The Edinburgh Reforms – the future of ring-fencing

Introduction

When the Chancellor announced the Edinburgh Reforms on 9 December 2022 among the papers that were published was an HM Treasury policy paper which responded to the independent review on ring-fencing and proprietary trading that was led by Sir Keith Skeoch. In the policy paper HM Treasury stated that it would consult on a number of reforms in mid-2023 with a view to bringing forward secondary legislation later that year. These reforms would cover the six so called ‘near-term’ recommendations of the Skeoch review that would improve the operation of the ring-fencing regime without undermining the UK’s financial stability. Among the reforms would be taking banking groups without major investment banking operations out of the ring-fencing regime and changing the threshold for the regime, which has not changed since its introduction in 2015, from £25 billion retail deposits to £35 billion. HM Treasury also stated that it would review the list of restricted activities applicable to ring-fenced banks and gave a couple of examples of certain areas it would review. 

Call for evidence

On 2 March 2023, HM Treasury issued a call for evidence on aligning the ring-fencing and resolution regimes. The call for evidence is the first stage in the government’s response to the so called ‘long-term’ recommendation of the Skeoch review for HM Treasury to review the practicalities of how to align the ring-fencing and resolution regimes. The review suggested that an effective way of aligning the two regimes might be to introduce a new power that would enable the authorities to remove banks from the ring-fencing regime when they are judged to be resolvable. The review also made clear, however, that the government should, by conducting a review of the practicalities of such an approach, ensure that doing so would not result in the weakening of wider powers, tools or policies that contribute to the maintenance of the UK’s financial stability.

Benefits

Chapter 3 of the call for evidence discusses the future benefits of the ring-fencing regime and reflect those identified in the Skeoch review. This includes that the ring-fencing regime theoretically provides for the optionality of handling different parts of a failed bank separately. The call for evidence also notes, among other things, that given that a ring-fenced bank is required to be operationally independent it should, during resolution, be insulated against any failing of service provision across the broader group. Other benefits mentioned include certainty, depositor confidence and being an ‘insurance policy’ against the relatively untested nature of the resolution regime. Among a number of supervisory benefits mentioned in the call for evidence is that as a result of their structural separation, ring-fenced banks are subject to a higher level of scrutiny than would otherwise be applied. The requirement for separate governance arrangements between ring-fenced banks and non-ring fenced banks also ensures that ring-fenced banks’ boards have strong and focussed leadership.

Limitations

However, there are limitations with the ring-fencing regime and a number of these were identified by the Skeoch review. In particular, it argued that ring-fencing had not increased the resilience of less complex banks within the regime. Also, the benefits of increased resilience and better protection were relevant only for the ring-fenced banks themselves and not the non-ring-fenced bodies and the wider group.

Since the introduction of ring-fencing in the UK, the resolution regime has evolved considerably. For example the Bank of England now has an objective to ensure the continuity of all critical functions regardless of whether they sit in the ring-fenced bank or the non-ring-fenced bodies. With critical functions on both sides of the ring-fence, the ring-fencing regime alone cannot manage the failure of a bank. The resolution regime now provides a more comprehensive solution to tackling the failure of a banking group that contains both a ring-fenced bank and non-ring-fenced bodies.

Costs

Chapter 4 of the call for evidence looks at the costs of the ring-fencing regime. The Skeoch review estimated that annual aggregate ongoing costs for banks as a result of the application of the ring-fencing regime could be in the region of £1.5 billion, broken down as £0.5 billion for operational costs, and £1 billion for other ongoing costs. The government notes that the implementation of the Skeoch review’s near-term recommendations will likely reduce this annual aggregate cost. So far, there has been no significant evidence suggesting that ring-fencing has had an adverse effect on the growth and competitiveness of non-ring fenced banks. Nor has there been any evidence to suggest that ring-fencing negatively impacts competition within the UK retail banking market, the UK mortgage market and the corporate lending and productive finance markets.

Alignment options

Chapters 5 and 6 of the call for evidence consider the options for better aligning the ring-fencing and resolution regimes in the long-term. In chapter 5 the government describes the criteria which it will use when identifying a preferred option. These include the impact on financial stability, firms, UK competitiveness and competition. In chapter 6 the government does not go into detail but instead sets out three broad options which are to (1) retain the regime with no changes, (2) dis-apply the regime and (3) reform the regime further.  In relation to the second option, the government would have to consider that the continued application of the ring-fencing regime would not bring any material benefits to financial stability. If this were the case another key question would be how to operationalise the disapplication of the regime. As for the third option the government gives no indication as to which parts of the regime it would amend noting that the exact nature of this approach would be dependent on the benefits that it were seeking to retain. Instead the government invites respondents to set out any priorities they might have for further changes to the regime beyond those announced as part of the Edinburgh Reforms.

Comment

Whilst the Governor of the Bank of England, Andrew Bailey, has said that the UK banking system is resilient, with robust capital and liquidity, ring-fencing and recovery and resolution has recently come back into the spotlight. Recent market events may have changed the political narrative. During the publication of the Edinburgh Reforms much was made about “growth” and “taking advantage of post-Brexit freedoms”. This may now have changed with much more emphasis being placed on maintaining the UK’s financial stability. 

In terms of what happens next, the deadline for responding to the call for evidence is 7 May 2023. Once the call for evidence is closed, the government, working with the Bank of England and the PRA through a Ring-Fencing Taskforce, will review the responses. This review will inform the government’s development of an initial policy position regarding the long-term future of the ring-fencing regime. The government will then issue its response to the call for evidence and set out its next steps. As for the six so called ‘near-term’ recommendations of the Skeoch review, the government intends to issue a consultation in mid-2023.

As for the outcome following the call for evidence, our expectation is that the government will not opt to keep the status quo nor remove the ring-fencing regime entirely. Instead it will propose further changes. At this stage it is probably too early to say what these changes are but in light of recent events they may not be as far reaching as they might have been.  As Sam Woods, head of the Bank of England’s supervisory arm, recently said at a cross-party Treasury select committee: “What you wouldn’t want to do is start with a very small hole in the ringfence and you turn around and suddenly there’s a massive one.”