Government plans to add more flexibility to the regime, but its long-term future remains undecided.

On 28 September 2023, HM Treasury published further papers in relation to the planned reform of the UK bank ring-fencing regime, which was announced as part of the Edinburgh Reforms (see this Latham article). The ring-fencing regime requires banks over a certain size threshold to separate out their retail deposit-taking operations into a ring-fenced entity.

HM Treasury has published a consultation on short-term reforms to the regime, aiming to implement (and, in some cases, go beyond) recommendations made in 2022 by the independent review of ring-fencing. The proposed reforms include raising the ring-fencing threshold from £25 billion to £35 billion of core deposits, and expanding the activities that a ring-fenced bank may carry on. HM Treasury has also published a response to its Call for Evidence on aligning the ring-fencing and resolution regimes in the longer term.

HM Treasury views the proposals as an evolution of the regime, although clearly a key driver for reform is ensuring that the UK is a competitive market for banks to do business. The UK is an outlier globally in having a ring-fencing regime, and some argue that such a regime is not required given the post-financial crisis prudential and resolution regimes for banks. For now at least, HM Treasury has not outlined a clear direction for the regime’s long-term future.

Short-Term Reforms

HM Treasury is proposing a number of changes to the ring-fencing regime, following the recommendations of the independent review.

Thresholds

The headline proposal is increasing the core deposit threshold from £25 billion to £35 billion, thus raising the level at which the ring-fencing requirements apply. HM Treasury explains that, given the improvements in UK banks’ resilience since the ring-fencing regime was introduced, it considers that the appropriate level for the deposit threshold has increased. According to HM Treasury, the higher threshold would result in approximately 90% of banks’ UK retail deposits being covered by the ring-fencing deposit threshold, which is broadly in line with the proportion covered when the threshold was set originally. Although this change is not expected to alter the banks currently within scope, HM Treasury considers that it would increase competition by removing a barrier to growth for banks currently below the £25 billion threshold.

The proposals would also introduce a “secondary threshold”, exempting retail-focused banks with trading assets of less than 10% of tier one capital, measured on a consolidated basis. This exemption would not be available to banks that are part of a G-SIB. This would exclude banking groups without major investment banking operations from the ring-fencing regime.

To introduce more flexibility into the regime, HM Treasury is proposing that ring-fenced banks should be permitted to incur aggregate exposures of up to £100,000 to any individual relevant financial institution. It expects that this proposal would reduce the compliance and monitoring burden, whilst maintaining an appropriate level of risk mitigation. It did not consider that the review’s recommendation to introduce a de minimis threshold around the amount of restricted activities a ring-fenced bank could carry out would be workable in practice, as it would be very difficult to measure.

Geographic Restrictions

The proposals would allow ring-fenced banks to establish subsidiaries or branches outside the UK or the EEA, which is currently prohibited. HM Treasury considers that this would help UK banks to compete internationally. However, banks should note that this change would also mean that they must include global core deposits (rather than just UK and EEA deposits) when calculating whether they cross the ring-fencing threshold. Linked to this, the PRA has published a consultation (CP20/23) on changes to its rules regarding the establishment and maintenance of third-country branches and subsidiaries within ring-fenced body sub-consolidation groups.

Transition Period for M&A

A new four-year transition period would apply for complying with the regime in various circumstances when a ring-fenced banking group acquires a non-ring-fenced bank. This would rectify the anomalous situation whereby a four-year transition period applies in other scenarios. Under the proposal, this transition would apply in all M&A scenarios, whether or not the acquired bank has entered resolution.

Permitted Activities

HM Treasury is also proposing various changes to the permitted activities a ring-fenced bank could carry out, including permitting equity investments in UK SMEs and permitting exposures to certain small financial institutions. The proposals would also permit ring-fenced banks to, amongst other things, undertake a wider range of trade finance activities, service central banks outside the UK, offer inflation swap derivatives, and deal as principal for certain purposes (including to correct share dealing errors and undertake test trades). These changes are intended to further the government’s aim of facilitating the provision of finance to SMEs, as well as adding flexibility to the ring-fencing regime and reducing its complexity.

Other Areas of Reform

HM Treasury is proposing some further technical amendments, and discusses a number of areas in which it is seeking more evidence on whether legislative change would be justified, such as whether the status of trustees and insolvency practitioners under the ring-fencing regime needs to be clarified.

Next Steps

HM Treasury considers that the proposals, if implemented, would reduce the existing regime’s rigidity and address unintended consequences, whilst maintaining appropriate financial stability safeguards. Responses are requested by 26 November 2023. The measures proposed in the consultation would be implemented via secondary legislation, and HM Treasury has also published a draft of the proposed legislation. It expects this legislation to be laid before Parliament in early 2024, coming into effect as soon as it is made.

The parallel PRA consultation closes on 27 November 2023, and the PRA expects the changes to its rules to apply in the first half of 2024, in line with when the proposed secondary legislation takes effect. HM Treasury notes that the PRA is also due to complete its five-year review of its ring-fencing rules by the end of 2023.

Aligning the Ring-Fencing and Resolution Regimes

The second HM Treasury paper, the response to its Call for Evidence on aligning the ring-fencing and resolution regimes, addresses another recommendation of the independent review, but one that is longer term. The review found that the benefits of the ring-fencing regime would likely reduce over time as the resolution regime for banks is embedded. It also concluded that the resolution regime offers a more comprehensive solution to addressing the problems of “too big to fail”, and recommended that the government consider the practicalities of aligning the ring-fencing and banking resolution regimes.

The Call for Evidence ran earlier this year and sought views on the ongoing benefits that ring-fencing provides to financial stability not found elsewhere in the regulatory framework, and on the possible steps to better align the ring-fencing and resolution regimes. It also asked about different options for the long-term future of ring-fencing, including: retaining the regime with no further changes, disapplying the regime, and reforming the regime further.

HM Treasury reports that it received 14 responses with a wide range of views. While the responses were mixed, there seems to have been consensus that the suggestion of disapplying ring-fencing when banks are deemed resolvable is likely to be difficult to operationalise.

Given the mixed nature of the feedback, the government is giving some further consideration to what the next steps should be, including reflecting on lessons from the banking sector turbulence earlier this year. HM Treasury plans to set out its policy response and any proposals for reform in the first half of 2024. For now, the long-term future of the ring-fencing regime remains unclear.