February 2018

February 2018

Commentary

Ring Fencing

Ask a room of bankers what “ringfencing” means, and you are likely to get the same headline definition. Ask how it will impact you as a borrower and you are likely to get quite a range of different answers depending on which bank you talk to and how far down the implementation process that bank is.

Ring fencing is an innocuous term that understates the impact it is having on the UK’s financial sector and the potential ramifications on treasury arrangements that finance teams now need to consider.

What is it?

From the 1st January 2019 those banks that hold over £25bn in deposits must separate retail banking from investment banking. The thinking goes that in the event of another financial sector crisis, the investment banking operations (or “casinos” as they are sometimes more emotively and rather unfairly referred to) outside the ring fence can be allowed to fail, with shareholders and investors taking the pain, whilst those elements inside the ring fence, which will by definition be inherently less risky and more crucial to supporting the real economy through lending and deposit taking to households and businesses, should be self-supporting. In extremis, the Government would only need to step in to support those elements critical to the fabric of life in the UK and so avoid those embarrassing headlines that the Government has bailed-out ”fat cat” investment bankers and their bonuses.

Interestingly, given all the policy experimentation in recent years, the basic proposition has a long intellectual history. There has for many years been an academic line of thought that bank equity levels have fallen far too low compared to earlier times and that this has been for the benefit of shareholders and management but the detriment of everyone else. We should, the argument goes, be pursuing a philosophy of “narrow banking”, of utility banks that do – ideally – much less even than the forthcoming ring-fenced banks. The policy has certainly been influenced by this analysis and one thing to watch for in the next crisis will be whether protecting the ringfenced banks alone genuinely does achieve a firewall from wider financial contagion. Look forward to the debate between people arguing that the ringfence should have been tighter and those arguing that the whole exercise was a diversion from some other perceived underlying issue. But returning to the current plan …

The regulations are relatively clear around which facilities and services must be within the ring fence. These will largely comprise lending and deposits for retail clients, corporates and SMEs, as well as more vanilla hedging arrangements. What must sit outside is more open to interpretation and we have already begun to see some divergence of approach between different institutions, albeit that debt capital markets products services, some hedging (particularly non-vanilla instruments such as options or inflation linked hedging), and any borrowers deemed to be regulated financial institutions (a definition that is both open to interpretation and may well include some financing SPVs utilised in many corporate and project financing structures) should sit outside the ring fence. Hopefully the brackets and question marks in the preceding sentence make the point that it is not yet crystal clear.

This has implications for borrowers.

Where once a bank would have a single face to market the two sides of a ring-fenced bank may well now start to diverge. Likely areas of impact will be credit ratings and cost of capital, the cost and availability of certain facilities and products, and the relationship and approach to the market.

  • A bank’s current credit rating will be bifurcated to reflect the divergent risk profile with a likely higher rating for the ring-fenced bank and a lower quality rating for the non-ring-fenced part. Being clear on who your contractual counterparty is by product, will be important.
  • Whilst the level of capital a bank must apply to any facility or product is determined by the risk presented by the customer, the cost of that capital to the bank will now be higher for any product outside the ring fence, and arguably lower inside the ring fence. Will this be passed on to borrowers and counterparties? Probably over time it will, starting with those customers who ask the right questions.
  • Borrowers may now find they have a need to manage two relationships within one bank with different limits, behaviours and approaches to credit risk. In principle this is two separate relationships, but banks may take the view that what is good for one “half” of their business is good for the other – again, practice may vary.

If not already on the agenda we are recommending to clients that they should discuss ring fencing with funders in order to fully understand latest thinking and to consider potential ramifications post January 2019. There is already some evidence that banks are beginning proactively to seek changes to loan and hedging terms to ensure that facilities fall inside the ring fence, in some cases opting to restructure hedging arrangements at no cost to the borrower in order to avoid having to hold more expensive capital against the position. This is clearly presenting positive opportunities for borrowers, but each request should be considered carefully on its own merits. We are seeing a mix of transparent and attractive offers, transparent but unattractive offers, and less transparent ones!

It is possible that treasury management policies will also need to be reviewed with particular focus on ensuring that counterparty rules and limits are fit for purpose under the new regime. As a general rule of thumb, the larger and complex the treasury operation in question, the greater the likelihood of issues arising from ring fencing and those HAs with smaller and very vanilla loan and hedging portfolios should have little to concern them as these changes come into effect. To be clear, many smaller HAs will live entirely inside the ringfence.

Should you have any questions in relation to ring fencing and its impact, the housing team at Centrus would be happy to assist.

Financial Markets and Economics Overview

Lloyds Bank Business Barometer, covering 1,200 companies, showed that the year started with a sharp rise in economic optimism. Business prospects have softened from December’s high but overall business confidence, an average of business prospects and economic optimism, moved from 28% to 35%, the highest figure since April 2017. Additionally, GfK consumer confidence rose for the first time since October from -13 to -9.

UK Q4 GDP growth was 0.5%q/q, which exceed expectations. The services sector continued its dominance in contributions by expanding 0.6%q/q in Q4, whilst the manufacturing sector also rose by 1.3% as it benefited from a boost in exports on the back of strengthening global economy. Employment also regained momentum. The construction sector, however, provided some offset in the GDP growth by registering a decline of 1.0%q/q, its third consecutive quarterly decline.

Carillion, the UK outsourcing and construction group, entered into liquidation last month. It owes £1.3bn to banks and the knock on-impact to Carillion’s hundreds of sub-contractors and the wider industry has raised concerns. The Financial Conduct Authority is carrying out an investigation into the financial statements and market updates ahead of Carillion’s profit warning last July.

CPI inflation eased in December falling to 3.0% from 3.1% thanks to lower annual price increases in fares, games and toys. The fall in CPI indicates that the effect of the of a falling pound on CPI has now peaked, and given that Q4’s average inflation was in line the MPC’s forecasts, the pressure has subdued for the Bank of England to raise rates immediately. Mark Carney, Bank of England governor, urges to abandon RPI from for use in government contracts as “it has no merit”. On average, the upward bias on RPI is 0.7% a year but in December the gap grew even bigger, as RPI showed an annual inflation of 4.1%.

Guilt and swap rates increased slightly reflecting upbeat economic news for growth in relation to expectations, bringing forward expectations of rate rises.

On the Brexit front, EU rejected an ambitious trade deal for the UK financial services sector and suggests that future arrangement to financial services will be based on “equivalence”, which means same access rights given to third-country institutions. However, nobody can be sure yet on the final outcome. What is sure is that the negotiations will not be easy, and both the EU and the UK have lots to lose if a mutual agreement is not reached.

Interest Rates

Inflation

Capital Markets

Bank Credit