Accenture-A-New-Dawn-Designing-the-Ring-Fence

A New Dawn?Designing the Ring-Fence

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Ring-fencingCritical choices with profound business implications

With these aims in mind, the ring-fencing of retail banking should achieve three objectives at the lowest possible cost to the UK economy:

• Make it easier to address financial problems at both ring-fenced and non-ring-fenced banks, without taxpayer-funded solvency support.

• Protect vital banking services on which households and SMEs depend from problems elsewhere in the financial system.

• Curtail government guarantees, thus limiting the risk to the public finances and putting the onus on banks to avoid running excessive risks in the first place.

The decisions that banks take today on their approach to the ring-fence, the positioning of different activities inside and outside it, and the corporate structures they create to maintain it, will shape and influence how they run their businesses under the ICB regime. While the ICB’s recommendations still need to be approved by government, and are not scheduled to come fully into force until 2019, we believe banks must start preparing now - especially for the ring-fencing provisions.

Ring-fencing of retail and SME banking is one of the three key pillars of the ICB’s final report, alongside loss-absorbency and competition. The primary objective of the ring-fence is to reduce the risk that retail and SME customers might lose access to banking services, by insulating them from other areas of the bank, and ensuring that services to them continue in the event of a failure of part or all of the bank. It also seeks to make the need for bail-outs less likely in the future.

Designing the Ring-Fence

Structuring the ring-fence: separation from board level downwards Under the ICB’s proposals, ring-fenced banks can be part of a wider corporate group, but must be separate legal entities with an independent board. If a wider corporate group exists, it is responsible for putting arrangements in place to ensure the ring-fenced bank has continuing access to the support functions it needs, regardless of the wider group’s financial health. Data and resources needed for the effective operation of the wider corporate group - for example Relationship Managers selling products across the ring-fence - can be shared. However, while ring-fenced banks are allowed to interact with non-ring-fenced banks within their wider corporate group, these relationships must be at an arm’s length, commercial basis. Crucially, both the ring-fence and non-ring-fence entities must be able to meet regulatory requirements (including capital, large exposure, liquidity and funding) on a solo basis.‘


Mandatory, permitted or prohibited?The ICB’s final recommendations set out a number of requirements for the structuring of the ring-fenced bank and its relationship with the non-ring-fenced business (see information panel). They also differentiate between different banking activities, and place various restrictions on where they can be performed.

Services such as deposit-taking for individuals and SMEs are ‘mandatory’ services that can only be delivered inside a ring-fence. In contrast, certain ‘prohibited’ services -

principally investment banking services, transactions with financial institutions and non-EEA business - can only be delivered outside a ring-fence.

Between these are a number of ‘permitted’ services - including corporate deposit and lending activities - that can take place either inside or outside the ring-fence, at the bank’s discretion. It is the location of these ‘permitted’ services that is the key focus when designing the ring-fence.

The final category is ‘ancillary’ services relating to the delivery of non-prohibited services - such as internal hedging activities and treasury - which are also allowed within the ring-fence.

Locating product activities The categorisation of these various activities is summarised in Figure 1. Where activities are specific to a particular client segment, these are included in brackets. While there are relatively few mandatory activities, the list of permitted activities is much longer, giving banks significant flexibility around the ‘location’ of

their ring-fence and the activities they include within it. We support this flexibility and believe it is aligned with the ambition of increasing competition within the UK Financial services industry.

A wide array of factors specific to the institution will determine how ‘narrow’ a bank decides to design its ring-fence. The likelihood is that banks will take a variety of different approaches, with some adopting an element of ‘wait-and-see’ as they observe how their competitors respond to the rules.

Category ‘Mandatory’EEA Deposit-taking andoverdrafts (Ind)

EEA Deposit-taking andoverdrafts (Corp)

EEA Deposit-taking andoverdrafts (FI)

EEA NRF product-on-sell,no exposure (non-FI)

Non-EEA deposit-taking(All)

Non-EEA Payment services (All)

EEA Trade and ProjectFinance (FI)

Non-EEA NRF productadvice (non-FI)

Derivative transactions(Arranging, executing) (All)

Investing in stock,securities, funds, etc, (All)

EEA Secured/unsecuredlending (FI)

Non-EEA Secured/unsecured lending (All)

Non-EEA Trade and ProjectFinance (All)

Non-EEA NRF product on-sell, no exposure (non-FI)

Securities transactions(Originating, trading) (All)

Underwriting sale of debtand equity securities (All)

EEA Deposit-taking andoverdrafts (UHNW)

EEA Payment services (All)

EEA Secured/unsecuredlending (Ind.)

