Banking Standards Joint Committee Contents

7  The components of a workable framework


99. This chapter considers the ring-fence in the context of wider reforms in order to assess its relative importance in solving the problems identified in chapter 2. A ring-fence can contribute significantly to the two broad objectives of making banks less likely to fail and reducing the risk to financial stability and public funds if they do fail. However, although a ring-fence may be a necessary component of reform, it is not sufficient. The ring-fence proposal gets considerable public attention because of its novelty and the simplicity of its underlying concept, but other proposed measures—particularly those on loss-absorbency and bail-in—are also important. These proposals, and the way they are treated in the draft Bill and associated measures, are explained further and considered in detail in chapter 11.

Reducing the risk of failure

100. An effective ring-fence can contribute to reducing the riskiness of the banking system through several of the channels discussed in chapter 3. In particular, it would stop banks from being able to fund wholesale activities on the back of their retail activities, encouraging creditors to demand the appropriate risk premium and making it more costly for investment banks to pursue excessive levels of leverage. The scope for improvements to culture, manageability and ease of oversight from having smaller and more focused banks could also be important.

101. Financial stability should also benefit from the tougher capital and liquidity requirements being introduced under Basel III. The other two components with the potential to bring benefits for financial stability are the proposals for even tougher capital requirements including a higher leverage ratio and the introduction of a "bail-in" tool in order to make sure that creditors bear losses when banks fail, so that they are incentivised to impose tighter monitoring and discipline on the risks which banks are running.

Making banks more resolvable

102. There is a danger that putting a ring-fence around certain systemically-important parts of a bank could be interpreted as an even stronger signal that such banks benefit from a government guarantee. Stephen Hester warned of this, saying that "the language of ring-fencing has a huge risk of moral hazard". He acknowledged that this was not the intention of the ICB, but identified a risk of customers "thinking that if they are inside the ring-fence, they have a Government stake, an imprimatur, on top of them".[154] Sir Mervyn King also warned against assuming that this was the case:

The purpose of the ring-fenced regime is not to stop a bank from failing, and I hope that all of you on this Commission will do a great deal to make all your colleagues in both the Lords and the Commons aware that the purpose of this legislation and the ideal policy is not to get to a world where ring-fenced banks are guaranteed by the Government. That is not the case, and it will be very important for all of you not to stand up in the House and complain bitterly about losses to your constituents, whether debt holders, shareholders, or deposit holders, above the insurance limit if a bank fails. That is absolutely vital. You can undermine the whole regime by behaving in that way.[155]

103. Just as it would be a mistake to think that ring-fenced banks are guaranteed, it would also be a mistake to assume that, as a result of the ring-fence, the investment banks on the other side of it can be ignored. Although some vital economic functions would no longer reside in these investment banks, they would remain sufficiently large, complex and interconnected with the rest of the financial system that a disorderly failure could cause enormous, systemic damage. Lehman Brothers would have sat outside the ring-fence, but as the Chancellor of the Exchequer pointed out, when it was allowed to fail and simply placed in insolvency, "Armageddon unfolded".[156] The Bank of England suggested that the key operations of a non-ring-fenced bank which might need to be protected through a failure "would be likely to include any international payments functions, clearing and settlement functions, and possibly wholesale market and capital markets activities where the firm had a dominant position in key markets".[157]

104. A guarantee, whether implicit or explicit, distorts incentives of managers and creditors, encouraging them to pursue excessive risk and leverage. It also distorts competition, and the allocation of resources, away from smaller banks to those large enough to be regarded as systemic. These problems are not removed simply by limiting guarantees to ring-fenced banks. While ring-fenced banks will carry out the majority of essential economic functions which need protecting, it is important to be clear that it is these functions that enjoy protection and not the bank itself or its shareholders or creditors. There should be no government guarantee of ring-fenced banks, nor perception of one. Neither does ring-fencing mean that risks from non-ring-fenced banks can be ignored, as such institutions will remain systemic and difficult to resolve. The stated aim of public policy, endorsed by the Commission, should be to reach a position in which a failing bank, whatever side of the ring-fence it may be, can be resolved without risk to financial stability or to public funds. The measures that we have considered in this Report fall well short of fulfilling this aim. The issues of banks which are 'too-big-to fail' and of investment banks in whatever country whose failure would pose systemic risks to the UK banking system are ones which will require further measures and to which the Commission will return in the New Year.

