Ring-fencing is a new regulation that requires the largest UK banks to separate their core retail banking services from their investment banking and international banking activities. The new structure must be live by January 1, 2019 and affects any UK bank with more than £25bn of retail deposits, which includes all the major high street banks.
This initiative is part of the UK government’s response to the global financial crisis and is a key element of their package of Bank Structural Reform. The goal of regulators is to protect UK retail banking from shocks originating in other parts of the banking landscape. During the 2007-2008 global financial crisis it was in investment banking where the problems arose, but being part of a universal banking structure, the retail banking divisions of many banks also became infected. A key aim of Ring-fencing is therefore to protect retail banking functions used by UK customers by separating them from other activities conducted outside the ring-fence.
Ring-fencing forms part of the regulators’ on-going work to solve the problem of banks being considered “too big to fail”. After the government-led bail-outs of several banks during the financial crisis, Ring-fencing aims to make banks safer and reduce the impact on the tax payer and the economy if a large investment bank were to fail in the future.
While the objective of this initiative — to achieve greater resilience and financial stability for the banking system – is greatly needed, the program is driving major restructuring at all the large UK banks, costing billions of pounds and creating a temporary increase in operational risk and potential for fraud. The changes this shift will require, impacting many customers whether they are businesses, consumers or indeed other banks, are numerous and complex to say the least.
To implement Ring-fencing, banks need to significantly restructure their activities and adopt new legal structures and ways of operating. Compliance with Ring-fencing raises numerous complexities covering the legal, operational and management aspects of running a bank. Any bank affected that undertakes investment banking or international banking must place them in a separate legal entity outside the Ring-fence. Any financial, management or operational relationship between these two entities must not pose a threat to the ring-fenced bank’s ability to provide core retail services. Ring-fencing does not prevent ring-fenced banks being owned by a parent company which also owns a separate bank which provides excluded activities, such as investment banking.
A ring-fenced bank also must not be financially dependent on other group members. It must have a governance and management structure that is able to make its own decisions in the interests of the ring-fenced bank, independently of the rest of the group. This reduces the risk of contagion from the rest of the group. The ring-fenced must be sufficiently capitalised and have enough liquidity to withstand shocks, without relying on other parts of the group for financial support. Essentially, the regulation requires Ring-fenced banks to ensure that they are able to carry on their business if other group members fail.
Additionally, the Ring-fencing program involves a major re-branding by UK banks to make it clear to customers which part of the bank they are dealing with. For example, HSBC has announced that HSBC UK, with a new head office in Birmingham, will be its ring-fenced bank, as opposed to its non-ring-fenced bank HSBC Bank PLC. RBS has even resurrected the branding of NatWest Markets for its non-ring-fenced bank.
Impact on Payments and Banks Accounts
Ring-fenced banks are required to be direct participants in the main payment systems they use. This ensures they are not dependent on other entities to continue providing core payments services. Some banking groups may seek direct membership to the primary UK payments schemes (including the Clearing House Automated Payment System) for both their ring-fenced banks and non-ring-fenced banks. Similarly, ring-fenced banks and non-ring-fenced banks of the same may require their own separate Nostro accounts with correspondent banks around the world, making clear visibility, up-to-date reporting of cash in multiple bank accounts and efficient intra-day liquidity management more important than ever.
Changes for customers include a possible need to change their sort code, as each bank will have to decide whether the sort code of a branch currently serving corporates and personal customers will follow the customers being moved to a new legal entity or stay with the customers that remain. These new sort codes will also mean affected customers’ International Bank Account Number (IBAN) will change.
The Bank of England has estimated that over one million customers could be required to change their sort code. Barclays is one of the UK banks most affected by Ring-fencing due the large size of its investment bank, which will require significant restructuring. The bank has had to warn its customers they will experience blackouts for online, phone and mobile banking services during several weekends over the coming months in order to complete the changes that are needed, including moving hundreds of thousands of customers to new sort codes. HSBC and RBS / NatWest Markets are also moving some customers to new sort codes. Meanwhile, Lloyds and Santander have been reassuring customers that there should be no sort code changes.
