New recommendations by the UK's Independent Commission on Banking (ICB) – in which retail savings in systemically important banks that have wholesale and investment banking operations must be ring-fenced – will have a fundamental impact on the structure of the UK's retail and small and medium-sized enterprise banking, as well as UK universal banks’ role in global investment banking markets. Considering chancellor of the exchequer George Osborne's endorsement of the report, the industry's strong working assumption is that the UK government will implement the ICB's recommendations in full, unless thwarted by the EU’s forthcoming Capital Requirements Regulation.
Given the extended implementation timetable for the ICB’s recommendations, the absence of certainty ahead of the UK government’s response to the report and the need for much greater detail and clarity around the design of the ring-fence, it can reasonably be argued that it is very difficult and potentially premature for the banks affected to begin to make decisions. Decisions taken now might need to be unwound and this could prove a costly exercise.
In particular, a significant residual uncertainty is whether, and if so what, bail-in powers are eventually introduced and whether the UK goes it alone or as part of an EU or global initiative. Bail-in will be relevant to the question of how much capital banks hold (ie. how much of an equity capital buffer will senior creditors expect to see in order to satisfy themselves that the prospect of being bailed in is close to zero?). In addition, bail-in will be important in determining both the nature (secured versus unsecured) and cost of funding.
It can reasonably be argued that it is very difficult and potentially premature for the banks affected to begin to make decisions. Decisions taken now might need to be unwound and this could prove a costly exercise
Action now
However, these uncertainties should not be a reason for delaying high-level planning and strategic thinking, some of which has clearly already been done by the banks in formulating their responses to the ICB’s interim report. Why?
- The ICB's recommendations will have a material impact on some banks' strategies. Some significant detail is already available. Working through the report, identifying at an early stage the most plausible scenarios and outcomes, narrowing down the options and beginning to size these impacts are imperatives. While this analysis might be viewed as insufficient as a basis for finally taking major strategic decisions, it will be crucial in understanding the potential impact of the ICB, for example, in developing contingency options and plans.
- The ICB’s recommendations come towards the end of the post-crisis re-regulation programme, which has already altered the economics of many lines of banking and capital markets business. Banks have been working through these effects, and it may be that for some the general thrust of the ICB’s recommendations, even absent the detail, is sufficient to crystallise some strategic decisions. In this sense, the ICB’s report may well be the straw that breaks some camels’ backs.
- Although the implementation timetable stretches out to 2019, the ICB urged the UK government and the country's banks to complete the ring-fence sooner. If some form of ring-fencing is taken as a fait accompli, it is clearly possible (and arguably desirable) to construct and position the ring-fence as a vehicle/legal entity/operation well ahead of knowing precisely which of the permitted activities will be placed in it.
- To the extent that the ICB causes banks to rethink strategic plans, there may be commercial advantage to being an early mover.
In conclusion, although there is significant residual uncertainty, this should not crowd out early scenario analysis and contingency planning. There is plenty to be getting on with.
Competition and ‘the British dilemma’
The ICB’s recommendations are a specific response to what the UK chancellor has described as 'the British dilemma': the desirability of maintaining the country's financial services industry and the jobs and revenue it generates without allowing the sector to threaten the whole economy. Although there is no shortage of global, regional and national initiatives to deal with the 'too big to fail problem', the UK is going much further in terms of advocating structural solutions (ring-fencing).
If other countries do pursue a different path, bankers argue this may well put UK banks at a serious competitive disadvantage relative to their peers
This raises the question of whether other countries may follow suit. At this stage, this seems unlikely but not impossible – even in countries with strong universal banking traditions (such as Germany) there have been some public expressions of interest in ring-fencing. (EU commissioner Michel Barnier called for a detailed study of the separation of investment and retail banking but commentators have indicated he would continue to support universal banking.)
If other countries do pursue a different path, bankers argue this may well put UK banks at a serious competitive disadvantage relative to their peers. UK institutions’ investment banking activities are likely to have to carry more capital relative to their non-ring-fenced peers to support a given rating. Moreover, there is an as yet unanswered question about how overseas supervisors react to a UK policy framework that is explicitly intended to allow entities outside the ring-fence to fail.
Resolvability – core but unresolved
The UK has been at the forefront of the development of recovery and resolution plans (RRPs) and, unsurprisingly, 'resolvability' is at the core of the ICB’s recommendations: credible RRPs are required for both the ring-fenced entities and the rest of the bank. Moreover, if large UK banks are not readily resolvable, they may incur a capital 'add-on' of up to 3% – a strong incentive for effective resolution planning. But the ICB’s recommendations do not necessarily make the overall resolution task easier and can result in further complications:
- While a ring-fenced business, with associated operational changes, may be more easily resolved, the recommendations do nothing to reduce the complexity of resolution planning for the rest of the business. Internal changes can facilitate resolvability, but another key factor will be the strengthening of the framework for cross-border resolutions, in particular for investment banking operations.
- Will the FSA expect impediments to resolution to be removed before the ring-fencing decisions have been clarified? Without such clarity, it is unlikely that firms will want to undertake structural changes related to resolution.
David Strachan is co-head of Deloitte's Centre for Regulatory Strategy.
