27 April 2015

Financial Times: The outdated ring fence that will starve City of London finance

At the heart of the ICB’s proposals was a plan to make sure that in future, catastrophic loses in the investment banking division of an institution such as Barclays or HSBC would not threaten the viability of its high street banking operations. The solution was a “ring fence” surrounding the retail bank, which would need to have enough resources to weather a crisis without falling back on its parent. The ringfenced bank would be held to more stringent safety standards than the rest of the group, with bigger capital buffers, a greater ability to absorb losses, and stronger corporate governance. Additionally, the entire group would be required to make plans for an orderly resolution in the event that it failed.

Creating a safe zone for a systemically important core of the financial system might have made sense if the territory beyond was forever to be a wild outback. But many of the risks identified have now been tamed by subsequent regulation. The ramparts that regulators are building around retail banks already look as quaint as the surviving fragments of London Wall. Consider, for example, the capital ratio that banks are required to maintain. This is a risk- adjusted measure of the proportion of a bank’s assets that can be written off without doing mortal damage. Back in 2011 the ICB argued that ringfenced banks needed a capital ratio of 10 per cent, significantly higher than the 7 per cent that most institutions then targeted. Since then, however, new regulatory demands mean that today, all UK banks run comfortably above 10 per cent.

The same goes for the leverage ratio (a similar measure that, unlike the capital ratio, makes no adjustment for risk). The ICB said in 2011 that ringfenced banks should target a ratio of 4 per cent, rather than the 3 per cent required by international regulations. Recent Bank of England rules have raised the bar, to nearer 5 per cent for the UK’s largest banks.

Other measures that the ICB argued would make retail institutions safer have likewise been surpassed, on both sides of the planned ring fence. The EU’s Bank Recovery and Resolution Directive requires all banks to have a credible resolution plan to carry on providing services in the event that failure goes further than the ICB’s proposals. The Prudential Regulation Authority, the UK watchdog, is introducing an accountability regime for all senior bank executives that is similarly more onerous than the one the ICB envisaged.

Even before it has been put in place, the ring fence is a redundant relic. Yet it could cost the banks £4.4bn a year to maintain, according to Treasury estimates. Douglas Flint, chairman of HSBC, last week cited the measure as one reason why the bank is considering moving its headquarters from London to Hong Kong.

Moreover, the practical value of separating “safe” retail banking from dangerous “casino” banking was always questionable. Northern Rock and Bradford & Bingley were among the first institutions to fall in 2008, yet neither of them had an investment bank. RBS and HBOS did between them suffer £21bn of trading losses, but it was the £70bn they lost from traditional bank loans that sealed their fate, mainly in real estate lending, which will remain inside the ring fenced bank.

This and other damaging policies, such as the now-permanent bank levy, may, in the end, drive banks out of certain business lines or even out of the country. That would reduce customer choice, competition, employment and tax revenues. It would squander the competitive advantage in banking that the UK has long enjoyed.

No other major country has followed Britain’s decision to build a ring fence. Unlike the longbow law, this is not a harmless quirk. The ICB’s proposals have been superseded. Persisting with them will do real damage. The government should reverse course.

© Financial Times