may be added that a sum of money may be a ‘deposit’ irrespective of the currency concerned: see Brazzill v Willoughby  BCLC 673,  EWHC 1633 (Ch), reversed in part but not on this issue,  2 BCLC 259;  EWCA Civ 561.
32 See Foley v Hill (1848) HL Cas 28 and the discussion of this point at paras 15.11–15.18 below.
38 Whilst this clarification is useful, such arrangements would normally fall outside art 5 because they would not have been entered into by way of business. On this subject, see para 1.16 below. The exemption was discussed in Financial Services Authority v Anderson  All ER (D) 250 (Feb);  EWHC 599 (Ch) but was of no assistance to the defendants in that case, where loans were raised from a range of individuals only some of whom were close relatives.
39 Where the debentures constitute short term sterling commercial paper, they will only benefit from this exemption if the subscribers are investment professionals and the face amount of the paper exceeds £100,000—see art 9 of the Regulated Activities Order.
40 Article 9A of the Regulated Activities Order, as inserted by art 3(2) of the Financial Services and Markets Act 2000 (Regulated Activities) (Amendment) Order 2002 (SI 2002/682). It may be noted that the issue of electronic money involves an obligation on the issuer to make payments (effectively, on behalf of the holder) to retailers which accept the use of the e-money. Consequently, the issuer of the e-money is accepting a deposit which has to be repaid at a later date. This may be contrasted with the position of a stored value card, which involves the provision of services (rather than the repayment of money) and is thus not caught by the legislation now under discussion. Whilst the issue of e-money is specifically stated not to constitute the acceptance of a deposit, issuers are subject to the different regime established by arts 9B–9K of the Regulated Activities Order.
41 See para 1.13 above.
42 See para 1.14 above.
44 For cases decided in different statutory contexts, see Davies v Sumner  1 WLR 1301 (HL) and R&B Customs Brokers v United Dominions Trust Ltd  1 WLR 321 (CA). For a recent illustration of this type of problem in the context of the (now superseded) ‘business’ test in the Consumer Credit Act 1974, see Tamimi v Khodari  All ER (D) 87 (Oct);  EWCA Civ 1042. In the context of the FSMA, some guidance on the ‘business’ test in contained in the FCA Handbook, PERG 2.3.
47 Article 2(1) of the Financial Services and Markets Act 2000 (Carrying on Regulated Activities by Way of Business) Order 2001 (SI 2001/1177), as amended. In determining whether deposits are accepted only on ‘particular occasions’, it is necessary to consider (i) the frequency of those occasions and (ii) any characteristics which distinguish those occasions from each other: see art 2(2) of that Order.
48 ie so that the joint venture company is not a subsidiary of either shareholder and thus does not qualify for the ‘group’ deposits exemption noted at para 1.14 above.
49 This analysis is not entirely free from difficulty. In order to satisfy the ‘particular occasions’ test, it is necessary to have regard to the frequency of the occasions and any characteristics which distinguish them from each other (see art 2(2) of the By Way of Business Order mentioned in n 48 above. If cash advances are requested on a frequent basis and for a variety of different purposes, then it may be more difficult to satisfy the ‘particular occasions’ test: see Financial Services Authority v Anderson  EWHC 599 (Ch), paras 53–56, where the court equated the expression ‘particular occasions’ with ‘special occasions’.
50 See R v Napoli and James  All ER (D) 209 (May);  EWCA Crim 1109, which considers the ‘By Way of Business’ Order mentioned in n 47. above.
51 See FSMA, s 19 reproduced at para 1.11 above.
52 For the consequences of this type of activity in the context of the EU ‘passporting’ regime, see paras 2.23–2.29 below.
55 On the principle of home State supervision in this context, see the discussion in paras 2.11–2.12 below.
58 See paras 2.20–2.22 below.
59 The power is conferred by FSMA, s 38. The Act itself confers exemption on ‘authorized representatives’ who carry on a regulated activity under contract with a person who holds a permission for the relevant activity under the terms of the Act: see s 39 of the Act.
64 In that context, the court must take into account the extent to which the unauthorized person reasonably believes that he was not contravening the general prohibition: see FSMA, s 28(5). For a case in which it was held to be just and equitable to allow an unauthorized person to enforce a regulated mortgage contract, see Helden v Strathmore Ltd  Bus LR 1592;  EWCA Civ 542.
