7 The components of a workable framework
Introduction
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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