The implementation of the UK’s Banking Reform Bill (BRB), covering the ring-fencing of retail banks, is taking shape, and it looks like we are headed to the family courts, dear. We see three main kinds of requirements: 1) KYC and due diligence requirements, linked to identification and transfer of core and non-core deposits; 2) restructuring and renegotiation of third-party contracts by ring-fenced entities to ensure adequate ‘operational independence’; 3) and new monitoring and reporting requirements, some in real-time, related to ring-fenced banks’ use of payment services and derivatives exposures. The latter will heavily test firms’ data systems and compliance functions.
In its current form, the BRB is largely an enabling bill, giving sweeping powers to HMT to implement the policy through secondary legislation. It was recently read for the second time in the House of Lords, along with an initial draft of this more detailed secondary legislation outlining key details of the ring-fence. These requirements will have to be implemented up to 2019 and beyond.
Real-time monitoring and reporting related to payment systems present one of the greatest challenges. Ring-fenced banks are prohibited from having exposures to other financial institutions, in order to limit contagion. However, an exemption is made allowing ring-fenced banks to take on short term exposures to other financial institutions where these relate to the provision of payments services.
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- Given the restrictions, will there be a commercial case for ring-fenced entities to trade derivatives after 2019?
- Will the Treasury exercise their power to force complete legal separation on banking groups?
- Will the market have third party solutions in place to deal with key requirements by 2019?
In order to prevent this exemption being abused, the bill restricts the size and timeframe of these payments-related exposures: They will not be permitted to exceed 2% of a ring-fenced bank’s capital to a single financial institution, or 10% across all institutions; and they cannot last more than 5 working days. However, because of the ‘short term and continually fluctuating nature of these exposures… they must be monitored in real-time’. Therefore, the legislation empowers the PRA to mandate real-time reporting of these short term, payment-related exposures.
The law also places restrictions on the types of derivatives that can be sold by the ring-fenced bank to its customers. These are limited to ‘simple derivatives’, the value of which is linked either to an asset or liability itself or a price from an established, sufficiently liquid market. The ring-fenced bank is not supposed to sell a product hedging uncommonly traded or illiquid instruments. It also restricts the type of derivatives sold to only forwards, futures and swaps within currency, interest rates and commodity markets. Other derivatives can be sold to customers within the ring-fence only on arm’s length commercial terms arranged with a third party.
While this is simple in principle, the implementation may in practice be anything but. A compliance risk will now be attached to decisions regarding the separation of derivative product lines offered across the ring-fence, with firms expected to verify that any derivative sold within the ring-fence derives its price from sufficiently liquid markets. This will pose strategic challenges for the group as a whole regarding decisions about which products to provide inside the ring-fence and which to keep outside, whilst taking into account both efficiency and compliance risk.
In addition to restricting the range of derivatives sold within the ring-fence, the draft law also places restrictions on both the net and gross exposure a ring-fenced bank can hold. The net cap requires firms to have a position risk exposure from derivative selling which can never exceed 0.5% of a firm’s own funds. This essentially requires virtually all exposures stemming from the sale of derivatives to be hedged as and when they are taken on. Meanwhile, the gross cap seeks to limit exposure from derivatives sales based on the total size of a ring-fenced bank’s lending activities. In practice, this will mean that a ring-fenced bank’s derivative sales can never exceed 20% of its credit risk capital requirement linked to lending.
These restrictions on derivatives sales therefore include both the range and volume (net and gross) of derivatives offered, and will require a step-up in controls and data management capabilities. If firms do not know exactly which type of derivatives products are being sold inside and outside of the ring-fence, the markets these products derive their value from, and the size of their exposures from derivative sales against both their own funds and credit risk capital requirement in real time, they will risk non-compliance.
The ring-fence is set to be ‘electrified’, so that if HMT do not believe the spirit of the ring-fence is being up-held, they can enforce full legal separation of the group (not just separation, but total banking divorce). While deadlines are still distant, with full implementation of the ring-fence due by 2019, firms will want to bake these requirements into their existing change programmes to avoid having to dig-up the foundations again in the next five years.
- Significant new reporting and control requirements are emerging alongside pre-identified ring-fencing requirements
- Caps on ring-fenced banks’ derivatives exposures will force another review of OTC derivative trading, even after EMIR and MiFID II
- Banks will have to gear up for real-time monitoring of granular payment-service exposures with joined-up reference data