69 The general requirement is imposed by FSMA, s 55B, and the threshold conditions themselves are set out in Sch 6 to that Act. The threshold conditions applicable to deposit-takers are set out in Part 1E of that Schedule.
70 FSMA, Sch 6, Pt 1E, para 5B. Although private individuals are able to apply for authorization from certain types of regulated activities under the FSMA, they are not permitted to apply in relation to the ‘accepting deposits’ activity.
74 Where the applicant has close links with an entity established outside the EEA, the FSA must also be satisfied that neither the administrative regulations in force in that country nor any deficiency in their enforcement will prevent the FSA’s effective supervision of the applicant. On the points made in this paragraph, see FSMA, Sch 6, Pt 1E, para 5F.
75 FSMA, s 55B(3). Note that, in giving permission, the PRA may impose such conditions as it believes appropriate, whether as to the applicant’s conduct of business, its relationships with other businesses, or otherwise: see FSMA, s 55F.
78 The necessary power (referred to as the regulator’s ‘Own Initiative’ power) is conferred by FSMA, s 55J. The section also allows for the withdrawal of permission desirable to protect depositors, or if the relevant entity has effectively ceased to carry on any regulated business.
80 The details of these procedures, including rights of appeal and other matters, are set out in Pt XII of the FSMA (ss 178–192). For present purposes, it is the general scheme of the legislation, rather than its detail, which is of relevance. However, notification and FSA approval is required if a person intends to acquire 10 per cent of any institution or to enter into arrangements involving significant influence over its business.
81 Regulated Activities Order, art 61, on which see paras 4.48–4.61 below.
83 Regulated Activities Order, art 53. For a discussion of certain aspects of investment activities carried out by banks for their customers, see paras 3.26–3.57 below.
88 For detailed definitions of some of the expressions about to be used, see s 37 of the 2013 Act. The offence will apply to credit institutions and the PRA-regulated firms that deal in investments as principal. The offence also applies only to firms that hold a permission under FSMA, Part 4A. It would thus not extend to senior managers of an EEA-passported bank.
90 For corresponding EU initiatives in the area, see paras 2.30–2.36 below.
92 FSMA, s 142B. The Treasury may only designate additional ‘core activities’ if the interruption of the relevant services could adversely affect the stability of any part of the UK financial system, and the continuity of those services is best secured by designating them as a core activity.
94 See FSMA, s 142C. Once again, the Treasury has the power to add to the list of core services if it believes that an interruption to those facilities could be prejudicial to the stability of any part of the UK financial system.
95 The PRA has an obligation to review the extent of proprietary trading by authorized institutions and to make recommendations as to appropriate reforms: see s 9 of the Financial Services (Banking Reform) Act 2013.
96 See FSMA, s 142D(2). The Treasury has power to make limited derogations from this rule, provided that these are unlikely to prejudice the continued availability of the core services in the UK: FSMA, s 142D(3). It should be emphasized that the excluded activity (‘dealing as principal’) is intended to prevent proprietary trading for the bank’s own profit but funded (in part) by deposits. A bank would thus still be able to enter into transactions of this nature as agent for a client, where the bank earns a fee or commission but the financial risk of the transaction is borne by the client.
102 On disciplinary proceedings, see para 1.48 below.
105 See paras 2.30–2.36 below.
108 FSMA, s 165A. Section 165B requires the PRA to prepare a policy statement regarding the use of this power. For that statement, see ‘The Financial Stability Information Power’ (Bank of England, June 2014).
115 FSMA, s 168. Once again, a parallel power is conferred on the Secretary of State. The investigatory powers may be exercised in relation to suspected misconduct and the possible use of the FCA’s own disciplinary powers: see Financial Services Authority v Westcott  EWHC 2392 (Comm).
116 ‘Overseas regulator’ means a corresponding regulator in another EU Member State or a regulator from a third State exercising functions essentially similar to those of the FSA itself: see FSMA, s 195(3).
123 See FSMA, ss 171, 172, and 173. In certain cases, s 175 empowers the investigator to require the production of information by third parties. A warrant may be issued to obtain documents and information if a person has failed to provide them on request: FSMA, s 176.
126 A ‘credit institution’ is ‘…an undertaking whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account…’. The definition is discussed in more detail in Chapter 2 below.
128 See Chapter 2 below.