Monday, April 1, 2013

UK Banking Reform – A new structure for stability and growth?

With its banking reform proposal, the UK government pursues two overall objectives:

  • Curtail implicit guarantees enjoyed by “too big to fail” banks (“The government guarantees core banking services in the UK, not individual institutions.”)
  • Ensure that failing banks can be resolved without recourse to public funds and without risk to financial stability

The government suggests that an implicit state guarantee distorts incentives of managers and creditors, encourages them to take excessive risk and leverage. Moreover, the guarantee is said to distort competition in the banking sector to the detriment of small banks.

At the heart of current reform discussions is the government's intention to ring-fence core retail deposits from excluded wholesale and investment banking activities. The legislator expects such separation to

  • support financial stability;
  • reduce the risk to the taxpayer;
  • change the culture of banks for the better;
  • make banks simpler and easier to monitor.

Inside or outside the ring-fence?

The ring-fence is a nice illustration used by the UK legislator:

The ring fence must be robust against attempts by banks to subvert or undermine it.”

The ring fence cannot be susceptible to erosion over time.”

Banks may seek to test the strength of the ring-fence.”

In the absence of the Commission's proposals to electrify the ring-fence, the risk that the ring-fence will eventually fail will be much higher.”

The underlying message of this picture is clear: Inside the ring-fence are the good boys who need to be protected from the bad boys outside the ring-fence. This vision seems a bit simplistic but can certainly be sold very well to the general public.

More specifically, the UK reform wants ring-fenced banks to be legally, economically, and operationally independent of their wider corporate groups. This implies a distinct capitalization. As a consequence, non-ring-fenced banks cannot directly own ring-fenced banks and a sibling structure with a holding company between a ring-fenced and a non-ring-fenced bank is always required.

Directors of ring-fenced banks shall be held personally liable for preserving the integrity of the ring-fence.

Activities of ring-fenced banks

As can be seen in the above schema, a ring-fenced bank will no more carry trading assets on its balance sheet. With regards to derivatives, the regulation proposal says that ring-fenced banks can sell these instruments if

  • they constitute simple derivatives;
  • adequate safeguards to prevent mis-selling of derivative products within the ring-fence are in place;
  • they represent only a small portion of the bank’s equity capital;
  • they respect an absolute cap in terms of volume and total value;
  • they hedge underlying client risk; and
  • such trading activity is reported annually to the UK parliament.

However, it is not yet clear whether proprietary trading activities should be banned altogether from a group containing a ring-fenced bank: “The Government will consider carefully any further recommendation from the Parliamentary Commission on Banking Standards (PCBS) on this topic.”

Activities of non-ring-fenced banks

The current proposal advocates that proprietary trading activities may only be carried out in non-ring-fenced banks.

However, the above schema shows that these banks may still be allowed to carry out lending activities. Deposits with non-ring-fenced banks may also be allowed if

  • they are made by high-net-worth private banking customers or larger organizations;
  • they constitute an informed choice of the depositors;
  • they lie within (not yet specified) thresholds.