Shifting the ring-fence: a move for the wider good?

United Kingdom

In March 2023, the Independent Panel on Ring-fencing and Proprietary Trading (the “Panel”) concluded that the British banking sector needs a regulatory regime which is as dynamic as the sector it governs and flexible enough to adapt to changing economic threats. On 29 September, the UK Government published its response to the Panel’s report, setting out the Government’s proposal to change the ring-fencing regime. 

These proposals would change the “height” of the ring-fence, the scope of the perimeter which sits within it, and the methods by which a large complex banking group undertakes M&A. However, the proposals are not a fundamental change in the approach to the rules, nor to the majority of the content within them. It is worth noting though, that the Government has indicated in a separate response (to the call for evidence on the alignment between ring-fencing and resolution) that it intends to consult on the benefits of ring-fencing further, with additional proposals expected in 2024. 

So where does that leave us? The proposals are a welcome shift towards flexibility, with a clear eye from the Government to increasing competition in the banking sector, together with a recognition that there is no “one size fits all” approach to bank regulation. The key criticisms raised with the Panel have largely been addressed by proposed clarificatory amendments to the detailed definitions (which we do not discuss in detail here).

In terms of the key proposed changes:

Raising the ring-fence – and cutting a few holes?

The first section of the proposed changes addresses an increase in the deposit threshold from £25 billion to £35 billion. The Government is clear that it does not expect this change to remove any firms who are currently in scope of the regime, but it does expect it to remove a barrier to growth for those challenger banks who are getting closer to the threshold and who are concerned about the compliance burden the ring-fence brings.

However, there is a material change to what sits within that threshold. As a result of the perimeter changes (see below), this threshold now includes core deposits held in any branches of a ring-fenced body (“RFB”). That is, any branch, wherever it is located, including outside the UK and European Economic Area (“EEA”). For those banking groups with substantial overseas operations, that may move the needle materially on their overall amount of core deposits.

One of the main criticisms of the regime over the last four years since implementation has been the “zero tolerance” approach to excluded activities (i.e. those activities which cannot sit within the ring-fence). The Government is proposing a “secondary threshold” for banks which are not global systemically-important banks which permits an exemption where there are low levels of excluded activities.

The calculation test for what constitutes “low levels” uses financial assets held for trading (excluding any used for own hedging purposes) as a substitute for measuring investment banking operations as a percentage of Tier 1 Capital. In order to qualify, the ratio must be less than 10% with the tests conducted at the highest UK consolidation level. The proposal is to use the definitions of “financial assets”, “held for trading” and “hedging assets” in the relevant accounting standards. This is as opposed to, for example, using the “trading book” definition in the UK Capital Requirements Regulation (“UK CRR”). Firms will want to feed back to the Government if they do not believe this is in fact a “more practical” or appropriate approach to measuring investment banking activities. As with the overall deposit threshold, this also includes overseas operations.

The final perimeter change will be a relief to any bank which has recorded a technical breach of the regime as a result of an inadvertent relevant financial institution (“RFI”) exposure – the Government is proposing to allow an exposure up to £100,000 to a single RFI at any one time to cover those small breaches. In addition, the introduction of a twelve month “grace period” on reclassification of customers who are no longer RFIs removes an additional reporting burden on in-scope banks.

Changing the perimeter

The most significant proposed perimeter change is that RFBs will be permitted to establish operations outside the UK or the EEA, with the caveat that this is subject to the Prudential Regulation Authority’s (“PRA”) rules and requirements. This is strongly welcomed by the wider banking sector and permits RFBs to support clients in non-EEA jurisdictions.

The PRA has published a parallel Consultation Paper (CP 20/23), which sets out the detail of how this will work. Broadly, such operations will be permitted provided any third-country branch or third-country subsidiary does not present a material risk to the provision of core services in the UK by the RFB. The CP includes a “non-exhaustive” list of expectations from the PRA, including that certain disclosures are made in the Internal Capital Adequacy Assessment Process document when non-UK branches or subsidiaries contribute over five per cent of the RFB sub-group’s risk-weighted assets and a focus on equivalent levels of supervision in relevant third countries.

There are further changes to the products and services permitted within the ring-fence in the proposals. In particular, the definition of trade finance activities has been expanded, the debt for equity swap exemption has been broadened, and inflation swap derivatives, hedge mortality risk (i.e. lifetime mortgages and equity release products) and certain FX collars will be permitted within the ring-fence.

Making M&A more attractive

The proposed changes also introduce flexibility in a distressed M&A scenario. Where an RFB acquires shares in a bank which is not subject to ring-fencing, it now has a four-year transition period to comply with the ring-fencing regime. However, it is worth noting that the PRA can still impose restrictions on these types of M&A transactions (including whether the purchaser is an RFB or NRFB).

In a further welcome change for the broader financial services M&A market, the Government has proposed a number of changes permitting equity investments into UK small and medium enterprises (“SMEs”). RFBs will be permitted to make these investments (subject to a cap of 10% of their Tier 1 capital, consolidated at the highest group level).

Helpfully, the proposals explicitly state that if the SME increases in size during the life of the investment, the RFB is permitted to maintain its stake. The test is whether the target met the SME definition at the point of investments.

RFBs will also be permitted to include exposures to RFIs who meet the definition of SME in UK CRR. The purpose of these particular amendments (to unlock financing for SMEs) is clearly driving greater flexibility which, again, will be welcomed by the wider banking sector.

If you would like to discuss any of the above, please contact Emma Clark, Chris Glennie, Tom Callaby or your regular CMS contact.