EEA NRF product advice(non-FI)

EEA Trade & ProjectFinance (non-FI)

Wholesale Funding(to support RF only)

EEA Secured/unsecuredlending (Corp)

Deposit-taking

Payments

Lending

Finance products

IB products

“Must be in ring-fence”

Key

AbbreviationsInd. Individual CustomersUHNW Ultr High Net WorthSME Small & Medium-sized EnterprisesCorp Corporate Clients FI Financial InstitutionsEEA European Economic AreaRF Ring-fencedNRF Non-ring-fenced

The ICB’s final report contains more detailed definition of clientsegments illustrated above and whatconstitutes an SME/UHNW/Corporate

“Must be outside of any ring-fence” “Can be either in/out of any ring-fence: at bank’s discretion” Key focus when choosing location of ring-fence

EEA Deposit-taking andoverdrafts (SME)

‘Permitted’ ‘Prohibited’

Mandatory

Permitted

Prohibited


Key Question 1: Will the ring-fencing proposals force us to overhaul our core business model so that we no longer need to operate both sides of a ring-fence?The most basic question is whether a bank will need to have activities on both sides of a retail ring-fence at all. A handful of banks already operate entirely within a ring-fence (e.g. retail-only banks with no ‘prohibited’ activities) or outside a ring-fence (e.g. niche investment banks with no ‘mandatory’ individual or SME deposit-taking). However there may be banks whose current product offering would require a ring-fence for only a minority of their business. For example, a small retail bank with a very limited customer trading offering may prefer to exit this business and operate entirely within the ring-fence to avoid the complexity and costs of operating on both sides of the ring-fence.

Key Question 2: How broad should my ring-fence be? For example, where should corporate deposit-taking occur?Going retail-only is not an option that most players (especially the major universal banks) would even consider - meaning they will move straight on to questions 2 and 3. This will mean deciding how to continue offering a combination of ‘mandatory’, ‘permitted’ and ‘prohibited’ services to clients. For them, they must decide which permitted services should

Three key questions As banks assess the implications of ring-fencing, the ICB’s recommendations give rise to three key questions that they will have to address in the near future. These are:


be located inside the ring-fence, such as corporate deposit-taking. The more activities they include, the ‘broader’ their ring-fence will be.

Key Question 3: How do I set up my support-function operating model to jointly support ring-fence and non-ring-fence business?Once the positioning of ‘permitted’ services and the breadth of the ring-fence are agreed, each bank will need to decide on the optimal operating model to jointly support its various ring-fenced and non-ring-fenced businesses. One option is for each side to be supported by its own separate support functions. Others include placing the support capabilities in a separate wholly-owned subsidiary, or outsourcing them to an independent third party. In the latter two cases, the subsidiary / outsource provider will supply ongoing vital services in the event of a failure on one or both sides of the ring-fence.

How wide is your fence?Assuming that a bank needs to operate both sides of a ring-fence, it must decide whether to implement a ‘narrow’ or ‘broad’ fence. Figure 2 illustrates the options at two ends of the spectrum. One extreme, shown on the left, is a ‘narrow’ ring-fence which only includes individual and SME deposit-taking and lending, and contains minimal ‘permitted’ business activities.

Figure 1: Categories of banking activity under the ICB’s ring-fencing proposals

Under this option, corporate banking - both deposit-taking and lending - would take place outside the ring-fence. This approach might be attractive to a universal bank that has traditionally used capital from corporate banking to support its investment banking activities, and whose retail business is relatively self-sufficient and siloed. At the other end of the spectrum, on the right, is a ‘broad’ ring-fence containing most of the permitted activities, including payment services, project/trade finance, and the lending businesses. Under this option, corporate banking - both deposit-taking and lending - would take place inside the fence. This approach might suit a bank whose corporate and retail activities are closely integrated, and which does not use cross-subsidise investment banking from corporate banking activities.

