Some UK bankers are warning that ring-fencing deposits in the largest banks will drive up capital and funding costs. However, there are those, including some major investors, who claim that the opposite may turn out to be true.

The most profound structural reform element proposed by the UK’s Independent Commission on Banking (ICB) was the concept of ring-fencing retail savings in systemically important banks (SIBs) that have wholesale and investment banking operations. If the riskier operations of the group result in losses that threaten the bank’s capital base, retail savers can be protected in a separate entity. Its survival might still need a taxpayer bail-out, but only to support the retail bank, rather than mopping up losses from activities such as securities trading.

According to the ICB’s final report in September 2011, “the UK retail subsidiaries would be legally, economically and operationally separate from the rest of the banking groups to which they belonged. They would have distinct governance arrangements, and should have different cultures".

The ICB also proposed increased capital adequacy ratios for SIBs, to between 17% and 20% subject to regulatory discretion. Both the holding company and the ring-fenced entity would have to meet these requirements on a standalone basis.

Inside the fence

The activities that must be inside the ring-fence are straightforward – “the taking of deposits from, and provision of overdrafts to, ordinary individuals and small and medium-sized enterprises [SMEs]". The definition of what must be excluded from the ring-fence already becomes more complicated, including anything not essential to providing payments services and economic intermediation in the European Economic Area (EEA), any services outside the EEA, and anything that increases the bank’s exposure to financial markets or complicates its resolution in distress.

And in-between, there is also a broad category of assets that can be included in the ring-fence, but at the bank’s choice – including the mortgage business. This leaves room for a wide variety of strategies, says Alistair Asher, head of law firm Allen & Overy’s financial institutions group, who has worked with many of the major UK banks.

“All four of the main UK high street banks appear to be taking a different approach, because they have different make-ups to their balance sheets. Those with a large mortgage book are asking if it has to fit in the same place as current accounts and savings. From a funding perspective it may be simpler not to do that, because some of the securitisation or hedging activities related to funding the mortgage book might have to be outside the ring-fence,” says Mr Asher.

Alistair Asher, head, Allen & Overy

Alistair Asher, head, Allen & Overy

Unclear implementation

Another early hurdle for banks will be how to handle existing bonds that mature after 2019, the date on which the ICB recommendations are meant to come into effect. First, legislation is needed to implement the report, possibly in the financial services bill planned for 2012, but certainly not later than 2013.

Mr Asher says banks would benefit if the government adopted a statutory scheme, similar to that used in the deregulation of the utilities sector. This would give banks a single legal statute to separate assets and liabilities either side of the ring-fence without needing third-party consent. At present, Part 7 of the Financial Services and Markets Act 2000 (Fisma) covers the control of business transfers. But that was intended to apply to retail savings, not to bond markets.

“The alternative is to do everything contractually, asset by asset, but that is a huge job. If you use Part 7 of Fisma, there are many loose ends, for instance, securities issued under foreign law that does not recognise UK law,” says Mr Asher.

Banks may be able to redeem and refinance some outstanding senior unsecured debt before 2019, making the new issuance out of a specific entity from either side of the ring-fence once the legal structure is in place. And the quantum of bank debt maturing beyond 2019 is quite limited, says Shyam Parekh, head of European financial institutions group (FIG) capital markets at Morgan Stanley. Most of it is subordinated debt, which is already trading at low valuations in many cases. This means the price might not be heavily affected even if the bonds were moved to a lower-rated entity outside the ring-fence.

“It is potentially problematic trying to raise debt now until there is final clarity on what the rules are and banks are able to respond with how they will structure the group going forward. In particular, raising debt with a term that extends post-2019 may pose challenges because of these uncertainties,” says Mr Parekh.

Investor responses

Beyond 2019, the challenge for banks is to craft a strategy that can cope with the ring-fence and meet the higher capital adequacy requirements. Angela Knight, chief executive of the British Bankers’ Association (BBA) and de facto spokeswoman for the affected banks, has made clear the concerns of BBA members on its website.

“Some theoretical calculations show that, apparently, it will not cost the industry that much more to fund itself to these levels. Few believe these calculations will pass the test of practice. Run up all the associated price tags and the fixed cost of operating a bank will be much higher,” she writes.

The Vickers Report’s aim of increasing clarity over what banks can and cannot do with our money is a laudable one that we would fully support

Tamara Burnell

But as Ms Knight points out in the same post, much depends on the attitude of major investors to the ring-fencing concept. And their views appear relatively supportive. In fact, Tamara Burnell, head of financial institutions and sovereign research at M&G Investments, which has more than $320bn in funds under management, suggests that investors have moved ahead of new regulations.

“The Vickers Report’s aim of increasing clarity over what banks can and cannot do with our money is a laudable one that we would fully support. In the absence of clarity, we have seen investors voting with their feet, for instance, showing their reluctance to buy senior unsecured debt,” says Ms Burnell.

Mr Asher suggests that the high capitalisation and supervision of the ring-fenced entity may create a perception of enhanced safety for UK banks. That would make their funding conditions easier, not only in an international context, but also in terms of their domestic competition.

“SIBs will have a temporary lack of competitiveness while they raise capital or delever, but once they have done that they will be seen as so stable that they may attract all the business and borrow most cheaply in the market, which will put the competitive pressure the other way, on second-tier banks,” he says.

Smaller risk, smaller profit

Peter Stage, head of credit analysis at fund manager F&C, which has more than $160bn under management, agrees that second-tier banks are likely to face tougher times ahead. But he also notes that the utility banking model inside the ring-fence will not be capable of producing the (intermittently) spectacular return on equity generated in the past by SIBs with big investment banking operations.

“From the credit investor viewpoint, if banks end up being a bit less profitable than they were pre-2007, but also less risky, that is not a bad outcome. But for that to happen, equity investors will have to accept lower return on equity, and I’m not sure we are there yet, even though equity investors accept the need for banks to be able to fund themselves affordably,” says Mr Stage.

SIBs will have a temporary lack of competitiveness while they raise capital or delever, but once they have done that they will be seen as so stable that they may attract all the business

Alistair Asher

That will still leave the investment banking arms to craft a new strategy that does not depend on cross-funding from retail banks. Financing may come from hedge funds that are more willing to take on higher risks for a higher return.

“The investment banks outside the ring-fence will need to think even more about how they fund and size their balance sheets in the same way that a pure-play investment bank has to do today. The investment banking arms are already thinking about these operations, they will just have to develop their plans more fully,” says Mr Parekh.

Shift to secured funding

What is not in dispute is that bank financing is already shifting to a secured basis, and uncertainty over the implementation of the ICB report may contribute to that. Ms Burnell says, in the absence of transparency over the use of unsecured funding, investors are exhibiting their preference for covered bonds or secured repo transactions.

“With covered bonds, investors can control contractually what the money is used for, such as low loan-to-value mortgages; they will not place money on an unsecured basis in the money-market, only on a reverse repo basis where they can determine what collateral they will take against it. And they are not accepting corporate bonds as repo collateral, because as much as 50% of European corporate bond indices are composed of unsecured bank debt,” she says.

The ICB report may well accelerate that trend. In particular, to minimise losses for retail depositors or taxpayers, the report recommends that “some activities might be formed into a ‘bridge bank’ under new management, their shareholders and creditors having been wiped out in whole and/or part”. Explicit retail depositor preference pushes unsecured bondholders further down the repayment waterfall, and Mr Asher notes that this will make secured debt more attractive to investors.

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