Proposals for Ring-Fencing and Loss Absorbency - Essay Example

The UK coalition Government put out a white paper on September 2011 discussing its suggestions for pushing forward the implementation of the proposals of the Independent Commission on Banking (ICB), which was chaired by Sir John Vickers, who is a British economist plus the Warden at All Souls College, Oxford. The Independent Commission on Banking, otherwise known as the Commission, was set up in June 2010 by the Government to reflect on structural and non-structural reforms of the Britain’s banking sector so as to uphold financial stability and competition in the nation (ICB 2011, p. 19). The Commission was given up to the end of September, 2015, to report their findings to the Cabinet Committee on Banking Reform. The white paper discussed many elements such as ring-fencing, high net worth individuals, prohibited services, SMEs for the purposes of ring-fencing, financial product restrictions, geographical restrictions, exposure to financial institutions, intra-group relationships, ancillary activities, legal and operational links, governance, economic links, scope, PLAC, PLAC composition, leverage ratio, loss absorbency, ring-fence buffer, bail-in, the bail-in process and depositor preference (ICB 2011, p. 19). Keeping in line with two of the stated topics above, this paper will describe the proposals for (i) ring-fencing and (ii) loss absorbency put forward by the 2011 Report of the Independent Commission on Banking (“Vickers Report”). The paper will discuss whether these measures likely to succeed in ensuring financial stability and how are these proposals being enacted into UK law. Ring-Fencing Ring-fencing or ringfencing is a situation in which a fraction of a firm’s assets or profits are financially split without essentially being considered as a separate entity (Freixas & Mayer 2011, p. 397). This might be for: separating into different income streams for taxation, regulatory reasons, or developing asset protection schemes in reference to financing arrangements (Freixas & Mayer 2011, p. 397). Ring-fencing in asset protection is used by separating particular liabilities and assets into different organisations of a corporate group. At times, it is utilised to mitigate liquidation risk or to enhance corporate credit rating (Haldane & Alessandri 2009, p. 12). In the UK, ring fence profits stem from gains and income from oil rights oil or extraction activities in the UK plus its continental shelf, and experience a higher rate from corporation tax (ICB 2011, p. 35). In the case of bonds or loans, ringfencing ensures that an investor has a link to a particular asset they possess, for instance, a wind farm owned by a utility, but still enjoying the full credit endorsement of the utilitys balance sheet, as well (Haldane & Alessandri 2009, p. 12). The most common form of ringfencing is when a public utility (regulated) business financially segregates itself from its parent firm, which takes part in non-regulated activities (ICB 2011, p. 35). This form of ring-fencing protects consumers of the most basic services like water, power and basic telecommunications from bankruptcy or financial instability in the parent firm arises from losses in their open market events (ICB 2011, p. 36). From the Commission’s explanation, ring-fencing is meant to isolate banking activities where recurring provision of services is significant to the financial system, as well as a bank’s client, with an aim of ensuring that this provision is not threatened due to activities incidental to lit and the provisions can be maintained in case of bank failure devoid of government solvency support (ICB 2011, p. 36). The Commission believes that retail ring-fencing should be planned to meet the following goals at the lowest-possible cost or expense to the economy: ease the process of sorting out ring-fenced banks and non-ring-fenced banks that get themselves into trouble devoid of offering taxpayer-funded solvency support; insulate significant banking services wherein households and SMEs rely from issues elsewhere in the financial system; and limit guarantees from the government, which will reduce the risk to the public finances making it less likely for financial institutions to run excessive risks (ICB 2011, p. 36). This would ensure that ring-fenced banks are more straightforward compared to some existing banking structures, thus making it easier to manage, oversee or even regulate them. In addition, macro-prudential regulation could be more accurately aimed at on ring-fenced banks compared to the existing banking structures (Freixas & Mayer 2011, p. 401). The two areas to be considered when it comes to the design of retail ring-fence are (1) the activities that will be taking place in the ring-fenced banks, investment or wholesale banks and other financial institutions, and (2) the level of separation between these institutions, ring-fenced banks and investment or wholesale banks, which the Commission termed as the height of the fence (ICB 2011, p. 36). The fence’s location is specified in three principles which describe: ‘mandated services’ that should occur in ring-fenced banks; ‘prohibited services’ that should not occur in ring-fenced banks; and ‘ancillary activities’ that are activities additional to the provision of non-prohibited services (Freixas & Mayer 2011, p. 401). Loss Absorbency The 2008-2009 financial crises made it clear that banks in the United Kingdom and other regions of the world are severely under-capitalised. Small decreases in asset values threatened insolvency (Haldane & Alessandri 2009, p. 30). Fearful of the consequences of allowing systemically significant banks and other financial institutions to fail, governments of their respective nations were forced to bail them out (Haldane & Alessandri 2009, p. 30). The Commission claimed that share- and stakeholders