Thursday, December 22, 2011

Implementing Vickers Commission Recommendations, UK Will Ring Fence Retail Banking from Proprietary Trading and Sponsoring Hedge Funds

The UK government will draft legislation implementing the Vickers Commission recommendation to ring-fence retail traditional banking activities from investment banking activities. Ring-fencing vital banking services on which households and small and medium-sized businesses depend from investment banking activities will effectively insulate them from problems elsewhere in the financial system, reduce risk taking, and curtail implicit government guarantees. While proprietary trading and investments in hedge funds would not be prohibited, these activities would be outside the ring-fence and thus isolated from retail banking where implicit government guarantees appear strongest.

In addition, the ring-fenced bank should be legally and operationally independent from the rest of its corporate group. Ring-fenced banks should be regulated for capital and liquidity purposes on a solo basis; should not be over-reliant on the rest of the corporate group for funding, and should undertake transactions with the rest of the group on a third-party basis.

According to the Vickers Commission, effective ring-fencing also requires measures for independent governance to enforce the arm’s length relationship. The Commission’s view is that the board of the ring-fenced retail subsidiary should normally have a majority of independent directors, one of whom is the chair. For the sake of transparency, the ring-fenced subsidiary should make disclosures and reports as if it were an independently listed company. While corporate culture cannot directly be regulated, noted the Commission, proper structural and governance arrangements should consolidate the foundations for long-term customer-oriented UK retail banking.

The Commission set forth five ring-fence principles identifying the features of financial services that should determine their treatment and thus provide a guide for the operation of the ring-fence when new products arise. Notably, the Commission pointed out that the Glass-Steagall Act, which prevented deposit-taking banks from underwriting or dealing in securities, was undermined in part by the development of derivatives.

Principle 1 is that only ring-fenced banks should be granted permission by the UK regulator to provide mandated services. Conversely, Principle 2 states that ring-fenced banks should be prohibited from providing services that make resolution significantly more costly, increase exposure to global financial markets, and involve risks not integral to the provision of traditional banking services to customers. Under, Principle 3, the ring-fenced bank should be allowed to conduct ancillary activities to support the provision of its core functions.

The height of the fence is specified in Principles 4 and 5, which describe the legal, operational and economic links which should be permitted between a ring-fenced bank and any wider corporate group of which it is part. Ring-fenced banks should be separate legal entities. Where a ring-fenced bank is part of a wider corporate group, its relationships with entities in that group should be conducted on a third-party basis and it should not be dependent for its solvency or liquidity on the continued financial health of the rest of the corporate group.

The Commission said that, under the Volcker Rule, banks are not allowed to engage in proprietary trading, and investments in hedge funds and private equity firms are restricted. In part the Volcker Rule aims to remove from certain activities the benefit of implicit and explicit government support for the banking system.

According to the Vickers Commission, those activities prohibited by the Volcker Rule should be prohibited from ring-fenced banks. Proprietary trading is not a necessary part of intermediation in the real economy and so should not be conducted in the same entity as the mandated services.

However, the Commission emphasized that prohibiting only those activities caught by the Volcker Rule would not achieve all of the objectives of ring-fencing. As a result, most of the efforts to improve the resolvability of universal banks involve requiring that all investment banking activities must be separable from the rest of the bank.

Also, in order to reduce the ring-fenced bank’s interconnectedness with the financial system and the correlation of its performance with that of financial markets, it should not conduct trading or other activities which give rise primarily to market risk or counterparty credit risk. The Commission reasoned that removing the complexity of some investment banking would make it easier for ring-fenced banks to be managed, monitored and supervised.

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