What is ring-fencing?

Ring-fencing is a term used to describe the process whereby a portion of financial assets are separated from another area of the business. This is to reserve the money for a specific purpose, protect against losses, and also in some cases reduce taxes.

Ring-fencing is often used in reference to banking in the UK, whereby retail banking is separated from investment banking for the largest banks. This is to ensure that in times of a financial crisis, the risks taken in investment banking do not adversely affect depositors, nor require a bailout from the government.

When was ring-fencing introduced?

The 2007 financial crisis sent the world economy into a complete economic disaster; the main cause being irresponsible activity from some of the world’s largest banks.

Despite the destructive activity from these financial institutions, they were marked as ‘too big to fail’ and received huge bailouts from governments in order to stabilise the financial system and put the world back on the road to financial recovery.

However, in order to avoid repeating such a costly bailout, the UK government announced the introduction of ‘ring-fencing’, which would ensure that if another meltdown were to happen, banks would have enough money to balance their books and not fall into irresponsible practices again.

The Financial Services Banking Reform Act of 2013 stated that the largest banks in the UK were required to comply with this regulation within six years. As of 1st January 2019, the banks included were required to have their core retail banking separate from their investment banking, and enough capital put aside for core banking to ensure that they would be able to cope with another economic crisis.

The largest banks in the UK as of 1st January 2022 include:

These banks are referred to as ring-fenced bodies (RFBs).

How does ring-fencing work?

Ring-fencing in banking works by creating a clear separation between the bank’s core banking activities, such as deposits and withdrawals from depositors, and the bank’s non-core activities such as investment and proprietary trading.

Banks with more than £25bn in retail deposits in the UK are required to be ring-fenced.

In order to be ring-fenced, a bank must identify the core and non-core activities of its organisation and then look to implement a structural separation. This can often be done by creating separate legal entities within the bank to ensure that the activities are separate.

RFBs are required to allocate capital and risk management measures for each separate entity, therefore ensuring that core banking activities have maintained enough capital to cover potential losses. This is essentially the entire purpose of ring-fencing – to ensure that core banking functions can continue to operate independently in the case of economic turmoil.

Building on this security feature, banks are also required to demonstrate resolution regimes, which is essentially the outlining of the steps that would be taken in the event of financial distress or a failure of the bank. This minimises risk further as it enforces that a bank implements the correct ring-fencing measures.

Is ring-fencing good?

Ring-fencing is a measure that has been put in place to restrict banks, which carries advantages and disadvantages.

Advantages of ring-fencing

Ring-fencing has generally enhanced the stability of the financial system in the UK as it ensures that there is no contagion. Core banking is protected and the shocks of a financial crash will be contained. Depositors are also better protected and can put greater trust into the banking system.

Ring-fencing is a measure to avoid a government bailout being required again, so ring-fencing also protects against potential damage to the government and the economy of the country. Furthermore, the money from the bailout is often comprised of taxpayers’ money, so ring-fencing also protects against further taxation and contempt of the banking system.

The separation of core and non-core activities also encourages a more transparent financial system, as it allows regulators to more easily assess the health of a bank.

Disadvantages of ring-fencing

Banks will generally argue against ring-fencing – the main reason being that it will stunt their profits, and make their operations more complex and costly. Setting up separate entities for core and non-core banking means that administrative burdens are significantly increased.

Some economists argue that ring-fencing stifles innovation and that banks are not able to engage as they would like in potentially profitable investment banking activities.

Ring-fencing also could bring about further economic risk, even though it is designed for economic protection. Financial organisations will always look towards profits, so some have suggested that ring-fencing encourages banks to seek ways to exploit legal loopholes or find ways to bypass the requirements for ring-fencing. As ring-fencing is only a UK measure for large banks, they can easily move operations to jurisdictions with more favourable regulatory environments, potentially taking away from the UK’s reputation as an economic powerhouse.

Easing ring-fencing in the UK

As part of post-Brexit financial reforms, in November 2022, the UK announced it is planning on ‘easing’ ring-fencing measures. This will mean that certain lending organisations will be exempt from some of the rules put in place and be able to expand on their trading activities.

Due to some of the large UK banks having limited trading activity and what city minister Andrew Griffith referred to as “trapped capital”, the plans are to allow Santander UK, Virgin Money and TSB to hold less capital against potential losses and also not be required to hold separate boards for core and non-core banking.

Barclays, HSBC, NatWest Group and Lloyds Banking Group will see no changes to their ring-fencing restrictions, as their investment activity has been considered too significant.

There is plenty of support for the easing of ring-fencing from outside banking, and an acceptance that ring-fencing “will likely diminish with time”, as the Bank of England develops new methods to help banks in financial trouble.

The introduction of a CBDCs has also been proposed as a solution for this, as it will be able to cope with the speed of economic shocks that some banks have been subject to, such as Silicon Valley Bank.

However, there is also a concern that financial organisations are falling into the same old habits again, pushing the end of ring-fencing in order to resume riskier investments and make more profits. Ring-fencing is still enforced, but the next few years may be interesting in terms of UK banking.

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