in some of the largest banks suffered huge losses, which wiped them out after enjoying strong returns in the years leading to the crises (ICB 2011, p. 79). However, creditors were hardly affected and workers in investment and wholesale banking were still paid their high salaries during the period (Haldane & Alessandri 2009, p. 31). Aside from the direct capital injections, taxpayers took huge contingent liabilities, as well. The report by the Commission claims that it is not only bank insolvency that is the problem (ICB 2011, p. 79). According to the report, as the financial crisis loomed, banking and financial institutions had inadequately protected themselves against their own undertakings. Therefore, as the losses began to erode their protection buffers, banking and financial institutions that were not ready found themselves with fewer resources that could absorb the impending losses (Haldane & Alessandri 2009, p. 31). In an effort to ease risk, banking institutions decided to shrink their balance sheets by cutting losses. However, impact has been more costly to the economy compared to the amount spent bailing out these banks. Therefore, it is important to come up with reforms that ensure banks absorb losses, which is essentially the concept of Loss Absorbency. The Commission sets out its idea that banks are supposed to hold minimum or least levels of effective loss-absorbing capacity, abbreviated as PLAC, in order to make sure they are properly resilient to shocks, plus can be rectified without bringing in taxpayer money (ICB 2011, p. 80). This is why the Commission claimed that ring-fencing should be applied to hold PLAC at 17% of the risk weighted assets (RWAs) for big organisations. The Commission put across that PLAC works best when it comprises of Additional Tier 1 (AT1) and Tier 2 (T2) capital, equity, and long-term unsecured debt, which are subject to a constitutional bail-in power (ICB 2011, p. 80). It should be noted that the Commission does not clarify how the total PLAC of a bank is met or achieved provided that it meets the least or minimum capital requirements. The Commission of provides other clear means of loss absorbency such as bank funding, leverage, implicit government support, differential tax treatment of debt and equity and shareholder reluctant to issue more equity (ICB 2011, p. 80). A bank can fund itself through issuing shares or equity and incurring debt such as through taking customer deposits plus issuing bonds. These funds are used to issue out loans and invest in other businesses, which are essential a bank’s assets. It can make profit through earning a greater interest rate on its assets compared to how much it pays on the debts it has (ICB 2011, p. 80). Finally, leverage refers to the ratio of assets to equity of a bank. The value of any bank’s assets equals the value of their equity minus the value of all other liabilities (non-equity). This implies that the greater a bank’s leverage, the more susceptible the value of their equity is to falls or rises in the value of their assets. Whether the Measures will ensure Financial Stability In order to ensure financial stability in any economy, it is vital to ensure that the key services that banks offer to people are always available from provision of payments services to changing savings into loans and allowing people to manage risks (Edmonds 2013, p. 9). The proposals put forward by the Commission of reducing distortions in credit allocation, which materialise from any implicit subsidies of banks deemed “too huge to fall” (ICB 2011, p. 124). This ensures a certain economy is good for business ensuring financial stability. Edmonds (2013, p. 9) argues that ring-fencing inflicts discipline on both ring-fenced and non-ring-fenced segments of any banking group through brining to light that the debt of each will be loss-absorbing in case of failure. In order to ensure financial stability, it is significant to ensure that there is a stable supply of credit to businesses and households in the economy. The Commission claims that ring-fencing offers a significant level of insulation for the United Kingdom retail banking sector from external shocks plus losses, which would otherwise come after the shocks (ICB 2011, p. 129). Ring-fenced banking and financial institutions would offer a more stable and reliable supply of credit to businesses and households in the UK, because it will form a large pool of steady retail deposits (Edmonds 2013, p. 9). Nevertheless, if harsh conditions caused government to try to support the flow of bank credit to the financial system, but devoid of solvency support to individual banks, this could be carried out in a much more targeted and efficient way with ring-fencing than without (ICB 2011, p. 129). Also, to ensure financial stability, it is vital to maintain self-standing reserves of capital plus loss-absorbing debts, which can stand shocks that materialise domestically, in spite of macro-prudential laws or be globally transmitted. Also, you also need to enhance resolvability. The commission argues that ring-fencing demands the upholding of self-standing reserves of capital and loss-absorbing debt in order to manage shocks that might come up domestically despite macro-prudential laws (ICB 2011, p. 129). Edmonds (2013, p. 10) claims that those reserves might not be exhausted below safe levels in order to boost capital in investment or wholesale banking sector. By doing this and enhancing resolvability, a nation stands the chance to curtail implicit government assurances and block incentives for unplanned risk-taking. In addition, ring-fencing ensures this is done without undermining the competitiveness of the United Kingdom banks that take part in global investment and wholesale banking since it ensures enhancement of domestic stability plus the use of global standards in global markets (Edmonds 2013, p. 