Banking Standards Joint Committee Contents

10  Specific issues on ring-fence implementation


173. We noted earlier that the Treasury has already provided information on six intended uses of its proposed delegated powers under the new primary legislation. In this section we explore four of those proposed uses. We also consider whether retail lending and lending to small and medium sized enterprises (SMEs) should be required to be inside the ring-fence, and the question of assigning legacy liabilities following the creation of ring-fenced and non-ring-fenced entities.



174. Banks currently provide a range of derivative products to help businesses manage risk, commonly from movements in interest and exchange rates. The ICB final report set out a series of principles about what services ring-fenced banks should be prohibited from providing. It explained that these principles would only allow the provision of risk management products such as derivatives if a number of restrictive conditions were met. A ring-fenced bank could only offer risk management services if:

it did so in a way which did not give rise to exposures which required the ring-fenced bank to hold regulatory capital against market risk, did not take on assets that would qualify for trading book treatment, and that the services were sufficiently simple that they did not threaten resolvability.[241]

The ICB went on to state that the most straightforward way to fulfil these conditions "would be for the ring-fenced bank to act as an agent, for example in arranging a hedge between a customer and a third party".[242] Sir John Vickers confirmed that the ICB had come down against ring-fenced entities being allowed to sell hedging products as principal, rather than just as an agent for another part of the bank.[243]

175. The Treasury, in its June White Paper, took the contrary view. A ring-fenced bank should be permitted "to provide 'simple' derivatives products to its customers, provided that a number of conditions are met".[244] The white paper went on:

The Government proposes to take a power to set out in secondary legislation the conditions in which ring-fenced banks may deal in investments as principal [...] These proposals will enable ring-fenced banks to provide a full range of services to individuals and SME customers, while ensuring that the vast majority of other investment banking services remain firmly outside the ring-fence.[245]

On publishing the draft Bill, the Chancellor of the Exchequer wrote to the Commission requesting a view on "the question of whether ring-fenced banks should be permitted to sell simple risk-management products, including simple derivatives, to their customers".[246]


176. Derivatives can both generate risk and protect banks from risk, depending how they are used. Allowing a ring-fenced bank to sell a derivative directly to a customer can expose the bank to market risk. For example, if a bank sells protection against rising interest rates and rates subsequently rise, the bank will be exposed to a loss. In practice, banks also hedge such market risk using derivatives, by buying onward protection in the wholesale market. They also use derivatives to hedge a range of other risks arising from their normal activities. Selling products such as fixed-rate mortgages or savings accounts exposes banks to the same kind of market risks as selling derivatives to SMEs, and on a significantly larger scale, given that these products comprise a higher portion of a typical retail bank's balance sheet. Even if a position is hedged, this may leave a bank exposed to counterparty risk—the risk that the institution providing the hedge would be unable to meet its obligations.

177. The Government is proposing to allow an exemption to the ban on "trading in investments as principal" to allow banks to hedge risks arising on their own balance sheet. However, in permitting the trading of derivatives, there is a risk that while they are intended as a tool for mitigating risks they could also be misused, and this could be hard for supervisors to detect without detailed monitoring. The proposed exemption would therefore come with a series of conditions on such hedging activity to minimise the scope for it being a back-door to proprietary trading, for example a cap on residual market exposure and a requirement to collateralise counterparty risk.[247]

178. Andrew Bailey identified a possible impact on resolution of banks if they were allowed to sell derivatives as principal:

In my experience, derivatives are typically not the proximate reason why banks fail. They can be very complicated to deal with when banks fail, even very small banks, but they are not typically the proximate reason. What we don't want is the derivative equivalent of proprietary position-taking going on.[248]

The presence of derivatives on a bank's balance sheet is likely to complicate resolution in the event that it fails, since they can be hard to value and hard to close out or sell off in a hurry without incurring losses. As highlighted by the resolution of Dunfermline Building Society, even the presence of a small derivatives book can significantly complicate resolution.[249] Large derivative books or the use of complex, non-standardised contracts would worsen this problem.

179. In contrast, Stephen Hester argued that there might be a greater risk in resolution from forcing all derivatives outside the ring-fenced bank:

Suppose the ring-fencing works as some people desire, and a crisis happens in which one side goes bust and the other does not. A customer might believe they had a fixed-rate loan, which is a combination of a floating-rate loan and a swap that made it fixed rate, but one of those is cancelled as non-operative because of the bust entity, and the other is not. Suddenly, the customer is exposed. They did not want to be exposed, but they were forced to take out those contracts with two different people.[250]

180. In the White Paper, the Government proposed a cap on the net residual market risk of a ring-fenced bank's derivatives. Under these proposals, un-hedged risks would be capped, but banks would be allowed to sell any volume of derivatives, provided that they hedged the market risk and collateralised their credit exposure. RBS suggested that there might also be a case for imposing a gross cap, which would ignore the extent to which market and credit risks were hedged and therefore place a ceiling on the ring-fenced bank's overall derivatives activity:

These restrictions could be supported by a materiality threshold on how much of the ring-fenced bank's business could be taken up by these client-originated products - for example, a cap on the proportion of the ring-fenced bank's revenues or gross balance sheet devoted to such products. This would address concerns about the impact of providing these products on the resilience and resolvability of a ring-fenced bank in a more general market crisis.[251]


181. A number of witnesses made the argument that prohibiting ring-fenced banks from acting as principal for derivatives would have a detrimental impact on SME customers, and that some form of derivatives should therefore be allowed within the ring-fence.[252] Vedanta Hedging summarised the rationale for SMEs' use of derivatives:

For SMEs that import, export or have a material exposure to foreign currency movements, derivatives can help them to budget and plan their business more effectively. Significant currency swings can easily erode tight profit margins in an increasingly global and competitive marketplace.