There is nothing in the proposals to prevent banks from offering permitted services on both sides of the ring-fence. But this is unlikely to emerge as common practice with complications around differing costs of funding leading to arbitrage opportunities for clients and creating competition between entities in the same group. However, depending on the flexibility of its support model, a bank can ensure it has flexibility to move activities either way across the ring-fence in the future, to reflect changes in its strategy or the competitive environment.

Category“Narrow” ring-fence “Broad” ring-fence

Ring-fence (RF) Non-ring-fence (NRF) Ring-fence (RF) Non-ring-fence (NRF)

Deposit-taking

Payments

EEA Deposit-taking andoverdrafts (Ind)


EEA Secured/unsecuredlending (Ind)


Non-EEA Secured/unsecured (All)

EEA Payment Services(All)

EEA Payment Services(All)

EEA Secures/unsecuredlending (SME)

Wholesale Funding (To support RF only)

Wholesale Funding (To support RF only)

EEA Secures/unsecuredlending (Corp)

EEA Secures/unsecuredlending (Corp)

EEA product advice (non FI)

Non-EEA product advice (non FI)

EEA NRF product-on-sell, no exposure (non-FI)

Non-EEA NRF product-on -sell, no exposure (non-FI)

EEA Trade & Project Finance (non-FI)

EEA Trade & Project Finance (non-FI)

Non-EEA Trade & Project Finance (non-FI)

Derivative transactions(Arranging, executing)(All)

Investing in stock, securities, funds, etc. (All)

Securities transactions (Originating trading) (All)

Underwriting sale of debt and equity securities (All)







Non-EEA payment services (All)


Non-EEA Secured/unsecured (All)

Non-EEA product advice (non FI)

Non-EEA NRF product-on -sell, no exposure (non-FI)

Non-EEA Trade & Project Finance (non-FI)

Derivative transactions(Arranging, executing)(All)

Investing in stock, securities, funds, etc. (All)

Securities transactions (Originating trading) (All)Underwriting sale of debt and equity securities (All)

Non-EEA payment services (All)


EEA Deposit-taking andoverdrafts (Ind)


Lending

Finance products

IB products

Key

AbbreviationsInd. Individual CustomersUHNW Ultr High Net WorthSME Small & Medium-sized EnterprisesCorp Corporate Clients FI Financial InstitutionsEEA European Economic Area

The ICB’s final report contains more detailed definition of clientsegments illustrated above and whatconstitutes an SME/UHNW/Corporate

Mandatory

Permitted Static across models

Different across modelsPermitted

Prohibited


EEA Secured/unsecuredlending (Ind)

EEA Secures/unsecuredlending (SME)

EEA NRF product-on-sell, no exposure (non-FI)*

EEA product advice (non FI)*

Indicates movementbetween models

Designing the Ring-FenceDesigning the Ring-Fence

1. Capital Constraints Context:The broader ICB recommendations will lead to generally higher capital buffer requirements in both ring-fenced and non-ring-fenced banks. However, on top of this, large ring-fence entities will need an additional buffer, incentivising banks to reduce the size of their ring-fenced balance sheets. So there may be an argument for splitting activities across the fence in such as way as to keep both balance sheets below the threshold which requires increased equity requirements.

Key questions:

• How is our balance sheet currently structured?

• Do the capital constraints mean we should minimise the size of our ring-fenced balance sheet?

• Is there an advantage in balancing the balance sheet more evenly across the ring-fence, in order to reduce the effect of the additional capital buffers contingent on balance sheet size relative to GDP?

2. FundingContext:Some banks cross-subsidise their activities, such as using capital from corporate deposits to help fund retail lending or investment banking. While banks can continue to pass capital across the ring-fence provided they stay above minimum capital adequacy levels, it will be harder to do this with a ring-fence in place. It will be particularly diffi cult in stress scenarios, when regulators and investors would be alarmed to see capital moving out of the ring-fenced bank. A further consideration is that the cost of funding is likely to vary across the ring-fence due to differentials in credit rating and perceived levels of risk.

Key questions:

• How is our current business funded? What is our future funding strategy?

• What are the current imbalances - such as a mismatch between assets and liabilities - in the funding of our retail, SME and corporate activities?

• How would our retail, SME and corporate funding imbalances be impacted by different locations for the ring-fence?