Banks are working hard to minimise the impact for those that do require a new sort code. Existing systems such as the Current Account Switch Service (CASS) will ensure that payments referencing an old sort code are redirected. However, banks are advising customers who are required to change sort codes to share their new details with any party due to pay them or collect direct debits from them, for example their own clients, employers or utilities.
Outlook for Treasurers
The major changes that banks are required to introduce will have an impact on customers. Some businesses, especially those with sophisticated needs, may find themselves dealing with both sides of ring-fenced banks. It is important for treasurers to be aware that the Ring-fencing rules are not totally rigid, since they do offer some degree of choice to each bank. Ironically, this flexibility probably increases complexity for corporate treasurers who are generally multi-banked, because each bank will adopt a slightly different structure.
For example, the Ring-fencing rules do not specify whether certain important banking services should be inside or outside the ring-fence. This includes trade finance, mortgage lending, simple derivatives and deposit-taking from large corporates. Treasurers therefore need to ask their UK banks detailed questions about their ring-fencing plans: What activities will be inside the ring-fenced bank and what activities will fall outside? Is there any impact on legal documentation? A treasurer is likely to get a different response from each bank.
Some banks will move their full corporate proposition into non-ring-fenced banks, while creating ring-fenced banks that are focused on providing retail services to individuals and small businesses. On the other hand, other groups are creating much broader ring-fenced banks which include a larger set of permitted activities. In this case, only activities prohibited inside the ring fence will need to be moved out. For example Lloyds, likely to create one of the largest ring-fenced banks in the market, will serve the vast majority of its corporate and commercial customers from inside the ring-fenced bank. They will offer transaction banking products, including payments & cash management, from inside the ring fence. They will only deliver products no longer permitted in the ring fence from its non-ring-fenced bank. These products include debt issuance, complex derivatives, and loans to large banks known as Relevant Financial Institutions. Lloyds will keep its membership of UK payment schemes within the ring-fenced bank and will continue to offer agency bank services to correspondent banks.
In contrast, Barclays’ ring-fenced bank, known as Barclays UK, will be a personal and business banking franchise. It will offer day-to-day products and services to individuals and businesses (with a turnover less than £6.5m) in the UK. Barclays International will house the corporate and investment bank as well as the group’s international cards and payments businesses. Barclays UK will have a new SWIFT Bank Identifier Code (BIC), so customers transferring to Barclays’ ring-fenced bank will need a new IBAN, since the IBAN contains a BIC.
Heightened Risk of Fraud
During this period of change, businesses and personal customers need to be extra vigilant against the risk of fraud. At a time when some banks are contacting customers about sort code changes, there is an increased risk that fraudsters could pretend to be the bank and persuade a customer to reveal e-banking credentials or, worse, fool someone into making a payment to a fraudulent bank account. So under the cover of work supposedly relating to Ring-fencing, a fraudster could perpetrate a scam to steal money.
The Ring-fencing initiative is also a timely reminder of the importance of having clear visibility into up-to-date balances and transactions on all accounts. Businesses and banks need to be able to monitor their employees’ activity relating to bank accounts and to check all transactions for any abnormal or suspicious activity; for example, transactions with an abnormally high value or new activity on an account that has been dormant. It is also important to monitor employees looking at accounts that they would not need to visit within the course of their normal duties. Such abnormal behaviour might be an early warning of intended fraud. This increased risk makes it more important than ever before for organizations to make smart use of cyber fraud and risk management tools.
As with any big infrastructure project, there is some potential for disruption to everyday activities as new group structures are established and new ways of operating are introduced, so treasurers need to be prepared for the worst by ensuring contingency plans are in place in the event of a bank’s systems malfunctioning. The challenges faced by treasurers regarding Ring-fencing are exacerbated by the sheer weight of other major changes going on in the banking and payments industry, such as Brexit, MIFID2, Open Banking, PSD2 and the New Payment Architecture. Furthermore, after ring-fencing is embedded, UK banks will be safer but there is a risk that they will become less competitive, given the extra costs of their new ring-fenced structures. It is too soon to tell, but treasurers will need to watch this carefully.
Marcus Hughes, Director of Business Development for Bottomline Technologies, is a senior transaction banker with a successful history of product innovation, thought leadership and business development in a major European bank, a UK clearing bank and prominent technology firms.