SMEs that have a substantial amount of borrowing relative to the value of their assets (gearing) may also wish to use some type of derivative to protect themselves from rising interest rates. In the same way that an individual obtaining a mortgage will have an option of repaying their loan on a fixed, floating or tracker basis, SMEs should also be able to make such risk management decisions.[253]

The Chancellor of the Exchequer pointed out that many customers buying derivatives in these circumstances might not even be aware they were doing so:

If you are a farmer who wants to hedge your income or protect yourself in fluctuations in the euro-sterling exchange rate, you go to your local branch in rural North Yorkshire and buy yourself a derivative. You may not know that you are doing so, but you are.[254]

182. Santander suggested that, if ring-fenced banks could only sell derivatives to SMEs on an agency basis, without it going through their own balance sheet, this would increase the cost and complexity for customers. Santander explained that increased costs would be largely due to the fact that a third-party provider would lack the same relationship with a small customer and would require additional collateral:

If businesses are unable to access simple risk management products from ring-fenced banks, Santander UK believes that SMEs and mid-caps will not be able to access them at all, or will only be able to access them from institutions outside the ring-fence. These institutions are unlikely to have the same close relationship and long term commitment to the business as the ring-fenced bank. Furthermore, as SMEs will also have to post additional collateral to entities outside the ring-fence for these services, they will also be more expensive, and likely prohibitively so.[255]

This point was echoed by others.[256] John Grout pointed out that non-ring-fenced banks might need to charge a high margin in order to make it worth their while offering such products to SMEs:

They can always provide those risk-management products on margin. That is to say that they can take cash off the small company to reduce their risk that the small company goes bust when its obligation under the derivative is to the bank [...] Additionally, that begins to tie up the credit of the company because no netting off is possible, which it would be in a broader relationship. That makes it expensive. Small companies, being small, do not provide a lot of business, so the return on understanding—doing the credit work to understand and set up a line of credit to use for dealing purposes—would not be remunerated.[257]

183. The ICB concluded, in the words of Sir John Vickers, not to accept the suggestion that "the agency model [...] would increase costs greatly".[258] It is notable that the Federation of Small Businesses submitted evidence in favour of a prohibition, suggesting that businesses themselves might not be concerned about the possible impacts on cost and convenience.[259]


184. The extent of the interest-rate swap mis-selling scandal only began to emerge in early 2012. The conduct of derivative sales was therefore not a factor which the ICB considered. It is also unlikely to have influenced the Government's conclusions in their June White Paper. In drawing the Commission's particular attention to this issue in October, the Chancellor of the Exchequer wrote that "recent events have highlighted the conduct risks around the sale of derivatives, including the risk of mis-selling by banks".

185. Some who opposed allowing derivatives within the ring-fence based their case in part on the view that a prohibition would improve conduct and prevent mis-selling. Hermes argued that excluding derivatives would mean that banks would need to convince customers that "the benefits of such tools made it worthwhile to deal with the bank outside the ring-fence".[260] Based on the experience of Payment Protection Insurance, Which? argued that, as key providers of credit, the ring-fenced banks would be in a stronger position to make the provision of a loan depend (or appear to depend) on the purchase of a derivative product. Which? suggested that, in consequence, "if ring-fenced banks are allowed to sell derivatives then they could be used to extract value from the ring-fenced bank to the wider group". In addition, there was a "risk of derivatives being sold inappropriately leading to subsequent payments of redress which might destabilise the ring-fenced bank".[261]

186. The Chancellor of the Exchequer noted that, "regrettably, mis-selling can, of course, occur with any product, and under any business structure".[262] Vedanta Hedging argued that it was possible that allowing the ring-fenced bank to provide some derivatives could even improve conduct if doing so resulted in SMEs being presented with only a limited choice of simple products:

We believe that if ring-fenced banks are permitted to provide simple derivative risk management options as per above, this will actually improve the conduct of how these products are sold. This is because there will be tighter rules governing how and what may be sold to these SMEs. If the ring- fence bank cannot provide these derivatives, and the SME must seek an alternative (non ring-fenced bank) for them, there is nothing to stop that bank providing any type of derivative, for any amount of notional size and duration.[263]


187. The case that the riskiness, resolvability and conduct of ring-fenced banks will not be damaged by allowing them to sell derivatives rests upon the presumption that ring-fenced banks will be restricted to the sale of "simple" derivatives. The Government has proposed to restrict the sale of derivatives by ring-fenced banks as principal to "simple" derivatives. In June 2012 it stated that "the appropriate definition of a 'simple' derivative could be one, or a combination of the following:

  • an instrument whose purpose is to fix or cap client market exposures to interest rate or foreign exchange rate risk related to the business of the ring-fenced bank (for example lending and payments services);
  • an instrument defined by the Prudential Regulation Authority (PRA) as standardised and for the purpose of hedging only interest rate and/or foreign exchange risk in deep and liquid markets [...]."[264]

188. Several witnesses argued that the range of permitted derivatives should be restricted just to those for managing interest rate and foreign exchange rate risk, and that the vast majority of SME needs could be served with only a few, well-understood products.[265] Lord Turner said:

It is clear that if the ring-fenced banks are basically selling products to households and small businesses, it is extremely unlikely that complex, bespoke derivatives will have a useful role. They are likely to be a relatively small suite of relatively well understandable derivatives in the arena of taking a variable rate and turning it into a fixed or the other way round, which is pretty much the limit of the sensible things for them to be selling.[266]

John Grout considered that another feature of "simple" derivatives should be that they do not include any options that can be exercised by the bank against the customer,[267] a point supported by Vedanta Hedging, who said:

By 'simple' derivatives, we mean derivatives where there are no knock-in / knock-out or digital options (a feature of 'structured collars') and no ability for the bank to unilaterally extend or cancel the derivative. These 'complex' products typically involve the SME selling one or more 'options' to the bank. These types of derivative can be viewed as more akin to 'speculative' products rather than 'hedging' products.[268]

