Ring-Fencing: Functions and Conceptual Foundations

“Ring-fencing” is often touted as a potential regulatory solution to problems in banking, finance, public utilities, and insurance. However, both the precise meaning of ring-fencing, as well as the nature of the problems that ring-fencing regulation purports to solve, are ill defined.  My new article, recently posted here on SSRN, examines the functions and conceptual foundations of ring-fencing.

The recent report by the U.K. Independent Commission on Banking (known as the “Vickers Report”) proposes ring-fencing banks by legally separating certain of their risky assets from their retail banking operations.[1]  Federal regulators in the United States are considering requiring the ring-fencing of systemically important financial institutions, including banks, to reduce systemic risk. They also are attempting to implement the so-called “Volcker Rule,” a form of ring-fencing. Congress has been considering enacting a ring-fencing scheme proposed in federal “covered bond” legislation, which would parallel European ring-fencing of certain secured transactions. State regulators often require the ring-fencing of utility companies by legally separating their risky assets and operations from the public-utility function.[2]  And the leading insurance standard-setting and regulatory support organization in the U.S. is proposing the increased ring-fencing of insurance companies.

Because it is proposed in different contexts as a solution to ostensibly different problems, ring-fencing is inconsistently defined; and even within a given context, it is often ill-defined. In a working paper, I examine ring-fencing, first attempting to define it by analyzing its functions. Ring-fencing can best be understood as legally deconstructing a firm in order to more optimally reallocate and reduce risk. The deconstruction can occur in various ways. For example, the firm could be made more internally viable, such as by separating risky assets from the firm, preventing the firm from engaging in risky activities or investing in risky assets, and ensuring that the firm is able to operate on a standalone basis even if its affiliates fail. The firm could also be protected from external risks, such as third-party claims, involuntary bankruptcy, and affiliate abuse.

Ring-fencing’s reallocation of risk raises important normative questions about when, and how, it should be used as an economic regulatory tool. My working paper examines and attempts to answer these questions, taking into account ring-fencing’s potential costs and benefits. Ring-fencing is often considered to help protect publicly beneficial activities that are performed by private-sector firms, such as public-utility companies and banks. From a cost-benefit standpoint, ring-fencing is highly likely to be appropriate to help protect those types of activities performed by utility companies, such as providing power, clean water, and communications. Not only are those services essential but the utility company, normally being a monopoly, is the only entity able to provide the services. Ring-fencing the utility company against risk helps assure the continuity of those services.

It is less certain, though, that ring-fencing should be used to help protect other publicly beneficial activities. For example, even if the public services provided by banks were—for sake of argument—as important as those provided by public utilities, the need to ring-fence banks would not be as strong as the need to ring-fence public utilities. That’s because the market for banking services is competitive. If some risky banks become unable to provide services, other banks should be able to provide substitute services. It therefore is uncertain whether the benefits of ring-fencing banks would exceed its costs.

Ring-fencing could also be used to help protect the financial system itself, by mitigating systemic risk and the related too-big-to-fail problem of large banks and other financial institutions. The competing costs and benefits of using ring-fencing for those purposes, however, would be highly complex. Not only would they depend, among other things, on the ways in which the ring-fencing is structured; they also would have to be compared to the costs and benefits of other regulatory approaches to mitigating systemic risk.

[1] I helped advise Sir John Vickers, Chair, and the Secretariat of that Commission in connection with the preparation of the Vickers Report.)

[2] I recently testified as a ring-fencing expert before the Maryland Public Service Commission in the merger of Baltimore Gas and Electric, a public utility company.