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Breaking Up Is Hard To Do

Breaking Up Is Hard To Do

The Financial Services (Banking Reform) Act (“the Banking Reform Act”) passed into law on 18 December 2013 and has been hailed by some as the most significant reform of the banking sector in a generation.  Its aim is to make the UK banking sector more resilient after the 2008 financial crisis. This somewhat populist statute certainly sets out steeper responsibilities and harsher penalties for senior executives including a presumption of guilt where regulations have been contravened, and prison sentences of up to seven years for allowing a financial institution to fail. The legislation also introduces significant changes from a pensions perspective including the introduction of ‘ring-fencing’ - the separation and protection of the retail element of UK banks from the more risk-laden investment arms, including the pensions obligations of each - and depositor preference on insolvency.

The ring-fencing process is still very much in its infancy and the Government will need further legislation to set out the details of how such changes will be made – there is little explanation of how a single financial institution may be split into its retail and investment elements, although the intention is to give as much flexibility as possible to banks and pension scheme trustees to undertake the restructuring of the relevant pension scheme(s).  Options include splitting an existing scheme, segregating the scheme into two or more sections or establishing a new scheme.  There are clearly a large number of challenges posed by such restructuring such as:

  • Employer covenant: Future employer covenant assessments and PPF levies will be affected. The Government has acknowledged that it anticipates that the ring-fenced and non-ring-fenced elements’ covenants are likely to be weaker as each will be supported by fewer employers.  On the other hand, hiving off retail from the more risky elements of banking may actually improve its employer covenant risk-wise, although it is likely to have a highly detrimental effect on the covenant and PPF levies of the investment side of a bank.
  • How such a separation would work: How will the historical and orphan liabilities of a scheme be allocated between separate elements, when no such retail and investment distinction existed before now? Will scheme assets need to be divided between separate funds for investment bank and retail bank employees, or can they be held under a common investment fund with a notional allocation between the two arms? Will current asset backed-contribution arrangements and contingent assets need to be undone and replaced by separate, proportional arrangements for each scheme? How will the administrative costs and investment charges be allocated between two newly separated schemes?
  • How employees will be considered: How will it be determined whether an employee should fall within the investment or retail pension scheme: based on his or her most recent service, longest service, or divided between schemes on a pro-rata basis? What would happen where an employee’s job-description contains elements of both retail and investment work? How will the future transfer of employees between retail and investment branches be dealt with?
  • Depositor preference:  Any debt owed to the pension scheme will become subordinate to FSCS-protected deposits, significantly reducing the amount that trustees would be able to recover  if a bank became insolvent.  As a result, on any restructuring, the trustees of the pension scheme will be in a strong negotiating position and will likely seek additional contributions or guarantees to safeguard and improve the security of members’ benefits.
  • The transitional period: With ring-fencing to be implemented by 2019 and the restructuring of the pension schemes by 2026, there is considerable ambiguity surrounding the treatment of and implications for the banks’ pension schemes during the transitional period.
  • Complex and costly: Any restructuring exercise is likely to be a major task for the banks with significant cost implications not just in terms of time and professional fees but also in managing potential section 75 debts which could be triggered and the financial mitigation that may be required to allow trustees to agree to the restructuring.

Although the timescale for putting in place the new measures is relatively lengthy, UK banks and their pension scheme trustees will no doubt be considering, at a strategic level at least, what the implications are for their pension arrangements.  However, given the comparatively short political cycle in the UK, it remains to be seen whether these measures will actually be implemented - at least in their current form.

Jennifer Chambers
Senior Associate