Does the UK’s Ring-Fencing Legislation Decrease the Stability of the Global Financial System?

10.27.18
Lloyd's of London
Business /27 Oct 2018
10.27.18

Does the UK’s Ring-Fencing Legislation Decrease the Stability of the Global Financial System?

Financial regulations are continuously imposed on the banking industry to ensure risk mitigation in the event of a further financial crisis. One such legislation to be introduced in the UK from the 2013 Financial Services Banking Reform Act is ring-fencing – which aims to ensure a banking group’s separation of core retail services from high risk banking activities such as investment banking.

As of January 2019, banks with over £25 billion in deposits will have to be ring-fenced – this covers banks including Barclays, HSBC, Lloyd’s, RBS, Santander and the Co-operative, therefore leading to structural reforms within these banks. If either the ring-fenced or non-ring-fenced part of the bank fails, the management of the failure would be orderly and ideally dealt with whilst avoiding a government bail-out. In theory, ring-fencing should increase the stability of the UK financial system with the expectation of fewer and less severe financial crises in the future and it would also prevent the burden on the UK taxpayers for the compensation of failed banks.

Surely this means that if every entity of each bank in each jurisdiction was ring-fenced, then globally we would be better safeguarded against the repercussions in the event of a large bank failing? Unfortunately this is not the case – studies conducted have stated both advantages and disadvantages to the approach taken by the UK.

Wilson Ervin’s “The Risky Business of Ring-Fencing” explains that initial ring-fencing improves the safety of the entity given that other jurisdictions are not ring-fenced and states that the first ring-fencer benefits from both local capital and the ability to access the bank’s central reserve. However other jurisdiction’s risks would increase as capital is trapped in the ring-fenced jurisdiction, which would lead to the rest of the jurisdictions’ adopting consequent ring-fencing policies to protect themselves. As a result, the likelihood of failure for the bank increases due to the misallocation risk that a bank has enough capital resources overall but cannot distribute these resources to the right entity to avoid local failure. Therefore, the outcome for the first ring-fenced country will end up worse than when it started. So in conclusion, the more the ring-fenced jurisdictions there are, the higher the risk of failure for the banking group.

Whilst the UK is rolling out this legislation, there has been reluctance from the European Union to pursue this approach which poses another interesting preposition for UK banks in the post-Brexit world. The United States has had a similar approach in the past with the Glass-Steagall Act of 1933, which prohibited commercial banks from participating in the investment banking business, and more recently there has been news surrounding the possibility of their own version of a ring-fence.

With the large banks working towards the implementation date of 1st January 2019, ring-fencing will successfully carry out its aim to protect the core UK retail banking services. However, it remains to be seen in the future as ring-fencing is rolled out in other jurisdictions if it becomes a case of “too many rings spoiling the fence.”

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