Monday, April 11, 2011

In Bow to Volcker Rule, UK Commission Recommends Ring-Fencing a Financial Institution’s Retail Banking Activities from Investment Banking

The retail banking activities of a financial institution should be ring-fenced from the firm’s investment banking activities, says a report of the UK Independent Banking Commission. In addition, the Commission recommended that an international benchmark of a 10 percent baseline ratio of equity to risk-weighted assets be set for systemically important financial institutions. Basel III is seven percent. The Commission believes that a ring-fence could be designed to fit within the EU legal framework and should be imposed on UK-authorized banks, including UK subsidiaries of foreign banks.

The ring-fencing proposal shares a common motivation and underlying philosophy with the Volcker rule being implemented under the Dodd-Frank Act. Similar to a retail ring-fence, the Volcker rule aims to curtail government guarantees and the instability they can create by subsidizing risk taking. Under the Volcker rule, because deposit-taking banks benefit from some explicit and implicit government guarantees, they should not be able to conduct trades or invest in funds purely for the purpose of making money on their own account. A rubric of both the Volcker Rule and the rink fencing proposal is that socializing part of the risk of these activities while privatizing their benefits encourages excessive risk taking that may damage the stability of the financial institution.

To date, the UK’s reaction to the Volcker provisions has been mixed. Chancellor George Osborne has said that large scale proprietary trading and large scale internal hedge funds do not sit easily alongside retail banking, but the current UK government has taken no steps to implement the Volcker Rule. Rather, the Chancellor has appointed this independent commission to study the matter and report back, which it has now done.

The Commission’s ring-fencing proposal is different from the Volcker Rule in that, while proprietary trading and investments in hedge funds would not be prohibited, these activities would be outside the ring-fence and so isolated from retail banking where implicit government guarantees appear strongest. Also, increasing loss absorbency and implementing a retail ring-fence would reduce perceived government guarantees across all banking activities by making the resolution of banks easier, less costly, and less disruptive to essential retail activities, which would address a major motivation for a Volcker rule.

The Volcker rule is also designed to remove the conflicts of interest between a bank’s own trading activities and those it conducts on behalf of clients. Such conflicts can arise, for example, if a bank were to provide merger advice to a client who was influenced by its own exposure to a particular company, or simply in the ordering in which client and proprietary trades are processed. The Commission noted that existing regulations are in place to protect clients and govern how financial institutions should manage conflicts, and it will be the responsibility of the Financial Conduct Authority to enforce these in the UK. The Commission noted that such regulations will always be required since separation does not prevent other market abuses such as the passing of inside information between individuals for their personal gain.

The fact that the Commission’s ring-fencing proposal is partially inspired by the Volcker Rule may provide some comfort to House Financial Services Committee Chair Spencer Bachus, who has urged federal financial regulators to interpret the Volcker provisions of the Dodd-Frank Act in a way that does not disadvantage US financial firms in competition with EU firms. In a letter to the Financial Stability Oversight Council, Rep. Spencer Bachus (R-AL), said that any Volcker Rule regulations adopted by US financial regulators must be set against the international regulatory framework so as not to foster regulatory arbitrage and not unfairly impact US financial firms. In the view of Chairman Bachus, the Volcker provisions collide with the European universal banking model that the EU is unlikely to abandon in the spirit of regulatory harmonization. More specifically, given the City of London’s significance as a world financial center, noted the Chair, the UK’s failure to adopt the Volcker provisions would result in a significant competitive disadvantage for US firms.

According to the Commission, definitional issues would be crucial for any ring-fence. Definitions would need to be robust against attempts both to conduct additional activities within the retail ring-fence and to re-define retail activities so that the ring-fence requirement did not apply. For example, the US authorities bailed out mutual funds during the crisis despite the fact that these had been created in part to avoid restrictions around retail deposit-taking.

The Commission is considering forms of retail ring-fencing under which retail banking operations would be carried out by a separate subsidiary within a wider group. This would require universal banks to maintain minimum capital ratios and loss-absorbing debt for their UK retail banking operations, as well as for their businesses as a whole. Subject to that, the banks could transfer capital between their UK retail and other banking activities.

Ring-fencing a bank’s UK retail banking activities could have several advantages. It would make it easier and less costly to sort out banks if they got into trouble, by allowing different parts of the bank to be treated in different ways. Vital retail operations could be kept running while commercial solutions such as a reorganization or wind-down were found for other operations. It would help shield UK retail activities from risks arising elsewhere within the bank or wider system, while preserving the possibility that they could be saved by the rest of the bank. And, in combination with higher capital standards, it could curtail taxpayer exposure and thereby sharpen commercial disciplines on risk taking.

Separation between retail banking and wholesale and investment banking could take various forms, depending on where and how sharply the line is drawn. While mindful of regulatory arbitrage possibilities, the Commission believes that there are practicable ways of distinguishing between retail banking and wholesale and investment banking. Both sorts of banking are risky and both are important, noted the Commission, but they present somewhat different policy challenges. For the most part, retail customers have no effective alternatives to their banks for vital financial services; hence the imperative to avert disruption to the system for their continuous provision. Customers of wholesale and investment banking services, on the other hand, generally have greater choice and capacity to look after themselves.

Markets for wholesale and investment banking services, including their provision by hedge funds and other participants in the shadow banking system, are also more international, whereas national policies can bear more directly on retail banking.
While full separation might provide the strongest firewall to protect retail banking services from contagion, observed the Commission, it would lose some benefits of universal banking. On the other hand, it is doubtful that separability of operational systems, though desirable for effective resolvability, would itself be enough.

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