In theory, both of these should contribute to protecting the taxpayer should financial institutions run into difficulty in the future. They address what happens when a financial institution runs into difficulty. This is a different focus than disclosure under the FDR Framework which focuses on moderating the difficulty a financial institution can get itself into.
The Telegraph carried an article and the Financial Times ran a column that discussed the practical realities of ring-fencing.
In the Telegraph article, the UK government was urged to consider a Glass-Steagall type of ring-fence that separates retail from investment banking.
Lord Lawson, who served as chancellor under Margaret Thatcher from 1983 to 1989, urged the government to consider a full break-up of banks.
He said the government should separate the retail and investment arms of the partially state-owned Royal Bank of Scotland and HBOS when they are sold off, adding the bailing-out of failed investment banks was "absolutely intolerable".
... [If there is not a full break-up,] he warned bankers would want any firewall to be permeable and said it could be "difficult" for different corporate cultures to co-exist within a bank.
... "The problem with this is while it is intellectually a sound move, the problem is that in practice, with the pressures of the real world, the ring-fence will not actually - to mix metaphors - be completely watertight. It might break down.
"It's very difficult when you've got the same management, the same board, the same group of shareholders," Lord Lawson said.
He said he welcomed the proposed ring-fence, but added: "I hope, incidentally, that the government will go further.
"You need two totally different cultures; a culture of prudence and caution in retail banking, the ordinary commercial banking; and you need the go-go culture - that's fine in investment banking. To have two different cultures in the same group is difficult, so I think a complete seperation might have been better.
The Independent Commission on Banking ... stopped short of recommending a full break-up of banking groups. Instead it proposed distancing retail banking from investment banking by setting up different subsidiaries for different business units under one parent holding company.
Banks should hold a minimum core Tier 1 capital ratio of 10pc for the UK retail operations - some 3 percentage points higher than the 7pc global minimum standard.
Lord Lawson said: "I'm quite sure the banks themselves would like [ring-fences] to be permeable, and I'm quite sure the government will do its best to see to it that a system is put in place - and it's perfectly possible to do this - where they are as impermeable as possible," he said.
"The point is not only to secure the economy for the future, but to protect the taxpayer. It is absolutely intolerable that investment banking is bailed out if it fails.
"At the end of the day there is a tax-payer guarantee for retail banking. That should not extend to investment banking. If investment bankers make a mistake they should go bust."The Financial Times column discussed potential solutions to make the Chinese wall between retail and investment banking, if there is not complete separation, as impermeable as possible.
The UK’s Independent Banking Commission has proposed that conglomerate banks in the UK should ringfence retail banking operations. The aim is to reduce the subsidy to large investment banks and the related risk exposures to taxpayers that arise from the belief that such banks are “too big to fail”.
The effect of these proposals is that the taxpayer would still be expected to protect depositors, and perhaps other bank creditors, from the consequences of banks’ bad lending but would be spared the losses from the banks’ inept gambling....
The issue is how to make the ringfence effective.
What activities are appropriate to a retail bank? A retail bank takes deposits from its customers and lends to businesses and households, and maintains liquidity to meet withdrawals. In short, it performs the traditional functions of a bank....
As HSBC has pointed out in its submissions, international accounting standards already require a distinction between banking activities and trading activities. In principle this is right. But banks have demonstrated how flexible a distinction based on inference of motive can be: bad assets – which can be held at book value – are said to be intended to be held to maturity, while profits from good assets are marked to market.
The core problem is that banks have no intention of abiding by the spirit, rather than the letter, of any regulatory rules. Indeed they have developed profitable business in regulatory arbitrage – selling instruments that avoid regulatory burdens by changing the form of the transaction but not the substance. So rules have to be direct and simple.
A suitable requirement might be that a high proportion – 90 per cent or more – of a retail bank’s assets be in residential mortgages, government stock or loans to non-financial businesses ... Such a rule helps solve a further difficulty: how to stop the ringfence being as permeable as, say, a Chinese wall.
In the absence of restriction, the retail bank could simply lend all its funds to the investment banking arm of the group; when the investment bank fails, the retail bank then has no assets. Treating such intra-group loans as third party exposures, as the commission proposes, would block that stratagem; but strict limitation on acceptable retail bank assets is needed to prohibit more complex transactions with similar practical effect.
Limits on the retail bank’s dealings in derivatives are also necessary, since modern financial innovation allows almost any desired exposure to be written as a derivative contract. It is hard to see why a retail bank needs to trade any derivatives on its own account other than interest rate swaps.
These measures might be reinforced by a statutory duty on the directors of the retail bank to protect its deposits. The purpose is to use the threat of personal liability to force them to face the conflicts of interest inherent in a complex holding company structure. If it proved difficult to find directors willing to take on such a responsibility, that would tell us the separation was not working.
If the ringfencing of retail banking were effective, it would be a big step towards a financial system more resilient to crises. The sanguine reaction of banks and markets to the proposal suggests they do not believe such measures will make much difference. It is up to the commission to prove them wrong.