Jan 17 - Additional safeguards of an “electric” ring-fence and “sibling” structure for UK retail banks could make the separation from the rest of a banking group more effective and benefit the credit profile of the retail bank, Fitch Ratings says. It could also lead to greater ratings differentiation between legal entities within a banking group.
John Vickers, who headed the Independent Commission on Banking, added his support to the Parliamentary Commission on Banking Standards proposal to electrify the retail ring-fence in his evidence to the banking standards commission yesterday.
The UK has already begun steps to introduce a bank ring-fence, which is likely to create safer retail banking entities with more stable and possibly higher credit ratings through economic and market cycles. A ring-fence would likely lead to a gap opening up between ratings of entities inside and outside of the fence. The new proposals to make the ring-fence stronger could widen this ratings differential further within a banking group.
The electrification of the retail ring-fence, involving a threat of full separation, could make the split of funding, capital and governance more effective. The Commission recommended that the Banking Reform Bill should include a reserve power for the regulator to enforce full separation if banks did not adhere to the principles and spirit of the ring-fence. A periodic independent review of the effectiveness of the ring-fence for the whole sector was also proposed. In practice, the rules governing the ring-fence are likely to be complex and hence measuring and assessing its robustness would not be straightforward.
The credit profile of the retail entity would be supported by deposit funding, relatively low-risk secured lending, capitalisation supported by a minimum 10% core Tier level and potentially a leverage ratio higher than the Basel III 3% minimum - another proposal by the banking commission. But the credit profiles of banking operations outside the ring-fence may weaken as they lose funding benefits from retail operations. Depending on the make-up of the non-ring-fenced operations, earnings may be more volatile and risks higher, particularly if securities trading and investment banking business lines are involved.
The structure of a group is also an important consideration in the assessment of an entity’s credit profile. The commission recommends a “sibling” structure for the ring-fenced and non-ring-fenced entities within a group, so the latter is prohibited from holding the former. A ring-fenced retail bank would be more isolated under such a structure. The ratings for the non-ring-fenced entities with more volatile and riskier operations would likely be lower because they would no longer benefit from the earnings and risk diversification of the safe retail unit.
The European Commission’s Liikanen group has also recommended a ring-fencing model, with similar intentions as in the UK. But there are important differences, notably the European version looks to put a barrier around certain securities trading activities, rather than retail operations. There is a risk that UK banks would have to ring-fence more than one part of their business if the rules are not harmonised. However, the UK is ploughing ahead with the implementation of its retail ring-fence to strengthen financial stability as the European proposal is at an earlier stage and could still change significantly if it is taken forward.