Retail ring-fencing of banks and its implications

Abstract

Financial stability remains a key theme globally in view of the Euro zone debt crisis. The latest strategy by Germany and France is to ring-fence the crisis among the PIIGS countries (Portugal, Greece, Ireland, Italy and Spain). In the United Kingdom, the big four major banks have all responded to the Independent Commission of Banking’s interim report key recommendation: ring-fencing retail operations into a separate subsidiary of any bank that wishes to operate in the United Kingdom. The report has clearly discussed the advantages and disadvantages of various types of subsidiarisation. Retail ring-fencing is considered a compromise as full subsidiarisation is too costly and operational subsidiarisation is too minimal. The Independent Commission of Banking published its final report on 12 September 2011. They recommended ring-fencing retail banking and a 10 per cent equity baseline. This article focuses on structural reforms of UK banks. It aims to address the question of financial stability from a wider European perspective. The first question is whether cross-border retail banking in the European Economic Area (EEA) is best served by branches or subsidiaries? The second question concerns the legality of setting up subsidiaries in the European Union (EU). Although there are no legal problems for UK-based banks setting up subsidiaries for their retail activities, there might be a legal hurdle for requiring foreign banks setting up subsidiaries in the United Kingdom. The third question concerns EU cross-border banking regulation and supervision. Are the ‘passporting system’ and the home country supervisory approach still applicable in this post-financial crisis era? Many factors influence the choice of setting up branches or subsidiaries. However, the general position is that branches are more suited for wholesale/investment activities because of ease of funds transfer. Subsidiaries are more suitable for retail banking because of the limited liability principle and extensive local network. Effective cross-border banking must be accompanied by effective supervision and resolution regimes. The ‘passporting’ concept under EU law and home country dominance are somewhat dated post-financial crisis. Host country control should play a dominant part in financial regulation, especially in the light of the importance of subsidiaries and the limited liability principle associated with them. The Icelandic bank crisis and collapse of Lehman Brothers International Europe illustrate the importance of host country control. Finally, the author argues that requiring banks to hold its retail activities in the form of subsidiaries in another European country is necessary to achieve financial stability.