Where to put the ring-fence: implications of the UK bank report
By Peter Elstob
LONDON, April 12 (Complinet) – The Independent Commission on Banking said on Monday that separating retail and wholesale banking in some way might have “a number of potential benefits”, and it invited views on the best design for a “retail ring-fence”.
In an annex to its interim report, the commission illustrated one way to devise such a ring-fence. This is to divide banking business into three broad categories: activities which must take place within the ring-fence; activities which may take place within it; and those which may not take place within it.
But the example leaves a lot of room for interpretation.
Under the three-part illustration in the annex, compulsorily within the ring-fence would be the taking of explicitly guaranteed insured deposits. Other services typically required by individuals and small and medium-sized enterprises might, but would not have to be, carried out within the ring-fence. The provision of capital markets services, trading and hedging services, primarily used by large corporations, financial institutions and governments, would be outside the ring-fence. Banking groups would also be allowed to provide these investment services, via their non-retail subsidiary, to small businesses and consumers.
The report suggested the following rules, while stressing they were purely illustrative:
— “If a subsidiary seeks a licence from the regulator to conduct retail deposit-taking, that subsidiary can only conduct activities which are permitted to take place in a retail ring-fence. The subsidiary must meet all regulatory requirements on a stand-alone basis.
— “Under no circumstances can the parent company transfer capital out of the retail entity if it would result in a drop below the minimum regulatory capital ratio prescribed.
— “The retail subsidiary cannot own equity in other parts of the group.
— “Intragroup exposures by, or guarantees from, the retail subsidiary will be treated as third-party exposures for regulatory purposes. Cross-defaults between the retail subsidiary and the rest of the group may also need to be limited.
— “The retail subsidiary must have access to operational services which will continue in the event of insolvency of the rest of the group; and/or … the retail subsidiary and the rest of the group must enter into separate master netting agreements.”
Clifford Smout, co-head of the Deloitte Centre for Regulatory Strategy, said that, on the whole, the interim report was a thoughtful and thought-provoking paper, but he thought it raised significant issues around policing the boundary between retail and wholesale banking and around the costs of ring-fencing retail business. Smout said the report left it uncertain what was going to qualify as retail banking and what as wholesale.
“I think there will be some issues, both as to where the boundary is, and how it is going to be policed. Until this becomes clearer, it is impossible to gauge the impact of the proposed ring-fencing of retail banking on wholesale banks,” he told Complinet. He also noted that the definitions of retail banking that the report offered revolved around deposits and other liabilities but did not attempt to define what retail assets were.
Andrew Gray, UK banking leader, PwC, said the boundary between retail banking on the one hand, and wholesale corporate banking and investment banking services on the other, was not straightforward. What one bank would include as part of its retail business could fall into the corporate/wholesale sector for another bank.
“In addition to where the boundary would be set if these proposals were adopted, there is the fact that there is a natural blurring of that boundary in any case,” Gray told Complinet. A clear example would be the use by a large corporation of a bank’s payments system to pay its employees’ salaries, where one side of the transaction fell into the corporate sector and the other into the retail sector. On top of this, the corporation’s treasury department might well make use of the bank’s investment banking division to manage its liquidity, including in relation to meeting its payroll.
“In a case like that, it may well be that the bank can provide a service on the retail-wholesale boundary of commercial banking more efficiently, because the client corporate is already ‘plugged in’ as a client of its investment banking services. So it can quickly be seen that the boundary is not a clear-cut one, and there is likely to be an impact on the wholesale sector by any changes to how the retail sector is prudentially regulated.”
Smout noted that large banking groups had found it relatively simple to circumvent previous attempts to separate the two sectors, such as Glass-Steagall in the US and the Basel Accord’s division between the trading and banking books. He added that the ICB interim report appeared to propose no additional regulatory capital burden on the wholesale and investment parts of banking groups above the internationally-agreed norm, and that the retail business could pay any excess capital across to the investment side.
“However, if you go from a situation where one organisation must meet, say, a 10 per cent capital requirement, to one where that organisation is replaced with two, each half the size, then unless the arrangements for switching capital between them are very flexible, you end up with more capital being needed overall,” said Smout.
Gray pointed out that confining the discussion of financial stability to the retail sector, as the proposals appeared to do, could be seen as implying that firms and the parts of groups carrying out investment banking could be allowed to go bankrupt. “But that is hardly a risk-free scenario for the economy. An investment bank going bankrupt damages corporates, which damages the wider economy, and also puts at risk at the sort of long-term savings assets, including pension funds, that rely on investment banking services,” he said.
Simon Lewis, the chief executive of the Association for Financial Markets in Europe, said that AFME’s members fully supported reforms to remove the risk that taxpayers would ever again be asked to support failing banks, and said investment banks would continue to work with regulators on developing mechanisms for enabling failing firms to be recapitalised or wound-down with investors and creditors bearing the cost, through contingent capital or bail-in provisions.
“We believe this would be most effective if agreed and implemented on a global basis,” said Lewis in a statement. “We therefore support the work that is currently being undertaken by the European Commission in this area as a starting point for international agreement, which we hope the ICB will take into account in its final proposals.” He added that AFME trusted that the ICB would include a full economic impact assessment with its final report in the autumn.
Simon Gleeson, a partner at Clifford Chance LLP, told Complinet that requiring banks to segregate their UK retail deposits into a separate subsidiary, while permitting them to mix retail deposits from other EU member states in with a general fund, would almost certainly be held by the European Court of Justice to be contrary to the European Union treaty provisions on free movement of goods and services. “There is still a general tendency in UK regulation to underestimate the extent to which financial regulation in the UK is decided by the EU under EU rules,” said Gleeson. “I believe the ICB should have had more regard to EU issues in putting forward their recommendations. To recommend an approach which is arguably contrary to the treaty is, to say the least, unhelpful.”
On a recent visit to London, European internal market commissioner Michel Barnier told journalists the commission was watching the IBC process closely. Gleeson also pointed out that some UK banks would see the vast majority of their activities in the ring-fenced retail bank. “It is hard to see how dividing such a bank into 90 per cent retail bank and 10 per cent investment bank would materially improve the ability to resolve the retail bank,” he said.
(This article was first published in Complinet (www.complinet.com). Complinet, part of ThomsonReuters, is a leading provider of connected risk and compliance information and on-line solutions to the global financial services community.)