Less than four years after full implementation on ring-fencing rules, a key measure to deal with the issues revealed by the 2007/08 global financial crisis, the Government has launched a call for evidence to consider how to align the ring-fencing and resolution regimes – which could possibly lead to abolition of the ring-fencing regime.
This is one of the Edinburgh reforms announced by the Chancellor on 9 December 2022, and follows the March 2022 report of the Independent panel on Ring-fencing and Proprietary Trading (The Skeoch Review).
The Skeoch Review felt “On balance, … that ring-fencing is worth retaining at present.” But that “the benefits will diminish over time”, most notably as the resolution regime beds down. The review recommended reviewing the alignment of the two regimes, “with a view to introducing a new power for the authorities to remove banks from the ring-fencing regime that are judged to be resolvable”.
Post implementation reviews are a necessary requirement of a well-functioning regime. It is also pertinent to ask if the different components of the response to the financial crisis are coherent. Reasonably, the call for evidence seeks views on the benefits and costs of the ring-fence regime, the criteria by which to assess the benefits, and the potential range of outcomes (eg retain, disapply or reform the ring-fencing regime).
However, given the ring-fence regime has been in place since 1 January 2019, there is a question whether it has had sufficient time to embed and operate across a business cycle, to enable all the benefits and costs to be identified and a robust assessment be made of its effectiveness or otherwise. While the resolution regime has been around longer - since the aftermath of the financial crisis – it has evolved and remains to be truly tested by a stress at a large bank. Only two small firms in 2009 and 2011 have had completed resolutions – to which SVB can be added.
It is also questionable how a review be undertaken, as both measures can somewhat only be tested by a downturn and a very severe one at that. It is not clear that, despite covid and the current energy crisis, we have had a sufficiently severe downturn to test the ring-fenced banks and may have some years to wait for one. This however is a challenge for all policy – when to review – and only in hindsight might you know the answer.
The call for evidence sets out a number of ring-fencing benefits, including the certainty created by the ex-ante separation of retail and investment banking operations. If a group gets into trouble the first step of separating the different parts is not required, and the group should be more capable of being resolved on a timely basis without additional cost. A firm’s resolution plans may adopt a similar approach, but the risk is that this does not have the same certainty: the resolution assessment may not be as comprehensive across all potential intra-group arrangements or at the same granular level of detail or may require some intermediate step. The ring-fence regime currently provides a strong ex-ante backstop to support and enforce the resolution regime, and its loss may weaken the resolution regime if there is not an adequate compensating measure.
A feature of the cycle of crisis and reform is that reform typically and quite naturally responds to last crisis and may not include provisions to manage the next crisis. A risk is that reform acts as a straitjacket and lacks the flexibility to manage the next crisis. Any review should reflect whether the benefit of certainty comes with a potential loss of flexibility. It is notable that the UK was the only regime to implement ring-fencing as a post crisis reform, which suggests that there are other options.
A degree of caution should be exercised, but the Skeoch Review estimated two types of cost from operating the regime – a £0.5bn operational cost and a £1bn opportunity cost from reduced business opportunities. Implementing the other recommendations in the Skeoch review should reduce some of the costs, while others may continue to be incurred as necessary to enable an effective resolution approach. Individually, a billion is a large number, but by way of context, the aggregate operating expense and net interest income lines in the recent financial statements of the groups in the regime are around £48bn and 50bn.
The criteria by which the Government will judge the regime include financial stability, effect on firms, impact on UK competitiveness and growth, and the impact on completion (in the interests of UK consumers). These are reasonable, but the Government does not set out how it will weigh the different criteria and the call for evidence is at pains to note that the order in the paper does not reflect their relative significance. A cynic might suggest in the current environment the impact on UK competitiveness at the expense of financial stability will be the primary motivator. The recent failure of Silicon Valley Bank highlights the risks in the banking may never be too far away.
The further and ever-present challenge when making regulation policy, is how to compare measurable costs with intangible benefits that only arise by non-occurrence of an event in a stressed environment. This is the challenge the call for evidence will need to meet.
The call for evidence closed on 7 May 2023.
