The Case of Ring-fencing Retail Banking – legal aspects versus
commercial reality
By Cynthia Ma and Stephen Moller of K&L Gates LLP
n June 2010, the Chancellor of the Exchequer
asked the Independent Commission on Banking
(‘ICB’) to consider structural and related nonstructural reforms to the UK banking sector to
promote financial stability and competition. The
ICB released an Interim Report (Consultation on
Reform Options) (‘Report’) on its findings and
recommendations on 11 April 2011, which the
Chancellor endorsed in his Mansion House
speech on 15 June. The ICB is expected to publish
its final report in September 2011.
I
The ICB recommendations
The Report makes two key recommendations: (1)
universal banks (which conduct both retail and
wholesale business) are required to ring-fence
their UK retail banking activities within
separately capitalised subsidiaries and, (2) a 10%
1
equity baseline (as against the 7% Basel III
2
requirement) will apply to systemically important
banks with additional loss-absorbing debt such as
contingent capital and bail-in debt. The 10%
equity requirement will also apply to large retail
banking operations in the UK.
The ring-fencing rules will apply to any bank (both
EEA and non-EEA) that would need to seek
authorisation from the UK regulator for
conducting retail banking activities. Subject to the
two points mentioned in the previous paragraph,
the wholesale banking businesses of UK banks may
remain at the prescribed Basel III 7% level, provided
that they have credible resolution plans in place.
Legal versus commercial considerations
Ring-fencing of retail banking
Ring-fencing a bank's retail business in a subsidiary
with its own separate legal personality and capital
achieves legal segregation from the parent group
and is intended to ensure its survival on the parent's
insolvency. In reality, economies of scale mean that
the retail subsidiary often shares a number of
business and operational relationships with the rest
of the group such as financial products, back-andmiddle office support services, IT infrastructures
and payment systems. These relationships could
possibly jeopardise the ability of the retail
subsidiary to operate on the group's insolvency.
The Report (Annex 7) sets out a number of
conditions to reinforce legal ring-fencing. These
include: a condition that the retail subsidiary can
only perform specific activities; the subsidiary must
meet all regulatory requirements on a standalone
basis; the subsidiary is prohibited from ownership
of other group entities, intra-group exposure or
guarantees are to be treated as third party
exposures; a limitation of cross-defaults between
the subsidiary and the rest of the group; a
requirement that the subsidiary has access to
operational services upon the group's insolvency;
and a requirement that the group shall enter into
separate master netting agreements with
counterparties.
To preserve legal segregation while enabling the
subsidiary to enjoy economies of scale by sharing
business resources would require the subsidiary to
enter into outsourcing arrangements with the rest
of the group. There has been much debate about
whether such arrangements are commercially
viable. Moreover, the costs involved if retail
subsidiaries are required to maintain their own
business infrastructure and support functions may
outweigh the benefits of segregation.
Apart from these constraints, there is the
fundamental question of which business activities
are to be ring-fenced. The only banking activity
proposed that must fall within the ring-fence is
retail deposit-taking. The Report also suggests the
potential inclusion of activities such as investment
products, wealth management advice, consumer
and business loans, trade/project finance,
individual/commercial mortgages and credit cards.
Activities such as the provision of capital markets,
trading, hedging services, securitisation structuring,
distribution and trading, M&A restructuring
advice and finance and proprietary trading cannot
be conducted within the retail ring-fence.
Treasury activities and asset-backed securities
The intrinsic mismatch between the short term
liabilities and long term assets on a bank's
balance sheet encouraged the use of the ‘originate
and distribute model’ as a liquidity management
tool. This led to a market structure under which
portfolios of loans are packaged and traded as
securities on secondary markets through
securitisation. Securitisation, derivatives and
other structured finance techniques continue to
form a significant part of banks' treasury
activities notwithstanding the financial crisis. If
ring-fenced retail subsidiaries are to engage in
lending activities, the funding gap between their
retail deposit base and their financing needs will
have to be met by either the issuance of debt (for
instance, corporate bonds, ABS or covered bonds)
or by funding from the rest of the group. The ICB
has yet to address the question of the financing of
ring-fenced retail subsidiaries in any detail.
Divergence from EU practice and regulatory
arbitrage
The ICB recommendation of a ring-fence
mechanism would subject universal banks to a
national regulatory regime that does not apply in
the rest of the EU. This has the potential to lead to
regulatory arbitrage as banks in other jurisdictions
in the EEA enter the UK market and avoid the
ring-fence by the ‘passporting’ mechanism. It is
also possible that UK retail banks may seek to
circumvent the measures by transferring ownership
of their business to an entity elsewhere in the EEA
and passporting it back into the UK.
Conclusion
The ICB recommendations need to be fleshed out in a
number of respects, including in relation to the
funding of retail subsidiaries and the extent of the
activities they can undertake. Perhaps more
fundamentally, questions remain as to the
commercial viability of ring-fenced retail banks in the
context of group insolvency and the use of the EEA
passporting mechanism to allow banks based in other
member states to offer retail products in the UK.
1. The Basel Committee on Banking Supervision
(‘BCBS’) has since announced further measures
on 25 June for globally systemically important
banks whereby the additional loss absorbency
requirements for these banks are to be met
with a progressive common equity Tier 1
capital requirement ranging from 1% to 2.5%.
This further common equity requirement,
which will be finalised following a
consultation process, would bring the ICB
recommendation closer to that of the BCBS.
2. The 7% Basel III requirement is made up of
minimum common equity of 4.5% and an
additional capital conservation buffer of 2.5%.
Stephen Moller is a partner
and Cynthia Ma is a senior
associate in the Finance
group of the London office
of K&L Gates.