Re-sizing the Ring-Fence

The UK’s proposed ring-fencing reforms represent a rationalisation of banking regulation which, while having implications for bank strategy and structural efficiency, also raise intriguing questions on how practically ring-fencing and resolution regimes could align without compromising financial stability.

At a Glance

• In this blog post, we examine the recently announced changes to the UK ring-fencing regime put forward by His Majesty’s Treasury (HMT) as part of the Edinburgh Reforms and their implications for the UK banking sector.
  
• The reforms, if legislated in their current form, represent a sensible evolution of the role of ring-fencing as a means to promote financial stability. In some quarters, they may be seen as a rational response to overlapping regulation that was implemented post-Great Financial Crisis (GFC) in the UK, designed to avert a chaotic bank failure.
  
• If implemented as proposed, in the medium-term for UK banks with no (or de minimis) trading operations, would no longer be subject to ring-fencing legislation. Although today ring-fencing is less restrictive for these banks, they may reap certain strategic and structural benefits from this change. Furthermore, the higher deposit threshold before ring-fencing applied could bring funding efficiencies for international banks’ UK arms.
  
• For firms with larger investment banking businesses ring-fencing would be retained, for now. In the longer term the reforms, if legislated in a form that brings the regimes covering ring-fencing and resolution (the latter being the focus of much attention in recent times) into greater alignment, could see altogether more substantive changes, with requirements for such firms relaxed or, feasibly, removed altogether.
  
• HMT’s Call for Evidence, published on 2nd March and closing on 7th May, offers respondents the opportunity to share their views on the benefits ring-fencing brings to financial stability and to put forward options for greater alignment between ring-fencing and resolvability.

Background

On 9th December 2022, HMT unveiled their Edinburgh Reforms, an extensive package of regulatory reforms for the UK financial services sector intended to increase the competitiveness of “UK PLC” post-Brexit. The reforms followed the publication in March 2022 of a review carried out by the Independent Panel on Ring-fencing and Proprietary Trading (the Skeoch Review), commissioned by HMT. A central component of these reforms was HMT’s announcement that they will consult on changes to the ring-fencing regime in mid-2023, with secondary legislation proposed to be put forward later in the year. HMT also announced they would issue a public Call for Evidence in Q1 2023 to gather views on the benefits of aligning ring-fencing and resolution regimes in the context of the development of the wider regulatory framework.

Ring-fencing is a child of the GFC and was possibly the biggest UK regulatory reform in a generation. It was introduced in the UK to mitigate the risk to households’ savings (as well as SME banking and customer payment activity) from their co-mingling with investment banking operations which were perceived to be riskier. The seven banks in scope at present are: HSBC, NatWest Group, Barclays, Lloyds Banking Group, Santander UK, TSB Bank and Virgin Money. While in certain other major jurisdictions – the US and Japan for example – legal separation in some form between deposit-taking and certain types of securities activities exists, the UK regime sets itself apart in mandating fuller independence of a ring-fenced entity’s board and greater constraints on moving financial resources between the ring-fenced entity and other group entities. The EU opted against legislating for the ring-fencing of securities trading recommended under the Likaanen reforms.

Appraising the ring-fence

The benefits of ring-fencing have been much debated; criticism of the ring-fencing regime has been, in pockets, vocal within the sector: banks unsurprisingly object to the cost of compliance and the constraints on allocating capital productively. The Skeoch Panel itself considered the objectives of ring-fencing – to insulate retail banking services from non-retail activities – and the context for that, being financial services’ outsized share of UK GDP compared to other sizeable economies and thus the heightened systemic risk of the failure of a large UK retail bank. It outlined its view on the effects of ring-fencing, considering two lenses: impacts on financial stability and impacts on competition and competitiveness.

On the first, the Panel recognised the benefits from creating well-capitalised standalone retail entities that can be more effectively supervised and more adequately protected in certain scenarios. However, it noted that these benefits do not extend to less complex banks in scope of the regime and that, within complex banks, the resilience of non-ring-fenced entities is not enhanced. Ultimately, the Panel concluded, ring-fencing has a limited role in reducing the implicit government guarantee or in addressing ‘too-big-to-fail’ and that the more effective means for this, the Panel says, is resolvability.

On the second, the Panel assessed that there has not been any noticeable effect on competition in UK retail banking, nor the competitiveness of UK banks, observed thus far. The Panel caveat however that the less favourable monetary environment that has emerged in recent times could see more meaningful impacts materialise.