10). In case ring-fencing would be absent, we would expect a case of higher capital requirements, which would, on the other hand, undermine United Kingdom banks’ competitiveness. The only warning that the Commission gives in this area is that when governments naturally try to shun away from the costs of a financial crisis and mitigate the big impact recessions bring forth to public finances, they tend to intervene too strongly missing out on significant issues, which can lead to a further, direct threat to the public finances that is mainly acute in the UK provided that UK bank balance sheets are over four times greater compared to their annual GDP (ICB 2011, p. 129). How These Proposals Are Being Enacted Into UK Law The European Commission published on 20th July, 2001, a draft proposal referred to as the Capital Requirements Directive IV or CRD IV, which was intended to implement the Basel III regulations on capital and liquidity standards (ICB 2011, p. 149). Some of extra issues that the draft addressed include corporate governance, collaboration and information sharing amongst national administrators and reliance on credit ratings. It came into effect on 1st January, 2014, following lengthy negotiations and the approval of the European Union Council (Clark 2014, p. 1). The Commission’s proposals are extensive comprising of a regulation that sets one set of harmonised prudential rules that apply to all banks in the Europeans Union directly. The regulation will be deemed as maximum harmonised, meaning that it will be impossible for member nations to demand tougher requirements in restricted cases. The Commission’s structural reform measures would best be practiced through primary legislation offering authorities suitable power to execute ring-fencing of retail banks (ICB 2011, p. 150). The Commission believes that banks would receive circumstances differently when establishing ring-fencing. It grants banks the freedom of transferring either or both of its retail or non-retail business into the fresh legal entities. They did not prescribe the method through which ring-fenced banking or financial institutions can be created (Clark 2014, p. 1). Banks will be faced with many legal and practical issues that they need to address in order to separate their businesses; they comprise of: (1) ensuring they have third party consents before transferring contracts; (2) separating ring-fenced bank contracts from other group entities; (3) renegotiating contracts to exclude third parties from option against the ring-fenced bank for defaults by other group firms; (4) transferring deposits; (5) renegotiating harmful pledge clauses that block the bank from disposing of certain assets or dropping below specific size of business thresholds; (6) managing foreign liabilities and assets and obligations and rights that are subject to international law; and (7) transferring personnel and managing related pensions problems (ICB 2011, p. 150). The Commission took legal counsel on these above issues and others linking to implementation of the ring-fence (ICB 2011, p. 150). They stated that whereas the process involved lengthy legal plus administrative dealings, there were no insoluble problems. Part 7 of the 2000 Financial Services and Markets Act offers an existing method of transferring banking businesses (Clark 2014, p. 1). If need be, the commission states that this process can be improved by new legislation. If the ring-fence is put into practice, there will be a constant need of overseeing and evaluating whether the regulations plus design of the ring-fence needs transformation so as to guarantee that it is attaining its goals, including whether banking and financial institutions are keeping up to the spirit and to the letter of the rules, plus the upsurge of external risks (ICB 2011, p. 151). Putting into practice and monitoring the ring-fence calls for improved technical skills and more managerial resources for regulators. The loss-absorbency measures of the Commission would be executed through primary legislation offering authorities suitable powers to implement the recommendations (ICB 2011, p. 151). Conclusion This paper has discussed proposals for (i) ring-fencing and (ii) loss absorbency put forward by the 2011 Report of the Independent Commission on Banking (“Vickers Report”). The paper has also discussed whether these measures are likely to succeed in ensuring financial stability and finished with how the proposals are being enacted into UK law. This paper finds that, in order to ensure UK is financially stable, banks should implement the recommendations state in this paper, especially in fourth part of this paper. To prevent a nation from facing a financial crisis, it is vital to ensure that households and business are being supplied with funds whenever they need. References Clark, G 2014, Government publishes draft Banking Reform Bill, viewed 7th December, 2015, at https://www.gov.uk/government/news/government-publishes-draft-banking-reform-bill Edmonds, T 2013, The Independent Commission on Banking: The Vickers Report, viewed 7th December, 2015, at https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0ahUKEwjKueOwnenJAhVCfhoKHTfkC1YQFggjMAE&url=http%3A%2F%2Fwww.parliament.uk%2Fbriefing-papers%2FSN06171.pdf&usg=AFQjCNE9m1fsfLndnMJK4WB3FVYHF9gHCA&sig2=DO6LjXEmyjsoG7zHIGkB5Q Freixas, X & Mayer, C 2011, Banking, finance, and the role of the state, Oxford Review of Economic Policy vol. 27, no. 3, pp. 397-410. Haldane, A & Alessandri, P 2009, “Banking on the state,” Paper based on presentation at the Federal Reserve Bank of Chicago, 12th Annual International Banking Conference, Sept 2009. Independent Commission on Banking (ICB) 2011, Final report and recommendations of the Independent Commission on Banking, September 2011, viewed 7th December, 2015, at http://www.ecgi.org/documents/icb_final_report_12sep2011.pdf Read More