Article

HM Treasury and PRA launch consultations on reforms to ring-fencing regime

Published Date
Oct 10 2023
On 28 September, HM Treasury (the Treasury) and the Prudential Regulation Authority (PRA) published consultation papers on the proposed near-term reforms to ring-fencing measures (available here and here). The Treasury also published its response to its call for evidence on the long-term reform of ring-fencing measures (available here).

Background

The ring-fencing regime has now been in force for nearly four years. The legislation introducing the regime required an independent review to be undertaken following implementation, and in March 2022, the final report of the Ring-fencing and Proprietary Trading Independent Review, led by Keith Skeoch (the Skeoch Review) was published. The Skeoch Review addressed itself to an existential question – whether ring-fencing is really necessary in the post-global financial crisis era given other regulatory developments (in particular in recovery and resolution) - and to a series of narrower questions around the technical operation of the regime. 

On the existential question, recognising the increasing alignment and overlap between recovery and resolution, the Skeoch Review made a long-term recommendation to align the ring-fencing regime with the resolution regime. On the technical points, the Skeoch Review made six near-term recommendations. In response, the government announced a series of reforms in response to the Skeoch Review's recommendations in a policy paper on 9 December 2022 (the Edinburgh Reforms).    

Long-term reform

On 7 March 2023, the Treasury published a call for evidence on aligning the ring-fencing and resolution regimes. The interplay between the two, and questions as to how far each secures financial stability and imposes costs, are complex and politically and commercially sensitive. The responses reflect the divergence of views and interests across stakeholders, and as a result do not present a coherent way forward on the questions raised by the Skeoch Review.

The government has indicated it will continue to consider options for reform over the medium-to-long term and will publish its policy response to the call for evidence in the first half of 2024.

Near-term reforms

The government is consulting on near-term reforms in four main areas of the ring-fencing regime, and is inviting further evidence on areas where the Skeoch Review made recommendations but did not consider that reforms should be made at present. In tandem, the PRA is proposing changes to reflect proposed alterations to the geographical scope of the regime. The reform proposals are as follows (we have followed the numbering used by the government):

A. Ring-fencing thresholds

1. Core deposit threshold. The government proposes to increase the ring-fencing threshold to apply to UK banks which have (or whose groups include) GBP35 billion or more of ‘core’ deposits, up from GBP25 billion.

When calculating the threshold, however, banks would need to include core deposits held in non-EEA branches for the first time (see B.1 below).

In practice, this is not expected to alter the scope of the banks currently subject to the regime, but may alleviate the barrier to growth posed by the current limit for banks near the threshold.

2. Exemption for UK banks with de minimis trading assets. The government proposes a secondary threshold which would exempt retail-focussed banks with trading assets of less than ten per cent. of tier 1 capital, except where the bank is part of a Globally Systemically Important Bank (G-SIB).

The government intends to use financial assets held for trading less assets held for hedging purposes under Article 6 (2) of the FSMA 2000 (Excluded Activities and Prohibitions) Order 2014 (EAPO) as a proxy for measuring investment banking operations. Trading assets would be measured as an average over a three year period and would include all operations of a UK banking group, including overseas operations - for example, for a UK bank that is part of a UK headquartered banking group, their trading assets and their tier 1 capital would be measured on a consolidated basis across the UK consolidation group under the UK CRR. For foreign-owned groups, the test would be assessed against all UK financial institutions’ assets, determined on a subconsolidated basis where relevant. There are some questions as to workability of these arrangements for complex groups.

3. De minimis threshold for exposures to RFIs. The government proposes to permit all RFBs to incur exposures of up to GBP100,000 to any individual RFI.

This formed part of the recommendations in the Skeoch Review, although the Skeoch Review also recommended that, where a bank is split into an RFB and an NRFB, the RFB should have the ability to conduct a de minimis level of excluded activities within the ring-fence and need only place excluded activities above the de minimis level in the NRFB, which may have had more effect on banks currently subject to the ring-fencing regime. The government considered this recommendation unworkable in practice and has instead proposed allowing RFBs to incur an exposure of up to GBP100,000 to any single relevant financial institution (RFI) at any one time, aiming to avoid cliff-edges and to reduce the compliance burden on banks. The GBP100,000 threshold is to be determined by reference to the aggregated exposures of the RFB, valued on a fair value basis under IFRS 13.

This change would avoid RFBs having to report small breaches, but would presumably still require significant monitoring on the part of RFBs relying upon it. Identification of RFIs is complex and time-consuming: we would query whether a different approach, under which an RFB is entitled to disregard the status of any person to whom it has exposures under GBP100,000 in meeting its ring-fence obligations, would free up more resources whilst achieving the same policy goals.

B. Architectural reforms

1. Geographical restrictions: permitting non-EEA branches and extending the core deposit definition. The government proposes to allow RFBs to operate branches and subsidiaries outside of the UK/EEA, subject to PRA rules. It also proposes to extend the definition of a ‘core deposit’ to cover deposits taken outside the UK/EEA.

