A central pillar of the Edinburgh Reforms launched on 9 December 2022 was a commitment to creating a competitive marketplace for the UK, promoting effective use of capital.  As part of this, the UK government has committed to updating the ring-fencing regime for banks in response to the recommendations made in the ‘Ring-Fencing and Proprietary Trading Independent Review’ chaired by Sir Keith Skeoch (the Skeoch Review) which delivered its final report in March 2022.

Purpose of the Call for Evidence: responding to the Skeoch Review

The Call for Evidence published by HM Treasury on 2 March 2023, represents the government’s first stage in responding to the Skeoch Review’s recommendations on aligning the ring-fencing and banking resolution regimes.

The Call for Evidence seeks views on two aspects.  Firstly, an assessment of the ongoing benefits that ring-fencing provides to financial stability not found elsewhere in the regulatory framework. The Skeoch review found that the benefits of the ring-fencing regime would likely reduce over time as the resolution regime for banks was embedded. It also concluded that the resolution regime for banks and ring-fencing regimes were broadly seeking to address the same risks to the UK’s financial stability but the resolution regime offered a more comprehensive solution to address the problems of ‘too big to fail’. The government states that it broadly agrees with the conclusion that the resolution regime might be a better mitigant, in particular, the resolution regime is best positioned to ensure the continuity of critical economic functions and manage a firm failure, across both ring-fenced bodies (RFBs) and non-ring-fenced bodies (NRFBs), without recourse to public funds.

Secondly, the Call for Evidence also considers steps that could be taken to better align the ring-fencing and resolution regimes without losing the financial stability benefits or over-burdening firms with new or alternative regulatory requirements. The Skeoch Review suggested that the government could introduce a new power to enable authorities to remove banks from the ring-fencing regime when they were judged to be resolvable.  For the purposes of the Call for Evidence, the government is taking the resolution regime in its current form and is not seeking views or changes to it.

HM Treasury is keen to stress that it is carrying out a “careful and considered process” in relation to ring-fencing and is fully committed to protecting and maintaining the UK’s financial stability with appropriate regulation. The Call for Evidence contains a commitment that the government will not take policy decisions that serve to adversely impact outcomes for the protections of public funds, the continuity of banking services and critical functions and the protections of depositors.

Benefits of the ring-fencing regime

The Call for Evidence sets out further detail on the benefits of the ring-fencing regime identified by the Skeoch Review as well as potential benefits identified either by the authorities or stakeholders that the government wishes to examine further through the Call for Evidence. The government is seeking views on whether the potential benefits listed in the Call for Evidence and set out below assist in facilitating more effective risk management and supervision, assist with planning for resolution and increase the prospect of a firm failure being effectively managed.  The government is also interested in additional material benefits not detailed in the Call for Evidence that ought to be taken into account in considering the future of the ring-fencing regime.

Post-resolution restructuring

The Skeoch Review found that ring-fencing has the potential to facilitate resolvability in that it could reduce the time and cost of the post-resolution restructuring process by providing the optionality to handle different parts of a failed bank separately. It could also increase the value for buyers interested in purchasing a RFB’s assets and liabilities, on the basis that buyers may be less likely to take retail assets and deposits that are in the same legal entity as the ‘bad assets’ that caused a failure. However, the Skeoch Review also noted that this is limited to a “narrow set of scenarios,” where the failure of a bank was caused by activities taking place within the NRFB alone, and argued that the benefit was time-limited given the development of the Resolvability Assessment Framework and the associated requirement for firms to prepare for restructuring in the event of a resolution in any case. The government welcome views on the Panel’s conclusions in relation to post-resolution restructuring.

Operational continuity

The government requests views on a further benefit offered by the ringfencing regime in providing a potential advantage to operational continuity in resolution due to the RFB being insulated against any failings across the broader group, thereby simplifying the resolution process. The PRA’s rules on “Operational Continuity in Resolution” contain similar requirements which might overlap with the ring-fencing regime.

Certainty

Ring-fencing provides clarity and certainty as to when a firm will be required to restructure its business.  It avoids a situation where authorities would have to get involved to make firm-specific assessments on a case by case basis.

Depositor confidence

The existence of a ring-fencing regime provides depositor confidence, particularly at times of market stress.

An “Insurance Policy”

Some stakeholders have also argued that the ring-fencing regime acts as an insurance mechanism against the relatively untested nature of the resolution regime. However, as the Skeoch panel noted, the critical economic functions provided by banks extend beyond their retail banking arm, meaning that ring-fencing may only provide partial “insurance.”

Business models and products

In terms of supervision, RFBs may be easier to supervise in comparison to institutions with complex business models and products.  This is due to RFB’ assets being predominantly made up of mortgages and commercial loans and their liabilities being in the main retail customer deposits. 

Governance arrangements

The Skeoch Review found that due to the separate governance requirement for RFBs and NRFBs, RFB boards have strong and focused leadership with a greater understanding of the business and associated risks. 

Bespoke supervisory processes

As a result of their structural separation, RFBs are subject to a higher level of scrutiny than would otherwise be applied thereby creating a bespoke supervisory process. For example, enhanced reporting requirements and individual requirements to hold key supervisory documents such as the Internal Capital Adequacy Assessment Process and Internal Liquidity Adequacy Assessment Process documents.