• Which revenue streams and client segments are our key target growth areas?

• How will the location of the ring-fence impact our relative cost of funding?

3. Customer ImpactContext:Given that different banks will put similar services on different sides of the ring-fence, banks will need to keep a close eye on their positioning relative to their competitors, and be alert to the risk of losing customers. It remains to be seen how the dynamics of the ring-fence - such as the impact on the cost of funding - will play out in practice, and whether a clear trend will emerge across the industry.

Key questions:

• Where will our competitors locate their ring-fence - and what are the implications for our business?

• What will be the impact of dealing with customers from both sides of the ring-fence? Will clients deal with multiple entities from the same bank?

• What products, if any, will we offer on both sides of the ring-fence? If deposit-taking is supported on both sides, how will we prevent a ‘corporate deposit run’ in a stress situation, with customers migrating from non-ring-fence to ring-fence?

• How can we ensure we retain enough fl exibility to revisit the location of ‘permitted’ activities and perhaps move them across, as industry approaches and regulation evolve?

4. Operational ImpactContext:Banks will need to show that, in the event of a failure, the ring-fenced bank will continue to be supported by key services for a period of time, enabling an orderly wind-down. The location of the ring-fence may impact this resolvability, which is an increasing focus for banks as recovery and resolution plans (RRPs) become mandatory. In addition, if the group’s support functions operate on both sides of the ring-fence, the location of the ring-fence could have signifi cant operational and cultural impacts.

Key questions:

• Do we have logical support function silos that naturally lend themselves to a specifi c ring-fenced location?

• How integrated are our systems, processes and resources across the group?

• Would our ability to maintain ‘vital’ services - such as individual and SME deposit-taking - be hindered by including more ‘permitted’ activities within the ring-fence?Figure 2: Location of activities in a ‘narrow’ or ‘broad’ ring-fence

No ‘one-size-fi ts-all’ solutionOur view is that the location of the ring-fence will be driven as much by existing internal business considerations - such as balance sheet structure and the funding mix - as by market-facing factors. However, banks need to keep in mind the implications for their competitive positioning, culture and operations.

In practice, many banks may adopt a ‘tactical’ short-term ring-fence location aligned with their existing business structure until the regulations have fully evolved and the future market trends are clearer. Once any clear trends have emerged, banks may drop this interim approach and move their activities to long-term ‘strategic’ positions in relation to the ring-fence.

Given this likelihood, and the fact that the optimal ring-fencing structure will vary for every bank, there is no ‘one-size-fi ts-all’ solution. However, we believe there are four key factors that every bank should take into consideration in locating its ring-fence: capital constraints, funding, customer impact, and operational impact.

Building the right operating modelOnce a bank has decided on the location of its ring-fence, it needs to choose and implement the right operating model to support the activities on both sides.

In its fi nal report, the ICB outlined a variety of operating models that could achieve suffi cient ‘operational separability’ to ensure that the ring-fenced bank could continue to operate without solvency support after a failure. Each model has pros and cons, and banks will need to conduct a thorough cost/benefi t analysis to identify the most suitable one for each of their vital services and support functions.

However, what is clear is that whichever model a bank adopts, there will be a signifi cant impact on the way its operations are structured and managed. In our view, the viable options for the operating model boil down to two choices for each function: ‘duplicate provision’ and ‘operational subsidiarisation’. Figure 3 illustrates how a bank might operate with these types of provision.

• Under a ‘duplicate provision’ model, the ring-fenced bank itself provides the necessary capability - infrastructure, resources and so on - to maintain the continuous provision of the vital service supporting the ring-fence. A separate and independent set of duplicate capabilities would support the non-ring-fenced entity.

In cases where existing support functions are already aligned with the activities going into the ring-fence, this may be achievable relatively easily. However where this is not the case, separating the required capabilities will require signifi cant investment.

In addition, this will almost certainly lead to duplication of system, data and processes between the ring-fenced and non-ring-fenced banks. In the event that a bank chooses to move its ring-fence in the future, a duplicate provision model is likely to make this change highly complicated, as it will also involve further separation of the existing embedded support function boundaries.

• With ‘operational subsidiarisation’, the group places the vital operational capability in a separate independent subsidiary. In the event of a failure of any part or all of the wider group, this separate subsidiary would be able to provide ongoing support.

