UK Ringfencing- quite exceptional

HM Treasury has published The Financial Services and Markets Act 2000 (Excluded Activities and Prohibitions) Order 2014 and an accompanying explanatory memorandum. The Order was made on 23 July 2014. Articles 1, 2 and 3 and the Schedule to the Order come into force on 1 January 2015, the substantive provisions of the Order come into force on 1 January 2019. The order finalises the “holes” in the ring fence, defining the circumstances in which retail\SME deposit-taking institutions may be permitted to deal in investments as a principal[1]. The list of exception is extensive, though they are primarily variants on the management of a ring-fenced body’s (RFBs) own risks and assets and the provision of simple derivatives to clients. The Order also imposes prohibitions (themselves subject to exceptions) on activities within the ring fence. An exceptional summary follows:

The Order prohibits ring-fenced bodies[2] from dealing in investments as principal and dealing in commodities except in the following circumstances:

• Hedging against:
•                                changes in interest, FX or commodity rates
•                                changes in any index of retail, equity or property prices
•                                default risk
•                                liquidity risk
• Liquidity and Collateral management
• Dealing in its own shares or debentures
• Taking or granting a security interest over investments and\or entering into a title transfer collateral arrangement
• Dealing with its own securitisation vehicles
• Dealing with a central bank or its wholly owned subsidiary
• Dealing in simple derivatives subject to the following conditions:
•                               restricted to: IRS, FX swap, FX Forward, the sale to a customer of an IR Cap or Swaption, the purchase from a customer of an IR floor
•                               position risk arising from all derivatives (including hedging) is at all times less than 0.5% of the RFBs funds
•                               position risk arising from derivatives transactions with an individual customer is at all times less than 25% of the RFB’s  credit risk capital requirement
•                               position risk arising from swaptions\caps\floors is at all times less than 20% of the total position risk arising from derivatives. Eg. position risk must be at least 80% non-contingent swaps and/or forward FX
•                              derivatives have to be compliant with EMIR as to trading venue and with IFRS 13 as to fair-value measurement

The Order also subjects RFBs to prohibitions on accessing payment systems and having exposure to financial institutions; clearly, without a long list of exceptions, such prohibitions would make even the simplest banking structure untenable.

RFBs will be prohibited from using an inter-bank payment system unless:

• The RFB is a direct participant in the system
• The RFB is ineligible to become a direct participant, but has been authorised by the PRA to accesses the system via a group member which is itself a direct participant

RFBs are prohibited from incurring exposure to a financial exposure except for the following purposes:

• Hedging (as above),
• Holding shares\securities of an RFB subsidiary or conducting a commercial transaction at arm’s length if the financial institution is a member of the same group (albeit outside the ring fence)
• Payment
• Trade finance. Financing, guaranteeing or making a payment in connection with a transaction undertaken by a non-financial institution
• Securitisation and covered bonds
• Conduit lending. Exposure to a financial institution that is owned by and run for the RFB, whose business does not include lending to other financial institutions
• Repo transactions.
• Ancillary exposures:
•                    Payment services
•                    Operational services
•                    Investment banking services for transactions with non-financial institutions
•                    Exposure arising from distributions of permitted products\services by the RFB or financial institution
•                    Guarantees, warranties, indemnities, or covenants from a financial institution to the RFB as part of a permitted acquisition or disposal by the RFB
•                    Breach of duty from the financial institution to the RFB or the appointment of the RFB as executor to an estate
•                    Purchase of insurance by the RFB from a GSII

An RFB is also prohibited from having a branch in any non-EEA country and from having a participating interest in any undertaking outwith the EEA unless such undertaking is solely for the provision of permitted ancillary services.

As always, the devil is in the details, the details above are particularly demonic- the 25% of CRR derivatives exposure to a single customer is particularly anomalous. While other jurisdictions have chosen to fence in the wild creatures, the UK has decided on the safari park option- enclosing the retail banks for their own protection. While its efficacy will depend on the assiduity of its application, the necessarily long list of exceptions reads like a regulatory arbitrageur’s wishlist. Banking is a risk-based business and is inimical to being run as a utility. There is nothing in this Order to prevent an RFB from self-immolation by tried and tested methods, such as overexposure to the often hysterical UK property market. It may be argued that, multiple exceptions notwithstanding, such a severe limitation of possible activities serves to heighten rather than lessen the risk of regular retail bank runs.

[1] As described in article 14 of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001

[2] Or their subsidiaries, conduit vehicles or sponsored structured finance vehicles