The Panel concluded that ring-fencing was worth retaining, but that the benefits would likely diminish over time particularly as a more holistic resolvability regime develops.

What are the proposed reforms?

The intention of the ring-fencing reforms is to “reduce the rigidity of the existing regime” and make it “more adaptable, simpler, and better placed to serve customers, while continuing to protect financial stability and minimising risks to public funds”, as HMT outlined. The proposed reforms, which largely align to the Panel’s recommendations, in their current form would:

• Remove ring-fencing for all banks in the medium term except those with ”major” investment banking operations (“major” is not defined but we expect the two large UK‑domiciled universal banks to be designated as such. Subject to the evolution of their business models, foreign banking groups with UK retail subsidiaries may eventually also fall in scope);
  
• Allow banking groups remaining in scope for ring-fencing to expand their retail deposits up to £35bn (from £25bn, a threshold unchanged since 2015) before ring-fencing is required. This was a provision incremental to those outlined in the Skeoch review;
  
• Give greater flexibility to banking groups remaining in scope by removing many of the restrictions causing “rigidity”, including allowing investment in non-UK subsidiaries; servicing non-EEA clients; an expanded product set within the ring-fence; and making equity investments in technology companies; and
  
• For remaining in-scope banking groups, give authorities new powers to relax ring-fencing requirements dependent on banks being judged resolvable. This remains subject to the Government’s Call for Evidence.

Strategic implications for banks arising from the proposed reforms

In the medium to longer term, the reforms would be expected to bring some momentum to most banks currently subject to ring-fencing operating in the UK and provide something of a boost to the international competitiveness of the UK banking sector. However, importantly, this momentum assumes the market views the broader implications for financial stability from rethinking ring-fencing as positive (or at least benign), which is not guaranteed.

For banks currently operating in the UK, the reforms may bring greater flexibility to deploy capital and excess liquidity more productively. More specifically, we see this manifesting in a number of ways. The reforms could impact upon the competitive position of banks in different respects, constituting a meaningful, if not dramatic, catalyst for change:

• Large UK universal banks could be impacted if they need to retain the more stringent requirements and higher costs of ring-fencing (for example constraints on moving excess liquidity from the ring-fenced bank) for longer.
  
• Large overseas banks with UK retail operations not yet subject to ring-fencing could benefit relative to UK banks from elevating the deposit ceiling on their growth from £25bn to £35bn, and from being able to fund markets businesses in the UK with retail deposits to a greater degree than previously. With the deposit threshold increasing to £35bn, potentially equivalent to a material boost to top-line income.
  
• Large UK “pureplay” retail banks, challenger banks and other recent entrants could benefit from the removal of certain brakes on growing their customer proposition, bringing opportunities to broaden their product set and the sectors they operate in and allowing overseas operations. The compliance burden of ring-fencing would be reduced, a welcome development given the much more modest benefit ring-fencing brought to those banks, and there may be potential for lower funding costs from a more diversified credit profile.

If, or when, the legislation nears finalisation and the exact details and timelines are known, banks should look to position themselves to grasp strategic opportunities (for example, the broader product range and geographic reach they can access); assess structural efficiency opportunities (for example, looking again at their legal entity and capital structure); and reconsider their funding structure across entities to satisfy themselves that the group is set up optimally.

Aligning ring-fencing and resolution

How ‘alignment’ between ring-fencing and resolution regimes could look in practice is an intriguing question: HMT’s Call for Evidence provides stakeholders with the opportunity to express their views on the benefits ring-fencing brings to planning for resolution, the effective management of failed firms, and the risk that firms fail in the first place. HMT goes on to ask respondents for their views on long-term options for aligning the two regimes and how best these can be operationalised. Additionally, recent market events have highlighted a number of lessons relevant to how ring-fencing and resolvability interact that we anticipate will help shape the ultimate outcome. Stakeholders have until 7th May to respond.

Concluding Remarks

• The proposals under the Edinburgh Reforms pave the way for the scaling back, and ultimately the possible cessation, of ring-fencing, a move which would reverse one of the most profound UK regulatory reforms in a generation. While the legislative process needs to run, an outcome along these lines may be considered by some as a welcome rationalisation of overlapping post-crisis regulation.

The reforms in the medium term could bring a meaningful change in market dynamics. Longer-term, should measures to align ring-fencing with the resolution regime be legislated, larger universal banks are incentivised to deepen focus on resolvability through the prospect of relaxation of the more restrictive aspects of ring-fencing.