Ring-fencing reforms: Next stage laid out

On 28 September 2023, the Government and the PRA published papers setting out the next stage in the reforms to the ring-fencing regime. Proposed changes include expanding the activities that a ring-fenced bank may carry out and increasing the ring-fencing threshold from £25 billion to £35 billion. The proposed amendments and clarifications will be welcomed by those who have called for a relaxation of certain aspects, so that the regime reflects current banking realities, as well as better serves customers. The Government plans to introduce legislation in Parliament in early 2024, subject to parliamentary time.

Background

The ring-fencing regime came into force in January 2019 via the Financial Services (Banking Reform) Act 2013 (FSBRA). It requires UK banks with more than £25 billion in "core deposits" to legally separate their retail banking services, such as deposit taking from all the other services that banks provide (such as investment banking). The regime also prohibits RFBs from having any exposures to relevant financial institutions (RFIs) (e.g. other banks, certain insurers or investment firms), so as to minimise RFBs' exposure to shocks in the wider financial system. 

The FSBRA also required a review of the regime to be carried within two years of the regime coming into effect.  In March 2022, the Ring-fencing and Proprietary Trading Review, undertaken by a panel of experts (the Panel) and led by Sir Keith Skeoch, published its final report. The Panel made seven recommendations, with six recommendations intended to improve the operation of the regime (near term recommendations), while also recommending that HM Treasury review how to align the ring-fencing and resolution regimes in the longer-term.

As part of the December 2022 Edinburgh Reforms (see our briefing here), the Government confirmed that it would be taking forward the recommendations and provided further detail of these reforms. It issued a call for evidence on aligning the ring-fencing and resolution regime in March 2023.

The September 2023 consultation issued by the Government includes policy proposals outlined in December 2022, as well as proposals designed to encourage investment by ring-fenced banks in small and medium enterprises (SMEs). The Government has also published draft secondary legislation that will implement these reforms, the Financial Services and Markets Act 2000 (Ring-fenced Bodies, Core Activities, Excluded Activities and Prohibitions) (Amendment) Order 2023.

Proposals

Key proposals contained in the consultation paper include the following:

• increasing the ring-fencing deposit threshold from £25 billion to £35 billion of “core deposits";
• introducing a "secondary threshold" by exempting from the ring-fencing regime retail focused banks with trading assets of less than 10% of tier 1 capital, except where they are part of a global systemically important bank (G-SIB);
• introducing a " de-minimis threshold" by allowing RFBs to incur an exposure of up to £100,000 to a single RFI at any one time;
• allowing RFBs to establish operations outside of the UK or European Economic Area;
• permitting RFBs to have exposures to RFIs that qualify as SMEs;
• introducing a four-year transition period for complying with the ring-fencing regime for ring-fenced banking groups that acquire a bank not subject to the ring-fencing regime; and
• permitting RFBs to: undertake a wider range of standard trade finance activities; offer inflation swap derivatives; deal in investments as principal for the purpose of correcting the failure of a securities trade due to error; and deal in investments as principal for the purpose of carrying out test trades.

Deposit Threshold 

The Government is seeking to increase the threshold to £35 billion to keep up with changes in the UK regulatory landscape, namely the resolution regime and higher liquidity and capital requirements for banks. The Government does not consider that a higher deposit threshold will change the scope of banks subject to the regime, but considers it would allow firms currently below £25 billion threshold to increase their deposit base up to £35 billion before being subject to the regime. The Government has also confirmed that core deposits held in any branches of an RFB, wherever its location (including those located outside of the UK or EEA) would be included in the calculation of a group's core deposits.

Secondary threshold

The Panel had recommended an additional threshold set as a percentage of bank's regulatory capital (secondary threshold). Under this proposal, a bank with a percentage of excluded activities below that level would become exempt from the regime. The Government confirmed that it would implement this recommendation in December 2022.  Under the Government's plans, the financial assets held for trading (trading assets) are intended to serve as a proxy for measuring a bank's investment banking activities (rather than the more familiar concept under ring fencing regime of "excluded activities"). The secondary threshold would be calibrated as a ratio of trading assets over tier 1 capital and set at 10%. The calculation would exclude any trading assets acquired under article 6(2) of the Financial Services and Markets Act 2000 (Excluded Activities and Prohibitions) Order 2014/2080 (i.e. those used for a bank’s own hedging purposes). 

The scope of the threshold would take into account all operations of a UK banking group (including overseas operations), and in the case of a foreign banking group headquartered abroad, all operations of its UK sub-group(s) (including overseas operations) and of any UK branches. Where a UK bank is part of a headquartered banking group, both the trading assets and tier 1 capital would be measured on a consolidated basis, at the highest UK consolidation level (that is, across the UK consolidation group under the UK CRR). 

The Government confirms that banks that are part of G-SIBs would not be exempt from the ring-fencing regime as a result of the secondary threshold.

De minimis threshold

The minimis threshold allowing RFBs to incur aggregate exposures of up to £100,000 to any individual RFI would include multiple exposures to a single RFI, provided that the total amount of exposure is not more than £100,000 at any one time. The proposal is intended to be read with the Government's other proposal allowing RFBs to incur exposures to an RFI where the RFI is an SME.