Additional capital buffers

The aim of ring-fencing is to protect core retail banking services from shocks originating elsewhere in the group and in global financial markets. It may therefore be desirable to have some extra capital associated with these services. The Call for Evidence sets out that the ring-fencing regime is one way to achieve this. RFBs and large building societies are subject to an O-SII buffer, while banking entities outside the ring-fence have their activities capitalised in accordance with the UK’s implementation of global standards. The O-SII buffer raises the capacity of banks to withstand stress, thereby increasing their resilience allowing them to maintain critical financial services to the real economy, particularly the provision of credit.

The “Ring-Fencing Bonus”

Recent research by the Warwick Business School considered the impact of structural separation on interest rates in the UK repo market and found evidence that RFBs are perceived to be safer with ring-fenced dealers able to borrow in the overnight repo market at lower rates than other dealer banks. This “ring-fencing bonus” is particularly reinforced in times of market stress.

Potential international benefits

Finally, the implementation of the ring-fencing regime in the aftermath of the global financial crisis sets the UK apart from competitor jurisdictions who stopped short of full structural separation. This benefit may further promote the UK’s position as a global financial services hub assisting with maintaining the UK markets’ safe openness.

The costs of the ring-fencing regime

The Skeoch Review estimated that the annual aggregate ongoing costs for banks as a result of the application of the ring-fencing regime could be in the region of £1.5 billion, broken down as £0.5 billion for operational costs, and £1 billion for other ongoing costs.

The government notes that the implementation of the Skeoch Review’s six near-term recommendations, which will include some firms being removed from the ring-fencing regime and allowing firms to expand their activities in some areas, will likely reduce this annual aggregate cost to industry.  It is intending to consult on these measures in mid-2023.

The Call for Evidence lists the following costs and seeks views as to the impact of the implementation of the near-term recommendations.

Impacts on competitiveness

The Skeoch Review considered a range of arguments regarding the impact of the ring-fencing regime on UK competitiveness. In particular, the increased NRFB funding costs, the challenges of UK NRFBs maintaining market share and the issue of regulatory arbitrage within the UK banking sector.  As a finding of the Skeoch Review, there did not appear to be significant evidence to suggest that ring-fencing has had an adverse effect on the growth and competitiveness and funding costs for NFRBs.  The government states that it is not looking to repeat the analysis of the Skeoch panel on this but would like to provide an opportunity for firms to respond on these conclusions.

Impact on competition

The Skeoch Review considered the impacts of ring-fencing on competition within the UK retail banking market, the UK mortgage market and the corporate lending and productive finance markets and concluded that the impact of the regime across these markets was marginal, if impactful at all. Stakeholders are invited to respond with any evidence to challenge these findings.

Long-term options for aligning the ring-fencing and resolution regimes

The Call for Evidence sets out the criteria that the government intends to use in considering future options for aligning the ring-fencing and resolution regimes and seeks views on the appropriateness of the criteria and whether other considerations should also be taken into account.  The criteria is listed as follows:

• The impact on financial stability

In particular, what is the impact on the ability of the Bank, PRA and Financial Conduct Authority (FCA) to promote their objectives including to ensure the continuity of critical economic functions?

• Impact on firms

In particular, what costs would each option impose on, or alleviate for, firms? Would firms be likely to materially change existing organisational structures? Would some options provide more or less regulatory certainty?

• Impact on UK competitiveness and growth

In particular, what effect would each option have on the attractiveness of the UK relative to other jurisdictions as a financial services hub and the ability of firms to support economic growth in the UK?

• Impact on competition

In particular, to what extent would each option diminish or strengthen the ability of individual firms to compete with each other in the interest of UK consumers?

The spectrum of options

The Call for Evidence sets out initial future options and seeks to elicit views from stakeholders to serve as a starting point for further reflection.

Retain the regime with no further changes

The government considers that given the materiality of the benefits the ring-fencing regime provides to both the resolution and supervisory regimes (and by extension to the UK’s financial stability and safety and soundness of firms) it may opt to fully retain the ring-fencing regime (as amended following the government’s implementation of the near-term recommendations).

Disapply the regime

Alternatively, the government states that it could conclude that it should legislate to disapply the ring-fencing regime from some or all in-scope firms. Should this option be pursued, a key consideration is how to operationalise the disapplication of the regime. The government would need to establish criteria, on either a firm specific or sectoral basis, that must be met before the regime is disapplied.  The government would also have to establish an approach to managing the transition to the new regulatory approach.

Reform the regime further

Another option would be for the government to seek to retain any material benefits of the ring-fencing regime by way of further reforms to the regime that remove or alter elements of the regime that do not provide such benefits. The exact nature of this approach would be dependent on the benefits that the government is seeking to retain. The Call for Evidence invites respondents to set out any priorities they might have for further changes to the regime beyond those announced as part of Edinburgh Reforms.

Next steps

HM Treasury invites responses to the Call for Evidence by 7 May 2023. In terms of the near-term recommendations set out in the Edinburgh Reforms, to improve the functionality of the ring-fencing regime and on plans to increase the deposit threshold from £25 billion to £35 billion, the government has announced its intention to consult on these particular reforms in mid-2023. The expectation is that the near-term measures will quickly improve the functionality of the regime while moving some firms out of scope entirely.  We will be following developments on this key Call for Evidence closely so please do get in touch with the Hogan Lovells Financial Services team to discuss further.

Authored by Melanie Johnson.