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.
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