Electrifying the ring-fence – the view from the transaction banking industry

By:
Rebecca Brace
Published on:

The ring-fence between retail and investment banking proposed in the Vickers report need to be 'electrified', according to a report by the Parliamentary Commission on Banking Standards (PCBS). But which side of the ring-fence will transaction banking services fall on?

The Vickers report

Published in September 2011, the Independent Commission on Banking’s (ICB) recommendations – also known as the Vickers report – proposed that UK banks divide their investment banking and retail banking divisions into “legally, economically and operationally separate” legal organizations.

The measures are intended to protect high-street banking activities from riskier activities, thereby preventing future taxpayer-funded bailouts.

Under the ICB’s proposals, retail and investment banking divisions would have their own board of directors.

While its requirements will lead to substantial changes in the UK banking industry, the Vickers report stops some way short of the Volcker rule in the US, which is based on a more fundamental separation of retail and investment banking operations.

PCBS report

The PCBS, which was set up last year in the wake of the Libor-rigging scandal, was asked to review the changes outlined in the Vickers report.

According to the PCBS report, published in December, the ICB’s recommendations need to be more robust to withstand the likely tests and challenges. The PCBS report expresses concern that politicians could succumb to lobbying from banks and others, adding to pressure to weaken the proposed reforms.

To guard against this and “electrify” the ring-fence, the PCBS recommends that the measures should extend to forcing a break-up of a bank if the proposed reforms prove insufficient and that directors should have a legal duty to preserve the integrity of the ring-fence.

In addition, the report recommends a periodic review of the effectiveness of ring-fencing across the sector to “determine whether ring-fencing is achieving the objectives set out in legislation, and to advise whether a move to full separation across the banking sector as a whole is necessary to meet those objectives”.

Responses to the latest report have been mixed. While some have welcomed the PCBS’s commitment to the ring-fence, others have expressed reservations.

Nicholas Brewer, senior analyst at Aite Group
“My view is that the PCBS response has been caught between the popular mandate and banking regulation, because it is a parliamentary body and it has to both legislate and represent the people who elected it,” says Nicholas Brewer, senior analyst at Aite Group. “On this occasion, it has found itself pulled much closer towards the popular mandate – and that is creating an uncertainty which, if it continues, will be quite divisive in the long run.”

Impact on transaction banking

It is clear that customer deposits will sit on the retail banking side of the fence and that complex derivatives will sit on the other – but which side of the fence will transaction banking products and services fall on?

Some expect the majority of transaction banking activities will fall on the retail banking side, but this is not set in stone – and in any case, the way in which these services are divided could vary from bank to bank.

“Banks cannot be neatly divided into retail banking and investment banking,” says Brewer. “Transaction banking is actually in neither of the two categories – or is in both, depending on how you look at it.

“If you are aiming to protect retail depositors’ money, you should also aim to protect companies’ money in the event of a bank running into financial problems – because that company employs people, pays taxes and is socially useful.

“On the other hand, what if the corporate is not just doing payments but is also taking out foreign exchange hedges for its future foreign currency cash flows? That suddenly looks a bit more like an investment banking activity.”

The PCBS report says there is a “case in principle” for allowing the sale of simple derivatives within the ring-fence, although it warns that adequate safeguards should be in place to protect against mis-selling.

Nevertheless, it is possible that companies’ banking activities could end up straddling the ring-fence, with cash management activities falling inside the ring-fence while hedging activities fall on the other side.

For companies which prefer to go to one bank as a one-stop-shop for all of their banking services, the arrival of the ring-fence could make this more difficult – and is likely to result in higher costs.

Challenges

Chris Skinner, chairman of the Financial Services Club
Putting in place a ring-fence is likely to be more challenging for some banks than for others. Lloyds claims to be in favour of the ring-fence and expects that most of its operations will fall on the retail banking side.

The universal banking model favoured by Barclays, in contrast, is likely to make the process of separating retail and investment banking a greater challenge.

How much protection would a ring-fence provide? “It is not the cure – it is basically what to do if someone gets the illness,” says Chris Skinner, chairman of the Financial Services Club. “If a bank does start to fail, the assumption is that if the investment side is separated from the retail side, you can just close down the poisoned chalice in the bank and it will continue to function as normal on the commercial and retail side.

“But as others have pointed out, Northern Rock didn’t have any wholesale side – they were basically securitizing their regional functions in the wholesale markets.”

There is little doubt that the ring-fence will come into being – but as the concerns raised in the PCBS report have underlined, its final form remains yet to be determined.