This element of the proposals is the most controversial in our view. Under the current ring-fencing regime RFBs cannot establish operations outside of the UK or EEA: the Skeoch Review identified that this limits RFBs' ability to service customers based outside the UK or EEA, and may be redundant given the UK has left the European Union. The government proposes to allow RFBs to operate branches and subsidiaries outside of the UK and EEA, subject to PRA rules.

Reflecting the geographical limit of the regime, the core deposit threshold in the FSMA 2000 (Ring-fenced Bodies and Core Activities) Order 2014 (RFBCAO) is currently limited to deposits taken in a UK or EEA branch. The government proposes to extend the core deposit definition to cover deposits taken anywhere.

Whilst there is nothing inherently objectionable in permitting RFBs to have branches outside the UK/EEA, the extension of the core deposit definition would have a number of knock-on consequences for UK banking groups whose UK banks have non-UK/EEA branches. These would need to:

(a) identify existing depositors with non-UK/EEA branches of UK banks;

(b) assess and quantify which of these are core deposits (or would be but for an exemption under the RFBCAO for qualifying organizations, qualifying group members, or eligible individuals);

(c) to the extent the bank is not subject to ring-fencing, assess whether the additional core deposits would put it over the GBP35 billion threshold;

(d) to the extent the organisation is already subject to ring-fencing:

(i) make requisite notifications to enable potentially in-scope deposits to benefit from an exemption (to reduce the number of non-core deposits) and make the notifications required under the FCA rules to such depositors (both existing and new depositors); and

(ii) transfer the core deposits to an RFB or non-UK bank; and

(e) create appropriate record-keeping and reporting.

For groups which have UK banks with non UK/EEA branches this extension of scope will involve a lot of initial and ongoing expense. Further, there seems little policy sense in extending the definition given the UK financial stability aims of the regime. Given the amount of work necessary to meet the requirements derived from core deposit status, it seems likely that industry will push back on this element of the package.

For groups which have UK banks with non UK/EEA branches this extension of scope will involve a lot of initial and ongoing expense. Further, there seems little policy sense in extending the definition given the UK financial stability aims of the regime. Given the amount of work necessary to meet the requirements derived from core deposit status, it seems likely that industry will push back on this element of the package.

The PRA is also consulting on changes to the Ring-fenced Bodies Part of the PRA Rulebook, which would introduce a requirement for an RFB to ensure that any third country branch or third country subsidiary within the RFB’s sub-consolidation group does not present a material risk to the provision of core services in the UK by the RFB. The proposed amendments to supervisory statement SS8/16 set out the issues the PRA would consider when assessing compliance with the rule. Firms with non-UK subsidiaries or branches that individually or in aggregate contribute over 5% of the RFB subgroup's risk-weighted assets would be required to disclose this fact in their Internal Capital Adequacy Assessment Process (ICAAP) and explain the steps taken to assess the materiality of risks posed to the RFB's operations and how they are mitigated. Firms should also ensure that the establishment of operations in subsidiaries do not create material risks through the nature of supervision in the third country, for example if the third country supervisor has no effective coordination with the PRA, or if their prudential regime is not sufficiently equivalent. This may require considering the third country supervisor's compliance with standards published by the Basel Committee on Banking Supervision. The PRA also proposes to set an expectation that firms should identify, assess and mitigate any risks to the resolvability of the firm that may arise from the third country subsidiary or branch.

2. Four year transitional exemption from ring-fencing requirements for bank acquisitions. The government proposes to introduce a four-year transitional period where a banking group which is subject to ring-fencing acquires a bank which is not subject to ring-fencing.

Currently, banks that cross the core deposit threshold (and become subject to the ring-fencing regime) have a four year transition period for compliance, as do banks in resolution which are bought via M&A. However, where a ring-fenced banking group acquires a bank not subject to the ring-fencing regime outside resolution, there is no transitional period. The government proposes introducing a four-year transition period for compliance, in line with the other scenarios, noting that this should facilitate the purchase of distressed banks by other banks.

In practice, this exemption, whilst welcome, is only a partial solution to the difficulties faced by banking groups making acquisitions. Typically, any target will need to be housed on one side of the ring-fence or the other. If the target is to be within the ring-fence then the PRA’s height rules will come into play. So ideally the statutory exemption needs to be accompanied by a commitment to waive applicable PRA ring-fencing rules and expectations if acquisitions into the ring-fence are to be readily permissible.

A further issue which the wider consultation does not address, but arguably should, is acquisition of non-banks into the ring-fence, such as private wealth businesses. These are currently challenging given that such businesses are likely to have RFI exposures which the target cannot identify and/or other activities which render them ‘excluded activity entities’ not permitted in the ring-fence. It would be helpful for the changes to address these, too.

C. Permitted products and services

1. Equity investment in UK SMEs. The government proposes to permit RFBs to make direct minority equity investments in UK SMEs, to make investments in funds which invest predominantly in UK SMEs, and acquire equity warrants when providing loans to UK SMEs. An RFB's equity investments under the exemption would be capped at 10% of tier 1 capital (consolidated at the highest group level).

