A key policy of UK financial regulation since the financial crisis has been the ring-fencing of retail banks into separate and independently operated entities, so-called “ring-fenced bodies” (RFBs), distinct from entities that carry on other, and especially investment, banking activities within the same corporate group. Such structural regulation of the banking sector – which went into effect on January 1, 2019, for all UK banks with more than £25 billion of retail deposits  – was introduced to ensure that retail banks were less likely to fail. Proponents of ring-fencing argue that it does so in at least three ways. First, it reduces the possibility of intra-firm contagion from investment banking to retail banking activities. Second, it reduces or eliminates the possibility that investment banking activities will receive an implicit subsidy through the state’s willingness to protect retail banks from failure. And third, it reduces the severity of the consequences of failure by facilitating the orderly resolution of troubled retail banks by transferring them to a stable purchaser.

Unlike the structural regulation of banking formerly imposed in the U.S. under the Glass-Steagall Act of 1933, the UK ring-fencing provisions permit retail banks to remain part of a banking group that also engages in investment banking activities. This means that an RFB is likely to be controlled by a holding company that also controls an investment bank. UK policymakers have acknowledged that, for this policy to succeed, the corporate governance regime applicable to the RFB must ensure that it is able to make decisions independently from the parent company. In a recent article published in the Journal of Corporate Law Studies, available here, I explore this issue and conclude that, because RFB directors remain accountable to the parent company,  the policy fails to ensure that the RFB will not be run in a way that panders to the interests of the parent company.

As a regulatory strategy, ring-fencing relies on a credible ring-fence that governs the relation between the RFB and the rest of the banking group. The ring-fence cannot be too strict or rigid, because that would complicate day-to-day interactions within the banking group and create the risk that the RFB acts like a rogue entity, making a group policy impossible. It cannot be too loose either, because that would make it easy for the parent company to force the RFB to act in the interests of the group rather than those of the RBF. Striking the right balance is complicated, especially ex ante, which is why the rules that define the ring-fence are incomplete and therefore leave room for discretion. The problem is that such discretion can also be abused to undermine the ring-fence. For example, RFBs are not allowed to deal in investments as principal, but there is an exception for hedging transactions that allows RFBs to manage risk in what is otherwise a relatively undiversified portfolio (due to the limitations on the transactions RFBs may engage in). However, the distinction between legitimate hedging and unwarranted investment is notoriously hard to define, especially ex ante.

To maintain the required discretion while minimizing the associated risks, the ring-fencing regime provides for two safeguards. One is a regulatory gap-filling measure that, for example, allows the regulator to split out the RFB from the banking group if the ring-fence is consistently undermined. However, such a measure can only be effective if regulators have detailed information and the skills to evaluate it, the ability  to ask questions  and act, and the willingness to take drastic steps to restructure the nation’s largest financial institutions when needed. It is unlikely that this measure can reliably guarantee the ring-fence’s integrity.

That other safeguard is the power to impose ring-fence governance that requires directors of an RFB to act independently and prioritize the interests of the RFB over those of the wider group. That would encourage RFB directors to push back against actions that might undermine the ring-fence, thus addressing the risk that the discretion created by the ring-fencing rules is abused to undermine the ring-fence in favor of the broader banking group. Andy Haldane, chief economist of the Bank of England, has described ring-fence governance as “essential if this ring-fence is not to prove permeable.” However, as the article sets out, although ring-fence governance is introduced for RFBs, traditional UK corporate governance still applies. Given the strong role of shareholder primacy in UK corporate law, this implies that the RFB’s directors will remain accountable to the parent company – the very party from which they were supposed to be independent.

Various steps that have been taken to remedy this problem are unlikely to resolve it. For example, to maintain independence, a greater proportion of RFB directors must be  independent – including from the rest of the banking group – but these independent directors are still hired and fired (at will) by the parent company. A more promising, but as yet incomplete, approach is that the UK’s Senior Manager Regime, which generates directors’ duties under public law, requires RFB directors to jointly bear responsibility for the integrity of the ring-fence. An important difference from regular directors’ duties is that the Senior Manager Regime can be enforced directly by the UK’s Prudential Regulation Authority (‘PRA’) and Financial Conduct Authority (‘FCA’), so that enforcement does not require consent from the shareholder (in this case, the parent company). But this responsibility also comes with risks, as it puts the onus on regulators to strike a complex balance: Enforcement that is too heavy-handed will make it harder to operate group-wide policies and may deter people from becoming directors, but reluctance to take tough and necessary actions – a charge that has been levied against the UK’s FSA in the wake of the financial crisis – will leave the ring-fence vulnerable.

The success of ring-fence governance will determine the credibility of the ring-fencing regime, perhaps the most important (and most costly) structural reform the UK has undertaken since the crisis. That leaves the RFB’s independent directors, as well as the supervisors at the PRA and FCA, with significant responsibility. Now that the regime is in effect, their vigilance and assiduity will be critical to the success of this regulatory strategy. Given that ring-fencing is increasingly being adopted around the world, the UK’s experience will be an important indicator of the viability of this strategy. It also highlights the important and underexplored role of  directors  where regulatory rules are unclear and helps elucidate the importance of intra-group governance in banking groups.

This post comes to us from Thom Wetzer, a DPhil candidate in law and finance at the University of Oxford. It is based on his recent paper, “In Two Minds: The Governance of Ring-Fenced Banks,” available here.