Policing the ring-fence perimeter: The winners and losers
Ignoring strident calls from some to ‘tear down the wall’ between banks’ retail arms and their investment and international activities, the Treasury has instead put forward ideas for near-term reforms.
Drawing on the Edinburgh Reforms and Skeoch Review, its consultation aims to rectify some of the original regulation’s unintended consequences for banks and customers.
So, are they a fundamental re-drawing of the ring-fence perimeter, or just a fresh lick of paint? Several changes will certainly help risk and compliance professionals at larger UK banks that require a ring-fence to sleep better at night, but the reforms stand to benefit some institutions far more than others.
Increasing the deposit threshold
Arguably the two most meaningful reforms are the proposed increase in the core deposit threshold from £25bn to £35bn and a new proposed trading asset threshold. Mid-sized challenger banks, such as The Co-operative Bank and Nationwide, will likely be the immediate beneficiaries of the former, because they can target more growth before coming up against the costly, often unappealing, hurdle of ring-fencing.
However, perhaps the main, overlooked beneficiaries are in fact overseas banks who have shied away from expanding their operations into the UK, partly because of this onerous regulatory requirement. Thanks to the simplicity of the deposit threshold, adjusting to the higher deposit hurdle will not require any material changes to their risk or compliance processes, but will create more options for strategic growth and, by extension, more competitive dynamics in the sector.
This is particularly the case given that deposits are a critical battleground for banks as companies and individuals become more selective in an era of higher interest rates. Accordingly, these changes will counter accusations that the original legislation stifled competition, because dominant UK ring-fenced banks with excess liquidity were able to drive more aggressive pricing of mortgages and loans.
Exemptions for some retail banks
Exempting banks with small trading operations from ring-fencing, irrespective of deposit size, will have other repercussions. It is a pragmatic solution; the exemption is set to be calculated by traded assets of less than 10% of Tier 1 capital, as a proxy for assets currently prohibited for ring-fenced entities, such as investments as principal, commodity hedging and exposures to “relevant financial institutions”. This is designed to ensure banks’ risk and finance functions can measure exposure against a recognised group of assets.
Yet the reform will trigger an important strategic decision for banks on either side of the current ring-fence: whether or not to limit themselves to being largely pure-play UK retail and commercial banks to avoid the ring-fence requirement.
From a risk management perspective, banks would do well to choose the first path, given that it will significantly simplify the risk and compliance landscape. Controls and measures can comfortably ensure the threshold is never at risk of being breached. This contrasts starkly with the alternative scenario of having to use complex, costly infrastructure to patrol the perimeter of a ring-fenced bank, resulting in a cottage industry of perimeter guidelines, complex booking models and shared service arrangements.
Access and pricing for SMEs
Will these reforms improve access and pricing of banking services and finance to small and medium-sized businesses? They are designed to simplify the perimeter rules, permitting ring-fenced banks to invest equity into SMEs and operate outside the UK, and to provide clarification around trade finance and other financial instruments.
High Street independent financial advisors and mortgage brokers have cause to cheer. They complain of reduced access to finance and banking services under the current ring-fence rules, having fallen on the wrong side of the perimeter. To rectify this, the Treasury is suggesting a “de minimis” £100,000 threshold for small financial institutions’ exposures to individual RFIs.
But for risk and compliance functions, this measure may create an even more complex set of additional controls and risk of regular breaches, compared with the current outright RFI exclusion.
While the reform aims to enhance the provision of services to SMEs — and reducing the legislation’s grey areas will lower the compliance burden on ring-fenced banks — it will not necessarily simplify banks’ risk considerations.
A missed opportunity?
The reforms, if implemented, will help UK-based SMEs to a degree and support mid-sized banks’ growth ambitions, but there remains uncertainty about the timelines to more meaningful reduction of the ring-fencing requirements. Risk and compliance teams can’t relax just yet.
The government recognises that the resolution regime will effectively supersede ring-fencing as the UK economy’s main protection from future excesses in the banking sector for all but the largest UK-headquartered universal banks.
How and when that point will be reached is unclear, and for as long as that uncertainty continues, the UK banking sector will remain an outlier in banking regulation. Despite broader efforts to improve the sector’s competitiveness, appetite for further investment in the sector may continue to be constrained relative to other major economies. In that sense, the proposed reforms do not yet go far enough to redress the balance between protecting the UK economy and driving its economic growth.