2. Exposures to investment firms which are SMEs. RFBs would also be permitted to incur exposures to RFIs which are investment firms and which meet the definition of an SME under the UK CRR. An RFI would cease to qualify as an SME if it exceeded the thresholds for two consecutive accounting periods. This would be in addition to the proposal to permit RFBs to hold exposure to a single RFI of up to GBP100,000 (see A3 above).

It is notable that, whereas the Skeoch Review suggested permitting exposures to RFIs, the government proposes permitting exposures (over the GBP100,000 limit discussed above) only to SMEs which are investment firms. Other RFIs, including financial holding companies and fund managers remain outside scope. As it is common for groups which include investment firms also to include a financial holding company and/or fund managers, this would leave the rather odd situation for some groups that an SME investment firm would be eligible for exposures over GBP100,000, but its holding company or fund manager affiliate would not.

3. Trade finance. The government proposes to permit RFBs to undertake a wider range of standard trade finance activities that the current exemptions do not always cover (including standby letters of credit, bills of exchange and promissory notes).

Whilst the proposal in the consultation paper is welcome, it is not clear that the drafting amendments proposed to the EAPO achieve this end. The changes broadly accommodate master agreements and transactions governed by multiple connected agreements. They also limit eligibility to situations where the RFB has a customer relationship with the supplier or recipient of goods or services – leaving the position unclear where the RFB’s customer is an intermediary.

4. Debt for equity swaps. The government proposes to broaden the scope of the existing exemption that permits RFBs to engage in 'debt for equity swaps', giving RFBs greater flexibility.

Equity held under this exemption would not count towards the 10% tier 1 equity investment limit in SMEs outlined above. The revised exemption would permit options and warrants to be issued and exercised as part of a restructuring, provided there was a release of debt either at issue or exercise and the purpose of the restructuring is to mitigate the financial difficulties of the borrower.

5. Central banks. The government proposes to permit NRFBs to take deposits from central banks outside the UK by exempting such deposits from core deposit status.

The consultation asks whether other multilateral/multinational organizations should also be included within the exemption.

6. Inflation swaps. The government proposes to permit RFBs to hedge inflation through inflation swaps.

The proposal permits fixed:floating inflation swaps only.

7. Mortality risk. The government proposes to permit RFBs to hedge mortality risk through mortality swaps.

The mortality risk definition is defined by reference to mortality risks arising from having loaned money. This may need to be widened to capture other exposures.

8. Share dealing errors. The government proposes to permit RFBs to deal as principal to resolve share dealing errors.

9. Test trades. The government proposes to permit RFBs to deal as principal in securities to undertake test trades for new products and services.

10. Divestments. The government proposes to permit RFBs to divest themselves of bonds.

11. Trustee services. The government proposes to permit RFBs to incur exposures to RFIs when acting as a trustee for minors or charitably incorporated organizations.

Note that the permission would still leave RFBs unable to act as trustee for corporates.

12. Simple derivatives. The government proposes to permit RFBs to offer FX collars whose components fall within the existing permissible (‘simple’) derivatives permitted under the EAPO.

D. Definitions and technical amendments

The government is also proposing some limited amendments to clarify and improve the functioning of the ring-fencing regime:

1. Structured finance vehicles (SFV): clarifying the current drafting so that an RFB can be exposed to an SFV containing assets created or acquired by the RFB or its subsidiaries or by another ring-fenced body in the same group, whether or not these were originated by the RFB or a third party. The revision to the definition would also permit RFBs to securitise assets acquired (but not originated) by the RFB or another ring-fenced body in its group, which is currently not permitted;

2. Correspondent banking: clarifying that the existing permitted exposure to RFIs where the exposure arises from correspondent banking arrangements involving two credit institutions applies where the correspondent banking arrangements involve two or more credit institutions; and

3. NRFB grace periods: introducing a 12-month grace period for NRFBs to move deposits of customers no longer classified as an RFI to an RFB.

Areas where the government is seeking further evidence

The government is also seeking evidence about other areas where the Skeoch Review made recommendations but the government found insufficient evidence to propose changes. These are as follows;

  • whether to remove or keep the notice of determination requirement for onboarding NRFB customers;
  • whether the status of trustees and insolvency practitioners under the ring-fencing regime needs to be clarified;
  • whether the definition of “conduit vehicles” in the ring-fencing legislation should be amended;
  • whether the definition of “related undertakings” in the ring-fencing legislation should be amended;
  • whether the definition of “qualifying organizations” and a member of a “qualifying group” for NRFBs regarding charitable trusts, companies, and associations in the ring-fencing legislation should be amended;
  • whether the reference to Globally Systemically Important Insurer in the definition of an RFI in the ring-fencing legislation should be amended; and
  • how the current ring-fencing legislation restricts RFBs from providing structured FX derivative products.

What’s next

The Treasury consultation closes on 26 November 2023 and the PRA consultation closes on 27 November 2023.

The near term changes are proposed to be laid before Parliament in early 2024 and to take effect immediately. As to the longer term question of whether the ring-fencing regime is fit for purpose, banks will have to wait until a policy paper on long-term reform is published in 2024 to assess the direction of change.

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HM Treasury and PRA launch consultations on reforms to ring fencing regime

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