Depending on the current operating model, isolating these capabilities is unlikely to require signifi cant effort. However, moving to this model will create a more complex legal structure: the operational subsidiaries will need to be fi nancially independent, with suffi cient funding to maintain operations in a failure. Applying the same principle, a variant of this approach would involve using a third-party outsourced provider to act as an alternative supplier to a wholly-owned subsidiary.

Designing the Ring-Fence Designing the Ring-Fence

Figure 3: Illustrative alternative support models under ring-fencing proposals

Ring-fenceEntity A

Finance (RF only) Finance (NRF only)

Treasury (RF only) Treasury (NRF only)

Operations (RF only) Operations (NRF only)

IT (RF only) IT (NRF only)

Payments (RF only) Payments (NRF only)

Ring-fence owned functionKey

Non-ring-fenceEntity B

Non-ring-fenceEntity C

Ring-fenceEntity A

Finance (RF only) Finance (NRF only)

Treasury (RF only) Treasury (NRF only)

Operations (All)

IT (All)

Non-ring-fenceEntity B

Non-ring-fenceEntity C

Dupl

icat

e Pr

ovis

ion Du

plic

ate

Prov

isio

n3r

dPa

rty

Ope

ratio

nal

Subs

idia

risat

ion

Non-ring-fence owned function Op Subsidiary owned function 3rd Party outsourced function

A: Illustrative “Duplicate provision” support model B: Illustrative “Blended” support model

Payments (All)

Operational subsidiarisation: the likely model of choiceOn balance, we believe that most banks will see a strong case for operational subsidiarisation, and that over time this model will come to play an important part in underpinning the ring-fence.

While the final decision will depend on each bank’s unique circumstances, operational subsidiarisation will generally deliver a number of key benefits. Not the least of these is greater flexibility to make changes in the future. With support being provided by a separate operational subsidiary, changes to the location of the ring-fence will have little or no impact, unlike under a duplicate provision model.

As Figure 4 shows, a bank’s need and suitability for operational subsidiarisation vary depending on its degree of integration and the location of its ring-fence. If the bank adopts a narrow ring-fence and has a high degree of integration between its ring-fenced (e.g. retail, corporate banking) and non-ring-fenced (e.g. investment banking) activities, then operational subsidiarisation may be the best option. Conversely, a bank with a broad ring-fence and limited integration across the ring-fence is more likely to choose duplicate provision.

In any case, our experience shows that splitting off support services into operational subsidiaries often delivers several standalone benefits that may make it an attractive solution to the ring-fencing challenge. These include increased operational simplicity,

greater business agility, higher service quality in line with service-level agreements (SLAs), and lower operating costs.

A long-term migration to a blended model Over the longer term, we believe that most banks will move to a blended model of the type shown in Figure 3 earlier, under which a combination of approaches are used for different support functions. Under this model, services will be sourced in three ways although this will be specific to each organisation:

• Some services will be duplicated on each side of the ring-fence - examples include Finance, because it may already be siloed and duplicated or Treasury, because its purpose is to support a specific balance sheet.

• Some will be placed in operational subsidiaries - such as IT and Operations, because they are highly integrated across the ring-fence, and difficult and expensive to duplicate.

• Some will be outsourced entirely to a third-party provider - examples include payments, where third party providers may have a competitive advantage.

Ultimately, the IBC’s ring-fence proposals will impact the majority of banks’ activities and operations. The legislation relating to the ICB recommendations is expected to be passed in 2012 however the implementation deadline of 2019 currently looks a long way off. But the sheer scale and scope of the required analysis, planning and change mean banks have no time to lose in considering how they will respond to this landmark regulation.


Little need foroperationalsubsidiarisation

Some need foroperationalsubsidiarisation

Significant needfor operationalsubsidiarisation

Degree of bankintegration

Scope of ring-fence

Broad

Narrow

Low High

Figure 4: Assessing the need for ‘operational subsidiarisation’

Accenture Contacts

David ParkerSenior ExecutiveFinancial Services UK+44 20 7844 [email protected]

Tom MerrySenior ManagerFinancial Services UK+44 20 7844 [email protected]

Karl MeekingsManager, Banking ResearchFinancial Services UK+44 20 7844 [email protected]

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