Last week, Douglas Flint, the chairman of HSBC, told the House of Lords’ European economic and financial affairs sub-committee that the changes required by the new ring-fencing rules would be “very expensive”, and estimated that the cost to HSBC of implementing them would be between £1 billion and £2 billion.

Mr Flint’s comments follow the publication earlier this month of the Prudential Regulation Authority’s Consultation Paper on the implementation of ring-fencing (PRA CP 19/14) (the CP).

What are the latest ring-fencing proposals? The CP sets out the PRA’s proposed ring-fencing policy, including rules and supervisory statements, in three areas:

  • The legal structure of banking groups
  • Governance
  • Continuity of services and facilities

(i) Legal structure

Under the latest proposals, the PRA’s expectation is that a Ring-fenced bank (RFB) should not have an ownership interest in any entity which undertakes excluded or prohibited “investment banking” activities. Instead, RFBs and entities that can conduct excluded or prohibited activities are expected to be structured as separate clusters of subsidiaries beneath a UK holding company. This is known as a “sibling structure”. By creating legally and operationally separate units to house their retail and commercial banking businesses away from their investment banking divisions, the PRA expects that risks to an RFB’s provision of core services will be reduced by preventing losses related to “riskier” activities from being passed to an RFB from a subsidiary. The PRA also expects that the rules will prevent an RFB becoming financially dependent on the income or profits of such activities.

(ii) Governance

The Financial Services and Markets Act 2000, as amended by the Financial Services (Banking Reform) Act 2013, requires the PRA to make rules on board membership for group ring-fencing purposes. In the CP, the PRA proposes the following rules on the membership of the RFB’s board:

  • At least half of an RFB’s board, excluding the chair, must be independent non-executive directors (NEDs)
  • The chair of an RFB must be independent during his or her tenure as chair
  • The chair of an RFB must not hold another chair position in another group entity board
  • No more than one third of an RFB’s board members may be current employees or directors of another entity in the group
  • An RFB executive director on the board of an RFB must not hold other executive director positions on the board of another entity in the group that carries out excluded or prohibited activities
  • An RFB must have its own risk, nomination, audit and remuneration non-executive board committees

(iii) Continuity of services and facilities

Although the CP states that the existing regulatory framework fulfils, to a certain extent, the PRA’s objective of ensuring that RFBs have appropriate arrangements in place in this area, the PRA proposes imposing additional restrictions in relation to:

  • Any intragroup service arrangements an RFB may have
  • Service arrangements an RFB may have with non-group entities where those arrangements may be affected by the financial position of a group entity

The PRA states that these proposals should be read in conjunction with the PRA Discussion Paper DP1/14 (DP) which sets out the PRA’s current proposals for the principles that all deposit-takers (excluding credit unions) and PRA-designated investment firms should follow to demonstrate operational continuity in resolution and facilitate recovery and post-resolution restructuring.

Consultation on other areas of the ring-fencing rules will follow in 2015. The current proposals are due to come into effect from 1 January 2019.

What is the likely impact of these rules for banks? The legal and compliance costs for implementing the new ring fence are likely to be very high, as the rules are likely to require new legal, operational and compliance structures to be put in place.

However, the ring-fencing rules will impact banks in the UK differently. UK banks with smaller investment banking divisions may find that the costs of complying with the rules eat into profit margins enough to outweigh the benefits of operating a separate investment bank, which may result in them selling their investment banking divisions if they can’t get a relaxation in the rules. Those UK banks with larger investment banking divisions are likely to swallow the compliance costs and keep their investment banking units, although they will not do so quietly.

A link to the CP is available here:

http://www.bankofengland.co.uk/pra/Pages/publications/cp/2014/cp1914.aspx

A link to the DP is available here:

http://www.bankofengland.co.uk/pra/Pages/publications/cp/2014/dp114.aspx

Client Alert 2014-287