Both John Grout and Vedanta Hedging also recommended that "simple" derivatives should require that the hedge be matched to the underlying risk, so that, for example, the term and notional value of an interest rate swap would not exceed those of the floating rate loan which was being hedged.[269]

The FSA highlighted the importance of clear limits in legislation around what kind of derivatives can be provided:

Any hedging exemption, for example, will require consideration of limits around product type, client type, and size of activity. It is essential that any exemption is crafted with certainty to enable the PRA to effectively supervise it. Without clarity, there is a significant risk that supervising the exemption could become unachievable or extremely resource intensive. Similarly, if the exemptions become too complex to supervise then the objectives of ring-fencing may be undermined.[270]

189. Some banks argued that narrow restrictions on derivative products would limit their ability to offer more customised and sophisticated products to clients who needed them. RBS said that one of the Government's proposals could "exclude innovative products of material befits to clients",[271] while HSBC said that restricting the range to just interest rates and foreign exchange would be "less efficient than they might be" because "not all risk hedges will be capable of being put in place using standardised derivatives contracts". They argued that "scope, within limits, should be created for non-standardised transactions, under standardised [...] documentation and with collateral posted".[272]

190. Several witnesses were concerned that permitting the sale of even simple derivatives within the ring-fenced bank could be, as Martin Taylor put it, the "thin edge of the wedge". He argued "This seems to be absolutely the sort of area that will go the slippery slope way, as Paul Volcker described on Glass-Steagall".[273] The ICB final report pointed out that

the Glass-Steagall Act, which prevented deposit-taking banks from underwriting or dealing in equity or securities, was undermined in part by the development of derivatives.[274]

Sir Mervyn King said "It is almost impossible to differentiate between a simple and a complex derivative",[275] while Sir John Vickers said:

It is easier to say "You can't do it" than "You can do it, but only if they're simple". It would be a supreme irony if we ended up with a 100-page rule book defining the meaning of the word "simple".[276]

However, Lord Turner was more sanguine about this challenge, saying "This is not something that terrifies us in terms of this being an open season for escaping and getting round it".[277]


191. Allowing ring-fenced banks to sell derivatives other than as an agent creates additional prudential and conduct risks. There are genuine concerns that this may lead over time to the sale by ring-fenced banks of more complex and risky products. The larger and more complex the derivative book, the more of a threat it could pose.

192. The effects on consumers of allowing or prohibiting certain derivatives from being sold by ring-fenced banks as principal are uncertain. Banks have argued that a prohibition would result in consumer detriment, but selling derivatives to SMEs has been a highly profitable activity for them and investigations of mis-selling of interest rate swaps demonstrate the risk this poses to trust between banks and their customers; if ring-fenced banks were limited in their ability to provide these products directly it is plausible that the wider market would evolve and that other providers would compete to pick up the business to the benefit of consumers. The control of the sale of derivatives to prevent mis-selling is a matter of fundamental importance, to which the Commission will return in the New Year, but it is far from evident that the use of a structural solution (preventing ring-fenced banks from acting as principal) would be the best tool to deal with this issue.

193. The sale of derivatives within the ring-fence poses a risk to the success of the ring-fence. The Commission has concluded that there is a case in principle for permitting the sale of simple derivatives within the ring-fence. However, such permission would need to be subject to conditions. The first is that there are adequate safeguards to prevent the mis-selling of derivative products within the ring-fence, a matter to which the Commission will return in the New Year. The second is that "simple" derivatives can be defined in a way which is limited and durable, a matter we consider in the next paragraph. The third is that there are limits on the proportion of a bank's balance sheet which is allowed to be taken up by these products. We remain concerned that allowing these products within the ring-fence may be the thin end of a wedge which could undermine the ring-fence.

194. In addition to the elements of a "simple" derivative already identified by the Treasury, it is essential that there is a requirement that the size, maturity and basis of simple products should be limited to hedging the underlying client risk. The definition of 'simple derivatives' must appear in legislation. The Commission recommends that the proposed initial definition should be provided to the Treasury Committee before the Bill has completed its Commons stages. Whatever definition is chosen in the first instance, the banks will argue, as certain banks argued to this Commission, that customers would benefit from broadening the definition. For this reason, the Commission recommends that the regulator be required to report annually to Parliament on the extent and nature of the sale of derivatives within the ring-fence, including the effects of any changes to secondary legislation proposed by a future Government.

195. The Government's proposals to limit the prudential risks arising from derivatives activity, such as limiting net market exposure to a small percentage of capital, are important and necessary. However, this would not limit the absolute volume of derivative activity. A large derivatives portfolio would still pose an unacceptable risk to the stability and resolvability of ring-fenced banks, even if it is supposedly hedged and collateralised. It could also affect the culture of the bank in an undesirable way. The Commission recommends accordingly that the Government impose an additional cap on the gross volume of derivative sales for ring-fenced banks, and on the total value of derivatives used for hedging. The Commission would expect consultation to take place before determining how a gross cap should be measured.

