Ring-fencing: will borrowers pay the price of safer banking?
Ask a room of bankers what “ring-fencing” 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 more risky investment banking operations 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 perhaps more directly and immediately sensitive to the real economy through lending and deposit taking to households and businesses, should be self-supporting.
In extremis, the Government (and therefore taxpayers) would only need to step in to support those elements critical to supporting retail depositors and the flow of credit and services to businesses, although the importance of investment banking operations as part of the overall banking ecosystem should not be overlooked.
Interestingly, given all the policy experimentation in recent years, the basic proposition has a long history going back as far as the Glass-Steagall Act of 1933. 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 ring-fenced banks alone genuinely does achieve a firewall from wider financial contagion.
Look forward to the debate between people arguing that the ring-fence should have been tighter and those arguing that the whole exercise was an unnecessary diversion cooked up by regulators chasing yesterday’s risks. 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.
• Credit rating: A bank’s current credit rating will be bifurcated to reflect the divergent risk profile with a likely higher rating for the ringfenced 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.
• Cost of capital: 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.
• Separate relationships: 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 ringfencing and those corporates 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 corporates will live entirely inside the ringfence.
Centrus is an independent financial services group that believes in a better way of doing business. White Paper – Ring-fencing Page 3 of 4 We specialise in corporate finance, technology and investment management and are united by a culture that values imagination, energy and purpose which unlocks significant value for our clients. Centrus supports a range of clients in their funding and financial strategy needs across residential, infrastructure, transportation, energy and utilities, corporates and financial sectors. Above all we’re working towards a new financial landscape, which we define as modern finance because it funds and supports the things that deliver real benefits to people and society. Should you have any questions in relation to ring-fencing and its impact, the Centrus Corporate Finance team would be happy to assist.