105. As noted in chapter 3, it is widely argued that an effective ring-fence could be a major contribution to making banks resolvable. As noted in chapter 3, structural separation should better facilitate the application of resolution strategies to retail and investment banks. It may also make it easier for the resolution authority to extract the key functions that need protecting from the failing bank, because these would no longer sit alongside and have links with such a wide range of other activities. For these reasons, the Chancellor of the Exchequer considered that the ring-fence proposal addressed the problem of banks that were "too big to fail".[158]

106. The Bank of England noted that the reforms proposed in the draft Bill, including the ring-fence, "need to be seen in the wider context of other prospective developments in the resolution regime." They added:

Those changes stem from the Financial Stability Board's Key Attributes of Effective Resolution Regimes for Financial Institutions [...] In Europe, the Key Attributes are currently scheduled to be incorporated into law via the proposed Recovery and Resolution Directive (RRD). Two elements of this wider regime are worth highlighting. First, resolution powers are to be extended to bank holding companies; that is already being effected in the UK via the Financial Services Bill. Second, the RRD powers include a 'bail-in' resolution tool, under which, once the equity of a distressed bank was exhausted, the Resolution Authority could write down debt claims in order to cover expected losses and could convert part of the residual debt into equity to recapitalise the distressed firm (or a successor entity).[159]

The Bank's subsequent explanation of how they would expect to resolve large banks after the introduction of the ring-fence illustrated the importance of being able to impose losses on creditors via bail-in. For example, in setting out how a failing ring-fenced bank might be resolved, they pointed out that "In order to avoid any taxpayer solvency support in resolving the failed RFB, the unexpected losses need to be imposed on external creditors of the RFB. One way of doing this would be via a bail-in".[160] Similarly, for resolving a large non-ring-fenced bank, they said "bail-in could again be appropriate." While other resolution strategies were outlined, these involved transfers or break-up of the failing bank's operations, but as the Bank of England noted, "the size and complexity of the books of most global wholesale banks greatly increases the challenge in rapidly separating the critical economic functions in this manner without causing severe systemic disruption."[161] HSBC also echoed the conclusion that a ring-fence alone did not deliver resolvability:

while ring-fencing adds clarity to different parts of the banking model and makes explicit the risks being borne by creditors to each portion it has less practical impact on the 'sorting out' of failed banks: it is financial bail-in which provides the solvency support to allow for a more considered restructuring of the firms at the necessary granular level using the information from the resolution planning process rather than the structural separation of activities.[162]

The Bank of England pointed out that ring-fencing plays an important part in facilitating the use of bail-in or permitting alternative resolution strategies if bail-in is not possible.

In those cases where a group was toxic through and through, [bail-in] would not be possible. Instead, the distressed business would need to be broken up into critical and less critical parts. In those circumstances, ICB-style ring-fencing of the domestic retail deposit-taking business comes into its own [...] The utility to the resolution strategy of the ring-fence of core services will be especially evident in such cases, where a [...] resolution from the top of the group was not feasible. [163]

107. A ring-fence alone does not make banks resolvable. Without wider reforms, it is possible that a ring-fence would simply result in one too-big-to-fail bank becoming two such banks, the failure of either of which would require taxpayer support to avoid major disruption. The resolution challenges of non-ring-fenced banks in particular should not be ignored. Of the measures still needed in order to make banks resolvable, ring-fencing and bail-in are the two most important. The draft Bill seeks to deliver a ring-fence and introduces some elements which will support bail-in, although this tool is mostly being delivered through the EU Recovery and Resolution Directive.

154   Q 909 Back

155   Q 1160 Back

156   Q 1069 Back

157   Ev w181 Back

158   Q 1059 Back

159   Ev w180 Back

160   Ibid. Back

161   Ev w181 Back

162   Ev w130 Back

163   Ev w181 Back

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© Parliamentary copyright 2012
Prepared 21 December 2012