UK retail bank ring-fencing recently took a step forward as two important pieces of secondary legislation were laid before Parliament, where they now await approval. These documents define the activities which ring-fenced banks will and will not be allowed to carry out from January 2019. They build on last year's drafts, but there are some significant amendments, particularly in relation to 'simple' derivatives, the process for taking customers out of the ring-fence, payments, the treatment of the Crown Dependencies, and risk management. Here we focus on the main changes compared to the earlier drafts.
The first Order defines the 'core activities' which must be conducted through a ring-fenced bank, and the second sets out the 'excluded activities' which cannot be conducted by a ring-fenced bank, as well as associated exemptions. The two Orders account for the bulk of the secondary legislation, with loss absorbency and the treatment of pensions the two main outstanding areas. A revised version of the legislation on loss absorbency is notable by its absence, with the Government having said that it is waiting for discussions to progress at the international level through the Financial Stability Board, where a vigorous debate continues.
The Orders are something of a mixed blessing. On the on hand there has been a streamlining of the process for keeping certain customers out of the ring-fence, and there has been an extension of the range of 'simple' derivatives ring-fenced banks can provide to their customers. On the other hand, the Government has removed the possibility of ring-fenced banks having branches in the Crown Dependencies, and the situation remains ambiguous with respect to payments and loss absorbency, where we will have to wait for further rulemaking for the details.
There is now more clarity on what is in or out of the ring-fence, the drafting is tighter, and various technical changes have been made. But this is only the second of three tiers of rule-making – the third tier (the PRA rules) remains, like the majority of an iceberg, wholly out of sight.
Derivatives – options allowed
Caps and floors (along with all other options) had been ruled out in last year's draft, but ring-fenced banks will now be permitted to provide certain caps and floors to their customers, as well as certain currency and commodity options. The types of derivatives ring-fenced banks will be able to provide will therefore be: currency swaps; interest rate swaps; currency and commodity forwards; certain options in relation to currencies and commodities; interest rate caps and floors; and interest rate 'swaptions' (i.e. giving the customer the option of entering into an interest rate swap).
However, these derivatives activities are subject to additional constraints: a ring-fenced bank's net position risk requirement will be limited to 0.5% of its own funds, and the sum of the position risk requirements for each transaction, without netting, will be limited to 25% of its credit risk requirement (which thresholds have been retained from the previous draft); their values must be assessable based on observable data (such as quoted market prices, or any other level 1 or 2 input under IFRS 13); and the derivatives will be restricted to those which can be traded on EEA trading venues, such as multilateral trading facilities, or recognised third country trading venues. This latter (new) criterion excludes non-standard OTC derivatives, although it should be noted that the universe of derivatives traded on venues is set to increase under MiFID II, which requires all standardised derivatives to be traded on regulated markets.
It is also important to note that ring-fenced banks are allowed exposures to recognised clearing houses and central counterparties – these are exempt from the general prohibition on financial institution exposures.
Process – opting out of the ring-fence
The process for enabling large companies and high net worth individuals to deposit outside the ring-fence has been somewhat simplified – where previously they were required to submit declarations signed by an accountant, large companies can now submit a copy of their annual accounts, and banks can accept declarations from HNWIs without a confirming statement if they are "satisfied that the declaration of eligibility is true." Most obviously, this means that a bank which has all the necessary information about a HNWI (e.g. because that individual has an account with the bank), will not need that declaration to be signed by an accountant. However, the bank will still have to process and validate declarations. The requirement to renew declarations on a regular basis has also been omitted.
There is a new requirement for non-ring-fenced banks to provide information to individual prospective customers to enable them to make an informed decision about where they place their deposits. The FCA will specify the information to be provided, but at a minimum it will include a description of the trading activities the non-ring-fenced bank carries out.
Crown Dependencies
In last year's drafts, there was an exemption to allow ring-fenced banks to maintain branches in the Crown Dependencies, despite otherwise being prohibited from having non-EEA branches or subsidiaries. The Treasury had said that deposits in the Crown Dependencies "play an important part in the funding mix and liquidity base of UK ring-fenced banks" and that as such, "access of UK ring-fenced banks to the Crown Dependencies has positive consequences for UK financial stability." However, this exemption has been removed – ring-fenced banks will not be permitted branches (or subsidiaries) in these territories. The documents do not give any explanation for the change of stance.
Payments
The drafting on payments activities has changed considerably. Where previously there was a detailed framework describing permitted payments exposures (with limits on the volume of payments ring-fenced banks could process on behalf of other banks, and a requirement that any such payment exposures should be reported in real-time), there is now only a matter of a few lines: the detail has been replaced with a statement that ring-fenced banks can have payment exposures to financial institutions, but only if the exposures comply with rules to be written by the PRA or FCA. This means that the details of the payments framework remain essentially unknown, and we will have to wait for the regulators to substantiate it.
Own risk management
The drafting to allow ring-fenced banks to manage their own risks has become more precise, making it clear that a ring-fenced bank can manage its own risks, as well as those of its subsidiaries, any of its securitisations or structured finance vehicles, and any of its other conduits. Furthermore, the list of risks for which it is permitted to trade for risk management purposes has been expanded to include indexes of retail prices or residential or commercial property prices, as well as any index of the price of shares, in addition to the original categories of interest rates, exchange rates, commodity prices, default risk, and liquidity risk. There is no restriction on the types of instruments a ring-fenced bank can use to manage its own risks – complex derivatives are permitted for these purposes – although derivatives used to hedge customer-related derivatives exposures will be incorporated into the position risk limits discussed above.
Ring-fenced banks are also now enabled to have exposures to non-systemically important insurance companies in general, and are permitted exposures to any insurance company (including those designated as global systemically important insurers (G-SIIs)) in order to buy insurance products needed in the general course of conducting business (such as buildings insurance).
What next?
The Government looks to be on track to meet its commitment to finalise all the legislation in relation to ring-fencing by the end of the current Parliament. But this is only a part of the picture – for many, the main event will be the PRA's ring-fencing rules which will define permissible relationships between ring-fenced and non-ring-fenced banks, permissible governance structures, and other crucial issues in relation to the operations of UK banking groups. The UK is clearly intent on developing its framework, notwithstanding what might emerge from Brussels on the EU's bank structural reform agenda.
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