The de minimis exemption

196. In its final report, the ICB considered whether banks below a certain size should be exempted from the ring-fencing rules, but was not persuaded of the need for such a 'de minimis' exemption. It considered that, although the costs of ring-fencing them would be relatively high, complex small banks could pose significant risks and any such exemption might mean that some banks would have a disincentive to grow, creating a competitive distortion. Furthermore, an exemption could confuse consumers.[278] In its response to the ICB's final report, the Government set out its view that some form of exemption would be desirable. The Government considered that imposing the ring-fence rules on small banks would be a disproportionate response to the risk they posed and might create barriers to entry. Nevertheless, the Government acknowledged that an exemption would be difficult to implement and undertook to consider the issue further.[279]

197. The draft Bill gives the Treasury the power to exempt certain deposit takers from the requirement to ring-fence core activities.[280] This is subject to a general condition relating to possible adverse effects on the continuity of the provision of core services that we discussed earlier.[281] Building societies are currently excluded from the definition of ring-fenced bodies, although, in due course, the Government will amend the Building Societies Act 1986 to bring it into line with the ring-fencing provisions of the draft Bill.[282] It is anticipated that institutions with total deposits from individuals and SMEs below £25 billion should be exempt from ring-fencing provisions. The exact form and size of the threshold will be confirmed in secondary legislation. [283]

198. Financial institutions supported an exemption, but there were differences of view on where the threshold should be set. The Building Societies Association considered that £25 billion of deposits might be too high a threshold on the grounds that, in the past, difficulties even at smaller banks have required significant amounts of public support:

£25 billion may simply be too high a threshold. This would have excluded Bradford & Bingley plc before it failed, even though at the time that bank was undoubtedly of systemic importance.[284]

RBS made a similar point:

We note that Northern Rock, at the end of 2006, had £22.6bn of retail deposits, yet the Government of the day took the view that it was necessary to take Northern Rock into temporary public ownership.[285]

Barclays developed the argument further by pointing out that a threshold of £25 billion would mean that only six UK banks would be captured by the ring-fencing provisions and that "an important lesson from this and previous financial crises is that smaller, less resilient institutions, without the stability that comes with scale, can be very easily compromised in large numbers by the impact of a shock".[286] Sir John Vickers said that on balance he had been convinced by the arguments in favour of a de minimis exemption since the ICB Report was published, but he also thought that the suggested £25 billion amount for the threshold should be considered further:

I think there are pretty good reasons for having a de minimis exemption. The Government are speaking about that threshold being £25 billion of mandated deposits. My instinct is that that is on the high side. In our own discussions, we were talking about £20 billion of total assets, which is probably a lot less than half of the £25 billion, if you think of total assets versus deposits. But I think it is probably right to have a de minimis exemption. I query whether it should be so high.[287]

199. The Chancellor of the Exchequer told us that, while concerns around the risks to financial stability from the exemption of large numbers of smaller deposit-taking institutions were understandable, the de minimis exemption had been introduced primarily for competition reasons. In terms of the level of the threshold, he said:

I think that it is just a judgment, if you have a de minimis, of where you apply it. We have chosen £25 billion. That means that currently 90 per cent of the banking industry will be in the ring-fence [...] As I say, it is not an exact science, but £25 billion is our estimate of where we think the right place to cut off is [...] One of the things that I think is wrong with the banking industry at the moment is that it is extremely difficult for new entrants [...] I would hate to impose, though this legislation, an overly restrictive, too low de minimis that runs completely counter to that policy.[288]

When asked why the threshold limit for such an important power had not been spelled out in more detail on the face of the draft Bill, the Chancellor of the Exchequer said:

The only thing is that you would presumably have to be able to uprate for prices. I am not sure you would want to put a number in primary legislation, because then it really would become out of date over time.[289]

When it was noted that one of the suggestions made in the papers supporting the draft Bill was that the threshold could either be a number or a proportion of GDP, the Chancellor of the Exchequer responded:

I am very happy to think about that. We can certainly discuss and try to get to an agreement on how we do this. One of the areas where I have departed from the Vickers report is in suggesting this de minimis, and if there is agreement on that, we can then discuss what it should be and how it should be applied.[290]

200. A de minimis exemption from ring-fencing for smaller deposit-taking institutions represents a sensible compromise between maintaining financial stability and encouraging new entrants to the banking industry. Although the level of the threshold is ultimately a matter of judgement, the Commission recommends that the considerations to be taken into account by the Chancellor of the Exchequer and his successors in setting or varying the de minimis exemption should appear on the face of the Bill. In addition to the factors that we have recommended in relation to the general power under proposed section 142A(2)(b) in paragraph 135, there should be a specific requirement for a decision imposing or revising a de minimis requirement to have regard to its effect on competition in retail banking and on new entrants in the market in particular. The Commission also recommends that the regulator be required to report annually to Parliament on developments affecting the appropriateness of the level of the de minimis requirement.

The large deposit exemption

201. The ICB proposed that the deposits of large corporations and private banking customers be exempted from the definition of core activities.[291] The draft Bill is consistent with this, in that the Treasury may determine the circumstances in which accepting deposits is not a core activity and does not need to be undertaken only by ring-fenced banks. The Treasury expects that this power will be used to allow deposits from larger companies and high net worth individuals to be held outside of ring-fenced banks. The thresholds for these exemptions will be subject to further consultation before secondary legislation is finalised.[292] Larger companies and high net worth individuals will be entitled to place deposits inside the ring-fence, and, in the case of high net worth individuals, there will be a presumption that their deposits will be inside the ring-fence. If individuals wish to deposit money in a non-retail bank, they will be required to self-certify that they understand the risks and benefits of such a decision.[293]

202. The Treasury has indicated that the thresholds for exemption might be up to £750,000 of free and investible assets for individuals and an annual turnover of up to £25.9 million for companies.[294] When eventually defined in secondary legislation, these thresholds will have a bearing on the range of services (such as derivatives) that ring-fenced banks may need to offer in order to service their clients fully.

203. The exemption for large deposits makes sense. It is right that holders of large deposits should be required to make an informed decision to hold their deposits in a non-retail bank.