Geographic restrictions

Under the current regime, RFBs are prohibited from operating a subsidiary or a branch outside of the UK or EEA. It is considered that this restriction has limited RFBs' ability to service customers based outside of the UK or EEA. The Government is proposing to remove the geographical restrictions that currently prevent RFBs from establishing operations outside of the UK or EEA.

Alongside the Government proposals, the PRA is consulting on rules for RFBs’ non-UK operations. The proposals would lead to changes to the Ring-fenced Bodies Part of the PRA Rulebook and PRA supervisory statement SS8/16. They would involve:

• requiring an RFB or ring-fenced affiliate to ensure that risks arising from its overseas branch or subsidiary are not material to the safety and soundness of the RFB, including its resolvability, and its ability to continue to provide core services in the UK; and
• amending SS8/16 to add a non-exhaustive list of supervisory expectations that the PRA will consider when determining if a third-country branch/third-country subsidiary of an RFB or ring-fenced affiliate poses a material risk to the provision by the RFB of core services in the UK (this includes expectations around: establishment of non-UK entities in countries whose supervision would pose risks to the RFB, and the impact of non-UK entities on resolvability).  

Permitted activities: RFIs

Feedback from stakeholders had suggested that restrictions concerning RFIs have been the biggest bugbears. The RFI definition can currently encompass high street independent banks, financial advisors and mortgage brokers (not traditionally seen as high risk) and can prevent them from accessing banking services (the product offerings of non-ring fenced banks are generally suited to larger businesses). The Government intends to update the definition of RFIs so that RFBs can incur exposures to RFIs that are investment firms and meet the definition of an SME under the UK CRR. This would capture RFIs which have: an annual turnover not exceeding €50 million; and/or a balance sheet total not exceeding €42 million; and fewer than 250 employees. An enterprise exceeding these thresholds would not lose the status of RFI SME unless the thresholds are exceeded over two consecutive accounting periods.

Permitted activities: trade finance

The Government is proposing to clarify that the current exemption allowing RFBs to incur exposures to RFIs to support trade finance activity would include a wider range of market standard arrangements (such as standby letters of credit, bills of exchange and promissory notes, and arrangements which take place under a master agreement).

Permitted activities: inflation swaps

Under the current regime, an RFB is not permitted to deal in derivatives unless an exemption applies The exemption does not currently include inflation swaps often used for project finance transactions. The Government is proposing to allow RFBs to offer inflation swap derivatives to customers wanting  to hedge against inflation risk (under the current regime, the RFB would have to ask the NRFB in its group to enter into the trade with the client, as the RFB cannot trade these swaps).

Permitted activities: test trades and share dealing errors

RFBs can deal in investments as agent in certain circumstances, and it is proposed that changes be made to the regime to allow RFBs to deal in investments as principal to rescue a customer trade which would otherwise fail due to a system/operating error. In this case, the security would need to be allocated to the relevant customer as soon as practicable following the acquisition.

The current regime also prevents RFBs from dealing in investments as principal where they want to test new products or services. Under the proposals, an RFB would be permitted to deal as principal for undertaking test trades in relation to the following securities: shares; instruments creating or acknowledging indebtedness; government and public securities; and units in a collective investment scheme. An RFB would be permitted to deal as principal in the lowest possible denomination for the purposes of carrying out a test trade.

Permitted activities: collars

In some areas, RFBs have argued that the current regime does not allow them to deal in all types of derivative products required by customers, leading to RFBs enlisting NRFBs so that customers are able to hedge certain types of risk (this often happens in relation to FX and interest rate risk). The Government considers that any easing of restrictions on derivatives would greatly increase the risks to RFBs, but it is proposing some relaxation in relation to FX collars (forward hedging strategy using options). It is proposing to clarify that RFBs are permitted to offer FX collar products, regardless of whether they are viewed as single agreements.

Definitions

The current prohibition preventing RFBs from incurring exposures to an SPV does not extend SPVs sponsored by an RFB, where the SFV only holds assets originating from the RFBs. The Government  proposes to clarify that: an SFV will qualify as a sponsored SFV where the SFV’s assets were created or acquired by the RFB or its subsidiaries or by another ring-fenced body in the same group; and that it would treat assets acquired by the RFB in the same way as assets it originated itself (given that any acquisition of assets would be subject to the ring-fencing requirements).

Summary of responses

On the same day, HM Treasury published a summary of responses to its March 2023 call for evidence on aligning the bank ring-fencing and resolution regimes. The call for evidence sought information on: ongoing benefits that ring-fencing could provide to financial stability not found elsewhere in the regulatory framework; and possible measures to increase alignment, without losing financial stability benefits/over-burdening firms. 

The Government notes a wide range of views, with some respondents referring to modifications made to the ring-fencing regime in order to allow for the acquisition by HSBC UK Bank plc of Silicon Valley Bank UK. Many respondents felt that the Panel’s proposal to disapply ring-fencing where banks are deemed resolvable would be difficult to operationalise (the call for evidence had noted that resolvability assessments would require point-in time judgements that could vary over time, meaning that firms may need to be brought in and out of the ring-fencing regime). 

The Government confirms that it will continue to consider all options for reform, taking into account the lessons learned. It also argues that recent bank failures demonstrate the effectiveness of the resolution framework and of the general regulatory framework.