Ring-Fencing: Mitigating Banking Risks?

Proposed by the UK’s Independent Banking Commission, does the proposed splitting of bank’s investment arm from its retail arm really mitigate the financial risks of banks?


By: Ringo Bones


Ever since the collapse of Lehman Brothers back in September 2008 as the banking crisis went global, everyone of us has found out in a rather nasty way that there is an arm of banking that’s quite different from the one that we often avail the services of our local banks namely saving money and allowing us to write checks – it is called investment banking.

Investment banking is a specialized phase of banking concerned with gathering together the savings of the community for permanent or long-term use by private enterprises and the federal, state and local governments. In the early days, the policy of combining commercial banking with investment banking – although sound in theory – did not prove successful in practice.

Commercial banking affiliates, in their eagerness to participate in the long-term capital market, purchased numerous issues of new securities which later could not be sold to the investing public. To dispose of their frozen inventory of unmarketable securities, the affiliate banks frequently “dumped” them into portfolios of the commercial banks and received payment in cash. In this way, the affiliate banks kept themselves liquid, but the commercial banks frequently became owners of securities which were not of the highest quality – i.e. way below the Triple-A Rating of Standard & Poor’s and other top credit-rating agencies.

The folly of such practice became evident in the US Banking Crisis of 1932-1933 when commercial banks were forced to liquidate their investments in order to meet the demands of panic-stricken depositors. They discovered that many of the securities in their portfolios were completely unmarketable or could be disposed off only at prices below the original cost.

As a result of abuses stemming from the combination of investment and commercial banking under the same roof, reform legislation was quickly enacted to separate the two functions. The Banking Act of 1933 stripped commercial banks of the power to underwrite new security issues. They were permitted, however, to continue to act as wholesalers and retailers of federal, state and municipal bonds.

However, the proposed UK’s Independent Banking Commission definition of “Ring-Fencing” that is separating the retail banking arm from the investment banking arm of "universal banks" like HSBC for example is rather draconian in comparison to the Banking Act of 1933 - as in ring-fencing will end commercial bank’s permission to continue to act as wholesalers and retailers of federal, state, county and municipal bonds. Given that most banks are “Universal Banks” – that is they are virtually composed of a commercial arm and an investment arm – like HSBC for example, will these result in universal banks fleeing the UK’s rather draconian banking regulation? After all, many universal banks have already complained that the practice of ring-fencing could render their daily banking operations rather unprofitable. Will this eventually result in a rather "uncomfortable" revolutionary upheaval in the global banking industry?