Geographical restrictions

204. With the aim of insulating UK retail banking from external shocks elsewhere in the financial system, the ICB recommended that a wide range of services should not be permitted in the ring-fence. One of its recommendations was that ring-fenced banks should be prohibited from serving non-European Economic Area (EEA) customers. The ICB's final report included illustrative examples of such potentially prohibited activities, such as providing mortgages to American homeowners, or a loan to an Australian energy company with no base, or subsidiary, in the EEA.[295]

205. The Government white paper proposed that, rather than imposing a prohibition on non-EEA customers, the Government would act to prevent ring-fenced banks from operating non-EEA subsidiaries or branches. It also proposed to require that all major service and credit contracts for ring-fenced banks be written under the laws of an EEA member state. It argued that this would "ensure that cross-border activities do not present a barrier to the resolution of ring-fenced banks". The Government also noted that, where arrangements were in place that ensured that doing business in a non-EEA jurisdiction did not present risks to resolution (for example having mutual recognition of resolution regimes), such a prohibition might not be necessary. [296]

206. In response to a question about whether the Government's modification of the ICB recommendation on geographical restrictions would represent a serious threat to the ring-fence, Sir John Vickers said "I believe the issue will be taken care of, but I think it is an important one to be alert to. I have no reason at all to think that the Government's intention is to allow that kind of thing to happen—on the contrary. However, it will be important to scrutinise the secondary legislation to make sure that such things cannot happen".[297]

207. Some witnesses expressed concern that overly stringent prohibitions could have an adverse impact on a ring-fenced bank's ability to support trade finance outside the EEA, or inward investment.[298] The Law Society has warned of possible unintended consequences from "the crude measure of blanket bans affecting all ring-fenced banks".[299] Dorothy Livingston expanded on the Law Society's concerns:

Nobody has modelled how a ring-fenced bank that is unable to deal, other than to a very limited extent, with non-EEA persons is going to be well equipped to have capital for a customer whose principal business is carried out in, say, dollars but whose manufacturing costs are in sterling. [...]If you put in place all the restrictions that Vickers proposes [...] you are squeezing down what the bank does closer and closer to what a building society does and making it less and less what a business would need.[300]

208. The Treasury sought to address some of these concerns:

The ICB noted that cross-border activities can pose a significant threat to resolvability. In order to reduce this threat, the Government proposes [...] to ensure that ring-fenced banks should not carry out any banking activities through non-EEA subsidiaries or branches, where this would present risks to the resolution of ring-fenced banks. Where arrangements are in place that reduce such risks, such as mutual recognition of resolution decisions, a blanket prohibition would not be necessary. This is therefore likely to limit the ability of ring-fenced banks to have non-EEA subsidiaries or branches except in approved circumstances, and determine the way in which such subsidiaries or branches may be approved.[301]

209. The Commission is broadly content with the Government's approach to meeting the ICB's objective of effective geographic limits on the business of ring-fenced banks. In pursuing this primary consideration, however, consideration needs to be given to the effects of the solution devised on UK banks' ability to support trade. It is essential that full consideration is given to the repercussions of the measures proposed. For this reason, the Commission recommends that the Treasury undertakes a full separate consultation exercise on the draft secondary legislation to give effect to geographical restrictions and publish its findings two weeks prior to the House of Commons report stage. The Commission also considers it essential that, when the relevant secondary legislation comes into force, the Treasury monitors and reports to Parliament on its assessment of the trade-off between the direct intended effects of the limits and the capacity of the banks to support trade.

Retail and SME lending

210. As we noted earlier, the draft Bill follows the ICB recommendations in providing initially that only deposit-taking and the provision of overdrafts are classified as 'core activities' which, subject to specified exceptions, may only take place within a ring-fence or in banks that have been exempted from the definition of a ring-fenced bank.[302] A further area that might appear to be a "core" activity is lending to individuals and SMEs. Andy Haldane emphasized the importance of these functions, saying that "loans to SMEs, trade finance and mortgages [...] are all activities that I think we would view as needing to remain in continuous service if a bank were to get into trouble".[303]

211. The ICB's final report set out a number of potential problems which might arise if lending was mandated to be provided only by ring-fenced banks:

Mandating that all credit provision to individuals and SMEs should be within ring-fenced banks would prevent non-banks from providing this credit. This would come at a high cost in normal times - significantly reducing the supply of credit and competition among credit providers [...] It would be a somewhat arbitrary rule introducing unhelpful distortions - given that continuous provision from banks is not in itself more important than continuous provision from non-banks for the same product [...] The provision of long-term credit by one bank only can be interrupted without overly negative consequences. For instance, provided there is a supply of new mortgages from alternative providers, it is not particularly damaging for an individual if the supplier of their mortgage fails [...] In general then, credit provision is different in nature from products which customers rely on to be able to make everyday payments.[304]

The ICB acknowledged concerns that ring-fenced banks should not be forced out of lending activities:

if a large volume of deposits were placed within ring-fenced banks then a significant proportion of the credit supply would be expected to follow. Banks need assets to match their liabilities. So while the Commission does not believe that credit provision need be mandated, it is expected that under its proposals a large proportion of the credit supply to individuals and SMEs would come from ring-fenced banks. As a result the ring-fence would play an important role in improving the stability of the aggregate credit supply.[305]

212. The FSA, while not advocating making lending a 'core activity', observed that "where banking groups contain RFBs, they should conduct all of their UK retail and SME lending from those RFBs".[306] Such a requirement would address the concern that ring-fenced banks would become too narrow, while preventing an "undesirable restriction of credit by non-banks".[307]

213. The ring-fence would, however, prevent retail deposits from being used to provide loans other than to non-financial sector borrowers—households, non-financial businesses and the public sector—within the EEA. Such a restriction could, in principle, result in deposits being 'trapped' inside the ring-fence and used, for instance, to fund the purchase of securities issued by EEA governments, rather than making credit available to the private-sector economy. The ICB considered that the risk of this happening was very low:

The total quantum of UK sterling household deposits is currently approximately £1tn, considerably less than the current stock of loans to the UK non-financial private sector of £1.6tn. So the retail deposits of ring-fenced banks en bloc are much smaller than the UK sterling loans they could hold [...] So ring-fenced banks as a group are unlikely to be over-funded in the medium term, and the system should be flexible enough to be robust to changes in the pattern of saving and borrowing in the economy.[308]

