In the years following the 2008 financial crisis, regulation of the UK banking sector has substantially increased. One of the most prominent policies has been the mandated ring-fencing of banks, which since 2019, has placed 1.2 trillion GBP of core deposits in ring-fenced bodies (RBFs). RFBs disconnect retail banking operations from investment banking activities, thus protecting consumers from investment banks’ decisions that could negatively impact consumers’ access to retail banking products. Thus, retail and investment banks, whilst still owned by the same parent corporation, become legally separate entities. Nearly two years later, can begin to evaluate this policy.
The financial crisis of 2008, which lost 19.2 trillion USD in global household wealth, highlighted the need to separate core retail services from international investment banking divisions. The subprime mortgage loans which triggered the crisis were bought as collateralised debt by foreign banks, including those from the UK. Retail arms of British banks, and by extension the savings of the general public, were therefore exposed to these faulty loans. Ring-fencing aims to insulate the safe haven of retail bank deposits from the riskier financial derivatives and volatile international capital markets of investment banks. Summarised by the Bank of England in a 2016 paper, “the aim is to protect UK retail banking from shocks originating elsewhere in the (banking) group and in global financial markets”.
However, the process of ring-fencing creates unnecessary costs and complexities. Citigroup analysts estimated the industry-wide cost of ring-fencing to be 7 billion GBP. HSBC, in response to the legislation, added 1600 employees to their compliance team which now totals 6000 people, costing the company 2.5 billion GBP annually. Moreover, the cost of establishing the ring-fenced HSBC UK totalled 1.5 billion GBP, an eye-watering 8.7% of 2017 global pre-tax profits. UK banks and their shareholders, already suffering from low valuations, poor capital appreciation and involuntary suspension of dividends, will feel the impact of these additional costs far more acutely.
Since the legislation solely applies to banks with more than 25 billion GBP of retail deposits, the impact has been limited. Of the major banks, only Barclays and HSBC have investment banks large enough for the effect to be noticeable. The investment arms of Lloyds Bank and NatWest were significantly downsized during their decade of state ownership. NatWest trading liabilities have decreased from 423 billion GBP to 225 billion GBP since 2007. Therefore, once ring-fencing was implemented, there was little impact on these two banks because they only had to separate their retail banks from a small investment bank. HSBC is heavily reliant on its core Asian operations, which delivered 84% of total profits in 2019. Ring-fencing has only significantly affected Barclays, which had to split its retail activities from its large investment bank which contributes 50% of group revenue.
In fact, ring-fencing may actually increase the risk to individual banks. RFBs are poorly diversified as they are only exposed to retail banking markets, and thus losses in these areas mean that the entire bank will be unprofitable. The reduced diversification increases their individual risk.
In summary, the benefits of RFBs have not yet been realised. It is a long term policy with benefits only likely to occur in a financial crisis similar to that of 2008. Meanwhile the problems of ring-fencing are already apparent. Substantial costs have been incurred on the already struggling banking sector. Furthermore, its effect appears to be limited by the downsizing of investment banking arms in the UK and the loss of diversification may inversely increase the risk to retail deposits. In light of these arguments and the greater amount of financial regulation already in force, it is becoming more difficult to explain why ring-fencing was necessary.
By Jon Garner
Sector Head: Jackson Philips