A keynote 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 entered into force for all UK banks with more than £25 billion of retail deposits on 1 January 2019– 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 enjoy 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 US 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’ of the parent company. In a recent article published in the Journal of Corporate Law Studies, available here, I explore this issue and conclude that RFB directors remain accountable to the parent company so that the regime fails to ensure that the RFB will not be run in a way that panders to the interests of the parent company to the extent of undermining the ring-fencing policy. 

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 it impossible for the parent company to execute a group policy. 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, making a ring-fence pointless. Striking the right balance is complicated, especially ex ante, which is why the rules that define the ring-fence are indeterminate and 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 to manage risk in what is otherwise a relatively undiversified portfolio (due to the limitations on the transactions RFBs may engage in) there is an exception for hedging transactions. However, the distinction between legitimate hedging and unwarranted investment is notoriously hard to define, especially ex ante

To maintain discretion required but counteract the risks it brings, the ring-fencing regime takes two sets of measures. First, it deploys what could be referred to as ‘regulatory gap-filling measures’, such as the ‘electrification’ of the ring-fence that allows the regulator to split out the RFB from the banking group if the ring-fence is consistently undermined. However, such tools rely on the regulators having detailed information and skill, the capacity to interrogate and act, and the willingness to take drastic steps to restructure the nation’s largest financial institutions when needed. It is unlikely that these rules can reliably guarantee the ring-fence’s integrity. 

That implies the second gap-filling strategy, the imposition of ‘ring-fence governance’ on RFBs, fulfils a critical role in ensuring that ring-fencing is a credible regulatory strategy. The idea of ring-fence governance is that directors of an RFB should act independently and prioritise the interests of the RFB over those of the wider group. That would incentivise 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 favour of the broader banking group. Andy Haldane, Chief Economist of the Bank of England, has described this role of 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 remain accountable to the parent company – the very party they were supposed to be independent from. 

Various steps that have been taken to remedy this problem are unlikely to resolve it. For example, to maintain independence RFBs have to have a larger share of independent directors – who, moreover, also have to be independent 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 of 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 with 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 potential directors from applying, but reticence to taking tough but 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 effort 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 force, their vigilance and assiduity will be critical to the success of this regulatory strategy. Given that ring-fencing is increasingly adopted around the world, the UK’s experience will be an important indicator of the viability of this strategy, highlight the important and underexplored role of interacting private and public law directors’ duties in the context of indeterminate regulatory rules, and help elucidate the importance of intragroup governance in banking groups. 

Thom Wetzer is a DPhil Candidate in Law and Finance at the University of Oxford.