214. The Chancellor of the Exchequer defended the approach of the ICB and the draft Bill in the following terms:

I don't deny that the provision of credit is an incredibly important function in our society; I just don't think it is the immediate consideration you have. [...] Provision of credit to small businesses is something that can be done by a number of institutions, and a small business can go to a number of different places. Under our reforms, it is possible to have small business lending within the ring-fence, and I suspect that, actually, quite a lot of institutions will want to do that, because they will want to match retail liabilities with retail deposits, but, on the advice of John Vickers, we have given them some flexibility. I think you have to be very clear about what is the absolutely essential thing that has to be operating the next morning. If there is a branch that is not able to give the small business that loan next morning, it is very unfortunate, but I am not sure that it is the absolute, essential, core service that you are seeking to protect that next day.[309]

215. The Commission considers that it is right in the first instance not to require banking groups with a ring-fenced entity to carry out all lending for SME and retail customers within that entity. This is a provisional conclusion, which should be subject to review in the light of experience. There is a possibility that banking groups will conduct their most profitable lending from outside the ring-fence, where capital requirements will be lower and there will be fewer restrictions on dividend payments, leaving less profitable lending within the ring-fence. This could reduce the commercial strength of the ring-fenced entity. It could also reduce the transparency of the operation of the ring-fence. The Commission recommended earlier that the regulator should monitor and publish a statement on how the ring-fencing rules have been implemented by the industry, with specific consideration being given to which services are provided inside and outside the ring-fence. The Commission has concluded that the development of retail and SME lending outside the ring-fence is a matter for the regulator to monitor as part of its work on this statement.

Independence and governance of the ring-fenced bank

216. The ICB was virtually silent on corporate governance in its interim report. In response to requests for its views, including from the Treasury Committee,[310] the ICB's final report addressed it briefly. The ICB recommended that, when a ring-fenced bank is part of a wider corporate group, the authorities should be able to isolate that bank and ensure the continuous provision of its services. This should be possible within a matter of days, and should not require solvency support. Furthermore, the ring-fenced bank should be economically separate from the rest of the group. This entailed the following requirements:

  • ring-fenced banks should be separate legal entities;
  • any company owned fully or in part by a ring-fenced bank should not conduct activities which a ring-fenced bank cannot;
  • the ring-fenced bank should have continuous access to any support functions it needs from the rest of the group, irrespective of the latter's health;
  • for any payments systems the ring-fenced bank uses, it should be a direct member or should use another ring-fenced bank as an agent;
  • the ring-fenced bank should meet its regulatory and disclosure requirements on a stand-alone basis, and transactions with anything other than ring-fenced banks in the same group should be on a third-party basis, with the relevant third-party regulatory limits applying;
  • the board and a majority of directors of the ring-fenced bank, including the Chair, should be independent, unless the vast majority of the group's assets were in the ring-fenced bank; and
  • the boards of both the ring-fenced bank and the parent should have a duty to maintain the integrity of the ring-fence.[311]

217. Andy Haldane suggested a list of functions that would need to be separate to ensure that a ring-fenced bank is no more exposed to problems elsewhere in the group than it would be to similar problems outside the group:

The following ingredients are essential if this ring-fence is not to prove permeable: one is entirely separate governance; the second would be entirely separate risk management; the third would be entirely separate balance sheet management, treasury management. We could not have debt issue out of a holding company because its cost would then be the blended mix of the two activities, complete with implicit subsidy. I would have a completely separate remuneration structure. We ought to contemplate completely separate human resourcing if there is indeed this cultural issue that we have been discussing. With those ingredients, I would have a degree of confidence that many of the benefits of full separation could be achieved.[312]

When this list was put to him, Sir John Vickers said: "I would add to it. There needs to be independence of capital and liquidity."[313] The Chancellor of the Exchequer stated his intention to implement this augmented list of requirements: "it is our intention to implement the Haldane principles, with the addition of what John Vickers talked to you about in terms of capital and liquidity".[314]

218. There was broad agreement among respondents that corporate governance was crucial to the success of the ring-fence, but also a broad range of views on what sort of arrangements were appropriate. For example, Martin Taylor stressed the importance of independent membership of the board of the ring-fenced banks:

The important thing simply is that they should not be people who gain their living from other jobs in the main banking group... These should be people who are outsiders and who don't rely on the bank for any living apart from their director's fee.[315]

There are examples of subsidiary boards being constituted broadly in the manner that Martin Taylor proposed. Douglas Flint explained that at HSBC:

All of our major banks have fully independent boards with a substantial majority of non-executive directors. We would have a non-executive board, but a chairman for most of the banks from within the group. We have gone one stage further for the UK—the UK chairman is now a fully independent non-executive director.[316]

219. However, a number of witnesses questioned whether it was necessary, desirable or even feasible to have a large number of independent directors on the board of the ring-fenced banks. Ana Botín claimed that, "with robust governance and with effective regulatory supervision, these subsidiaries can work independently" even though board membership might overlap.[317] Davis, Polk and Wardwell LLP doubted the desirability of an independent board:

We do not believe that establishing separate, independent boards at the holding company, the ring-fenced bank, and the non-ring-fenced bank will be conducive to effective management of what will remain integrated groups from both a financial reporting and a market perspective. It may be better to consider alternatives, such as including some independent board members, rather than a majority, on the ring-fenced bank's board of directors [...] If a ring-fenced bank is part of a larger banking or financial group, we do not think it is realistic for the board of directors of that bank to be fully independent of the parent company of the group.[318]

