Ring fencing is a term to describe the situation where a firm makes part of its business a separate entity to the rest of its business. The purpose or ring-fencing an aspect of your business is so that losses in one area can’t affect another.
Ring Fencing Banks
The recent Independent Commission on Banking ICB wants UK commercial banks to ringfence their retail division from their riskier investment banking divisions.
This involves making the retail and investment arms of a bank separate legal entities.
Reason for Ring Fencing Banks
When banks lost money on buying sub-prime loans and credit default swaps, this placed retail deposits at risk. Losses on other aspects of business put ordinary deposits at risk. The government wants to guarantee all retail deposits to retain confidence in the banking system, but this meant they were intervening in banks to pay for risky investment losses. By ring fencing retail parts of banks, the government hope:
- It will be less likely they have to bail out banks. Retail operation of banks less risky than investment branches which dabbled with a wide variety of financial derivatives.
- If they do, it will cost less.
- Currently, there is a motive of moral hazard for banks. If they take risks (e.g investing in sub-prime loans) but fail they can rely on bailout from the taxpayer. This new system would allow investment banking divisions to fail, therefore they have incentives to avoid taking risks.
Potential Problems of Ring Fencing Banks
Some argue that ring-fencing banks could increase the cost of borrowing for firms. This is because they can’t use other profitable areas to finance lending. However, this is disputed by others
Example of Ring Fencing
Portland General Electric was acquired by Enron in 1997. However, as part of the deal, the company was ring-fenced by the state of Oregon. When Enron declared bankruptcy amidst shady accounting, the state electric company’s assets were protected from Enron’s creditors. If it hadn’t been ringfenced the Portland electric company could have also been wound up to pay off Enron’s creditors.
Readers Question: Is this (ring-fencing) likely to make retail banking a more expensive service?
Yes, A separation of retail and investment arm will incur higher costs. The banking industry claims it will cost £7bn, which could lead to higher charges for consumers. But, taxpayers are still paying high costs to bailout banks
Will it actually make the retail side of the bank any safer in a global credit crunch?
It might help to some extent. But, if you take Lehman Brothers, (whose collapse sparked the credit crunch) they were only an investment bank, they didn’t have a retail arm. Also, the size of the banks still remains very high. Until the 1970s, banks’ assets as a percentage of UK GDP remained steady at approximately 50%. By 2006, after decades of deregulation, banks’ assets as a percentage of UK GDP were more than 500%. [ source: 1]
Splitting banks into retail and investment divisions still leave scope for government needing to bailout banks. Suppose the Barclays investment decision got into financial difficulty. It would be easier to let it fail, but there might still be the same knock-on effect to retail savings – even though in theory they are separate.