Is ring-fencing making UK banks safer?
It has been more than 10 years since the financial crisis, yet one of the biggest regulatory changes aimed at preventing another crisis has only just come into effect – the Structural Reform section of the 2013 Banking Reform Act, or ring-fencing.
While this simple idea of separating services seems sensible, it needed the seven in-scope banks to transform their structures and move assets on a huge scale, costing around £3bn ($3.9bn). In addition, banks are now required to report their compliance against the ring-fencing legislation, while implementing new operational continuity and resolution requirements brought in, such as Operational Continuity in Resolution and Minimum Requirements for own fund and Eligible Liabilities (MREL).
The question now is whether this enormous undertaking has actually been worth it? Now that the banks should have made all of the necessary changes, we ask whether ring-fencing makes the financial sector more robust and safer.
The UK Prudential Regulation Authority (PRA), which led the development and implementation of ring-fencing, is confident the legislation is successfully safeguarding core banking services. And we agree.
The PRA holds ring-fenced banks to higher capital requirements and insists on improved resolution strategies, such as MREL. This then ensures any ring-fenced bank that gets into trouble will be able to maintain core services without a government bailout. The challenge banks must now face is how to ensure that their smaller banking entities, particularly the retail banking units, can stand alone and thrive in an increasingly competitive and complex regulatory and economic environment. Increasing capital requirements under Basel III, along with the economic uncertainty resulting from Brexit only exacerbates this challenge.
With any regulatory change comes challenges as well as risks. And when dealing with an economy’s biggest sector, they become priorities to manage. For ring-fenced banking, we see two challenges banks need to focus on – the volatility of the large non-ring-fenced banks and the ability of banks to govern their ring-fenced and non-ring-fenced banks separately.
Grouping the riskier and more volatile assets into non-ring-fenced banks could make the UK banking sector more susceptible to liquidity risk. With more than £3tn of assets in these higher-risk banks (more than a third of the UK banking sector), any issues could threaten the liquidity of the entire sector. For example, if non-ring-fenced banks encouraged riskier lending practices and inter-bank lending increased, a liquidity shortfall in one bank could destabilise others and trigger a crisis across the sector.
Governing ring-fenced banks
Each side of the ring-fence now has its own board to handle the new regulatory requirements. To fill the new board positions, the seven banks have been competing hard for the best talent they can get from a shrinking candidate pool, resulting in people who have never sat on that bank’s senior board before filling more than 50 positions.
In addition, the PRA has given permission for some people to sit on multiple boards across the ring-fence, which challenges the true independence of the board’s decision-making and could create conflicts of interest and poor corporate governance.
Overcoming the challenges
The risks of a liquidity crisis are unlikely in the short-term as the regulator and banks have closely monitored funding sources and financial projections during the implementation of ring-fencing. But in the medium-term, banks and regulators must ensure they remain focused on assessing the risks on both sides of the ring-fence.
The banks who have split off large investment banks from their UK groups will be the ones to monitor closest, particularly those with an international presence where ring-fencing rules have not been enforced.
In order to tackle the more immediate concern on ring-fencing governance, the PRA has stated in its business plan that it will begin to challenge the governance and leadership as well as the risks and controls of new ring-fenced banks shortly after implementation.
To address these challenges banks should focus on training, transparency and data.
Whether board members have 20 years’ experience or none, they will need to receive regular and relevant training to govern in this new regulatory landscape. Regular training on ring-fencing responsibilities and evidencing it in communications with supervisors will foster a positive relationship with the regulators.
The board must also demonstrate how it reaches decisions, showing that its processes are robust and tested. Only by doing this both internally and externally can the board build trust that the other side of the ring-fence does not influence their decisions.
Finally, more complex organisational structures and regulatory requirements can create an overwhelming volume of data. Giving board members the most relevant and timely data will help focus discussions and aid quicker decision-making.
Only time will tell whether ring-fencing leads to a safer UK banking sector. But ensuring good governance of newly created ring-fenced and non-ring-fenced banks is essential to preventing another financial crisis. It will take time to embed the right actions in banks, but they are essential for effective decision-making and for identifying and mitigating governance issues.