The Financial Reporting Council expressed a related fear: "If the board of the ring-fenced bank is separate from the group and separately appointed, it cannot be accountable - directly or indirectly - to the shareholders of the group". [319] Baroness Hogg was sceptical about whether separate governance was even feasible:

the notion that a ring-fenced bank could have entirely separate governance is wrong, a mistake. I cannot see how a ring-fenced entity could sensibly have entirely separate governance. I think that would create a vacuum of accountability to anyone other than the regulator, and would sever the line of accountability through the parent to the providers of risk capital, and therefore make banks less investable. It would have serious knock-on consequences, as well as creating a vacuum of accountability.[320]

220. Company directors have duties under the Companies Act to promote the success of the company primarily for the benefit of the shareholders. The directors of ring-fenced banks which are wholly owned by larger groups will therefore be legally obliged to act in the interests of their parent. This obligation risks conflicting with the integrity of the ring-fence, for example if the ring-fenced bank has capital or liquidity that the wider group needs elsewhere. Andrew Bailey suggested a possible solution to this:

The draft Bill should specify that the directors of a ring-fence bank and potentially other appropriate entities in the group should have a statutory objective to ensure the integrity of the ring-fence. This could involve ensuring that the directors have an obligation to protect the ring-fence bank from contagion from the wider financial system. This would include risks arising from the rest of the banking group.[321]

David, Polk and Wardwell drew attention to how some banks are regulated in the United States:

An alternative to requiring full independence of a bank subsidiary board is to require directors of an insured bank to take into consideration the interests of stakeholders other than shareholders in discharging their duties. This is, in fact, the approach generally taken with respect to the duties of the directors of insured banks in the United States.[322]

221. HSBC noted that a proliferation of directors' duties was not without cost: 'Whilst it is feasible for directors to be required to manage a number of different objectives, this does make their role increasingly complicated [...] There will also need to be a clear regulatory definition of what is meant by the 'integrity of the ring-fence".[323]

222. There is likely to be a tension between the integrity of the ring-fence and the duties that directors of ring-fenced banks will owe to the parent company and through them to shareholders. This tension will be present regardless of the whether directors of the ring-fenced bank are employed elsewhere in the group. It is not possible under current company law to create a subsidiary which is entirely independent. The Commission recommends that the Government insert within FSMA a legal duty on boards of directors to preserve the integrity of the ring-fence.

223. The Commission further recommends that the Government set out, in its response to this Report, a full account of how directors would be expected to manage the relationship between such a duty and their duties to the shareholders. The Commission considers that an element of conflict between the duties may be unavoidable, and that this will constitute a permanent challenge for any structural solution which falls short of full structural separation.

224. In the previous chapter, the Commission recommended that the core minimum requirements for a ring-fence of adequate height should be set out in secondary legislation subject to affirmative resolution procedure, and not be the subject of regulatory discretion. The Commission welcomes the Chancellor of the Exchequer's clear position on the key elements that should be included to ensure the proper independence of a ring-fenced bank. The Commission recommends accordingly that the initial secondary legislation made under proposed section 142H of FSMA (as envisaged in our recommendation in paragraph 139) should give the regulator a duty of ensuring operational independence for the ring-fenced bank in respect of governance, risk management, treasury management, human resourcing, capital and liquidity.

Relationship between the ring-fenced bank and the holding company

225. The ICB was not prescriptive about how groups containing ring-fenced banks should be structured, and in particular did not specify whether the ring-fenced bank should be a 'sibling' or a 'child' of the other operating companies in the group. Subsequently, in their evidence to the Commission, both Martin Taylor and Sir John Vickers indicated their preference for a 'sibling' structure, in line with the recommendations of the Liikanen report.[324] Importantly, the FSA stated a clear preference for a 'sibling' structure, in part to ameliorate governance tensions

The ['sibling'] ownership structure we are proposing... would ensure consistency with the ICB's independence principle that states that the relationship between the NRFB and the RFB should be on an arms' length third-party basis. Allowing an NRFB to own an RFB would permit a parent-subsidiary relation based on control, which would contradict this principle. Business conducted by the RFB can be reasonably isolated from the NRFB through regulation when both companies are subsidiaries of a holding company. However, it is much harder to do in a parent-subsidiary structure where the NRFB owns the RFB.

The FSA pointed out that such an approach would enable the authorities to deploy different resolution tools for the two entities, reduce the risk of contagion because the holding company would act as "a firewall" and "help instil market perceptions of credible separation".[325]

226. In contrast, the banks generally did not favour prescription either way on this point. Anthony Jenkins said that, for Barclays 'it would be more practical for us to go with the parent/daughter model'.[326] Ana Botín told us:

227. I don't see why it always has to be a holding company with two sisters. It depends on the weight that the non-ring-fenced bank has in the business. For example, in the case of the Santander group model, most of our business would be within the retail ring-fenced bank.[327]

228. The Commission found that the arguments for prohibiting a non-ring-fenced bank from directly owning a ring-fenced bank are persuasive. This is a clear and straightforward way to strengthen the ring-fence, and is far better done at the outset. The Commission recommends accordingly that the regulator be given the power to require a sibling structure between a ring-fenced and non-ring-fenced bank, with a holding company. The Commission would expect this power to be exercised.


229. Which? noted that, in the run up to the implementation of the ring-fence, "there may be a lack of clarity about where possible liabilities for legal or regulatory action will lie if they crystallise in the future".[328] When asked how legal liability would be allocated between the ring-fenced and non ring-fenced banks for any activity conducted before the split, the Treasury stated:

Liability for any activity conducted before a banking group is split into a ring-fenced bank and non-ring-fenced bank will remain with the legal entity which was responsible for the activity in question before the split. [...] Banks will have some flexibility about how they implement the ring-fence. It is therefore possible that in implementing ring-fencing a banking group will create new companies, but this would not mean that liabilities for activities such as mis-selling would be transferred to the new entities. If by contrast implementation of a ring-fence led to the dissolution of a company, that company's liabilities would be cancelled. In that case, a creditor, or other third party may be able to restore the company in order to bring a claim against it. However, we would not expect implementation of the ring-fence to involve the dissolution of any company. Legal liability for past action is therefore unlikely to be affected by the introduction of ring-fencing.

