Regulator needs power to prevent "gaming" of ring-fencing rules, MPs say

In its first report (144-page / 685KB PDF), the Parliamentary Commission on Banking Standards called on the Government to "electrify" the proposed 'ring-fencing' requirement, which is intended to increase financial stability by ensuring retail banking activities can continue even if the rest of the business falls into difficulties. It recommended that that financial regulators be given the power to force banks to separate certain activities as part of the draft Financial Services (Banking Reform) Bill, which will if approved implement the new system.

"A ring-fence ... can, in principle, contribute to the Government's objectives of making the banking system more secure," Andrew Tyrie, Conservative MP and chair of the Commission, said. "But the proposals, as they stand, fall well short of what is required."

"Over time, the ring-fence will be tested and challenged by the banks. Politicians, too, could succumb to lobbying from banks and others, adding pressure to put holes in the ring-fence. For the ring-fence to succeed, banks need to be discouraged from gaming the rules. All history tells us they will do this unless incentivised not to."

However banking law expert Tony Anderson of Pinsent Masons, the law firm behind Out-Law.com, said that the Commission's proposals were "more like a moat without a drawbridge than an electric fence".

"The Banking Reform Bill as drafted doesn't really have a 'stick', but suggesting full separation for not 'playing within the spirit' of what is proposed under the Bill invites a range of unintended - and probably unknown - consequences," he said. "Surely other sanctions would be more appropriate, without risking damage to the wider economy by making 'red-carded' banks re-engineer themselves once again."

The ring-fence, as recommended by Sir John Vickers' Independent Commission on Banking (ICB) in its report on banking reform last year, will ensure that retail banking activities are provided by a separate subsidiary of a wider banking group. Ring-fenced banks will need to be legally and operationally distinct entities from non ring-fenced banks, and will not be able to own or hold the capital of other non ring-fenced entities within the group. In addition, ring-fenced banks will not be able to carry out any activities through subsidiaries or branches based outside the European Economic Area (EEA).

Only ring-fenced banks will be able to accept deposits from and provide overdrafts to retail customers. They will not be able to carry out certain pre-defined activities including international and wholesale and investment banking services, and dealing in investments as principal. However, they may be permitted to provide "simple" derivative products to their customers provided that a number of conditions are met.

The Government has pledged to approve the necessary legislation by the end of the current Parliament, in May 2015. Banks will have until 2019 to comply with the new rules although smaller banks, holding less than £25 billion of mandated deposits, will likely be exempt from the requirements.

In its report, the Commission called on the Government to include further measures in the Banking Reform Bill to ensure that the ring-fenced part of the bank remained "truly independent", including a new regulatory duty of "ensuring operational independence". Bank executives should also be given a statutory duty to "preserve the integrity of the ring-fence". Regular reviews of how the ring-fence operated in practice should also be carried out, with the regulator's legal authority to break up banks only available to it after the first review, it said.

The Commission also expressed concerns that too much of the banking reform programme was due to be implemented through secondary legislation, to be drafted at a later date. It said that the absence of this legislation had "seriously impeded" its ability to examine the proposals in full.

Tyrie said that the Commission would report on other aspects of the reforms next year, including what impact changes in areas such as competition, corporate governance, supervision and regulation could have on financial stability. It also plans to examine whether banks should fully separate their proprietary trading activities from retail banking, rather than simply ring-fence these activities. This type of separation would mirror the 'Volcker Rule', proposed by banking authorities in the US.

Banking law expert Tony Anderson warned that without better coordination on an international level, the various banking reform processes underway in the UK, US and EU could pose "considerable challenges" to global banks.

"In the UK, the Banking Reform Bill is due to go before Parliament early next year, the Liikanen Report on EU Banking Reform was released a little over a month ago and the French only announced their proposals yesterday. They are the first of the European countries to do so," he said.

"There are significant differences in each approach and will obviously not come into effect simultaneously. These differences in approach and timing will present considerable challenges to any global bank looking to maintain a presence outside of its home jurisdiction," he said.

In October, a panel of banking experts led by Bank of Finland Governor Erkki Liikanen recommended similar restructuring of the trading and retail activities of European banks. The European Commission is currently considering how it will implement these recommendations.