A bank's approach to implementing the ring-fence will almost certainly require sanction by court order under Part VII of FSMA, and under the amendments proposed in the draft Bill, any application for approval of a Part VII transfer must be approved by the PRA. The regulator is unlikely to approve any scheme involving the dissolution of a company within a banking group if that would affect any liabilities for mis-selling.[329]

230. The Commission finds it disconcerting that the Treasury should raise the possibility that the establishment of the ring-fence might lead to the dissolution of a company and the cancellation of its liabilities. The onus should not be on the regulator to prohibit the dissolution of a company. Nor should the onus be on creditors of a company to make a court application to restore the company in order to meet obligations. The Commission recommends accordingly that the regulator be required to set rules to ensure that the creation of ring-fenced and non-ring-fenced entities is not used as an opportunity to shift liabilities or potential liabilities in an artificial way.

241   Independent Commission on Banking, Final Report, September 2011, para 3.43 Back

242   Ibid. Back

243   Q 786 Back

244   HM Treasury, Banking reform: delivering stability and supporting a sustainable economy, June 2012, Cm 8356, p 4 Back

245   HM Treasury, Banking reform: delivering stability and supporting a sustainable economy, June 2012, Cm 8356, para 2.39 Back

246   Ev w1 Back

247   HM Treasury, Banking reform: delivering stability and supporting a sustainable economy, June 2012, Cm 8356, p 23 Back

248   Q 993 Back

249   Bank of England, Bank resolution and safeguarding the creditors left behind, Bank of England Quarterly Bulletin 2011 Q3, p 220 Back

250   Q 943 Back

251   Ev w106 Back

252   Ev w42 para 9 [Building Societies Association]; PLS 014: Ev w70 para 23 [ICAEW]; Ev w24 [Lloyds Banking Group]: Ev w10 para 16.1; Ev w124 para 9.1 [Santander UK]; Ev w135 para 1.56; Q 709 [John Grout] Back

253   Ev w189 Back

254   Q 1075 Back

255   Ev w124 Back

256   Ev w105, para 16.2 [RBS]; Q 694. Back

257   Q 708 Back

258   Q 786 Back

259   Ev w188 Back

260   Ev w65 Back

261   Ev w167 Back

262   Ev w w1 Back

263   Ev w191 Back

264   HM Treasury, Banking reform: delivering stability and supporting a sustainable economy, June 2012, Cm 8356, p 4 Back

265   Ev w97 [Nomura]; Ev w124, para 9.5 [Santander UK].  Back

266   Q 994 Back

267   Q 743 Back

268   Ev w190 Back

269   Ev w190 Back

270   Ev w62 Back

271   Ev w106 Back

272   Ev 135 Back

273   Qq 386-387 Back

274   Independent Commission on Banking, Final Report, September 2011, p 36 Back

275   Q 1191 Back

276   Q 786 Back

277   Q 993 Back

278   Independent Commission on Banking, Final Report, September 2012 Back

279   HM Treasury, The Government Response to the Independent Commission on Banking, Cm 8252, December 2011, para 2.70 Back

280   HM Treasury, Sound banking: delivering reform, Cm 8453, October 2012, Chapter 3, p 3 Back

281   Ibid., para 2.17 Back

282   Ibid., para 2.17 Back

283   Ibid., para 2.16 Back

284   Ev w42 Back

285   Ev w104  Back

286   Ev w30 Back

287   Q 786 Back

288   Q 1071 Back

289   Q 1072 Back

290   Q 1073 Back

291   Independent Commission on Banking, Final Report, September 2012, paras 3.17-3.18 Back

292   HM Treasury, Sound banking: delivering reform, Cm 8453, October 2012, paras 2.18 to 2.21 Back

293   Ev w174, Para 13 Back

294   Ev w174, paras 14 and 15 Back

295   The Independent Commission on Banking Standards, Final Report, September 2012 Back

296   HM Treasury, Banking reform: delivering stability and supporting a sustainable economy, June 2012, Cm 8356, para 2.22 Back

297   Q 850 Back

298   HM Treasury, Sound banking: delivering reform, Cm 8453, October 2012, para 2.34 Back

299   The Law Society, Banking Reform: delivering stability and supporting a sustainable economy, September 2012, para 80 Back

300   Q 692 Back

301   Ev w176, para 30 Back

302   HM Treasury, Sound banking: delivering reform, Cm 8453, October 2012, paras 2.14 and 2.15 Back

303   Q 595 Back

304   Independent Commission on Banking, Final Report, September 2011, paras 3.9 to 3.10 Back

305   Ibid., paras 3.11 Back

306   Ev w62 Back

307   Ev w62 Back

308   Independent Commission on Banking, Final Report, September 2011, A3.30 to A3.31 Back

309   Q 1068 Back

310   Treasury Committee, Nineteenth Report of Session 2010-12, Independent Commission on Banking, HC 1069 Back

311   Independent Commission on Banking, Final Report, September 2011, p 67-72 Back

312   Q 596 [Andy Haldane] Back

313   Q 789 [Sir John Vickers] Back

314   Q 1049 Back

315   Q 399 Back

316   Q 492 Back

317   Q 489 Back

318   Ev w51, paras 5.1 and 5.3 Back

319   Ev w56 Back

320   Q 707 Back

321   Ev w189 Back

322   Ev w51 Back

323   Ev w 136 Back

324   Qq 404, 749 Back

325   Ev w61 Back

326   Q 500 Back

327   Ibid. Back

328   Ev w168 Back

329   Ev w194 Back

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Prepared 21 December 2012