UK: PRA Puts Ring-Fencing In Industry's Court

Last Updated: 14 October 2014
Article by Clifford Smout and John Andrews

Most Read Contributor in UK, August 2017

The Prudential Regulation Authority's (PRA's) first consultation paper on UK bank ring-fencing puts the ball back in industry's court, holding back from extensive prescription in favour of an approach which gives banks some leeway to tailor solutions to their business models. In most areas there will not be a 'one size fits all' approach, and the onus will be on individual banks to demonstrate how their plans comply with legislation and the PRA's objectives.

The paper confirms the PRA's approach along a number of dimensions, though few components will strike seasoned ring-fence watchers as entirely new or unexpected. While the paper does not provide all the answers to the many open questions which remain, it does provide a set of parameters within which firms can undertake further work. The process of implementing ring-fencing will be evolutionary, and despite asking for preliminary plans to be submitted by the turn of the year, the PRA recognises that those plans may change as it provides further details of the regime.

PRA rules provide the third layer of detail designed to transform ring-fencing from high level policy to a practicable framework, following finalisation of the Banking Reform Act in December 2013 and several pieces of secondary legislation in summer 2014. Uncertainty about the PRA's stance on design-critical issues such as governance frameworks, sibling structures, and shared services had made further planning difficult, but some of that uncertainty has now been eliminated.

Given that many UK banks over the £25 billion deposit threshold have been engaged in some degree of planning over the last few years, the three month deadline to produce provisional plans should be manageable. But it will necessitate a transition in banks' planning from the exploration of options to the taking of decisions. These plans will need to include anticipated legal and operating structures, with provisional balance sheets and profit and loss statements, as well as clear project governance arrangements. And although January's submissions will be preliminary, the 1 January 2019 implementation deadline means that they cannot be preliminary for too much longer. The journey to ring-fencing will likely be long and arduous, but the PRA's new paper provides a firm push forward.

The paper should also be read in conjunction with the PRA's new discussion paper on operational continuity in resolution, although the focus of what follows is on ring-fencing.

Sibling structures

The PRA confirmed that banking groups subject to ring-fencing will be expected to operate a 'sibling' structure: ring-fenced banks (RFBs) will not be permitted to own entities which carry out excluded activities, and vice versa. Banks will therefore need at least two 'subgroups' – one with a RFB, and one with excluded activities – which would sit under a holding company.

Independent governance

At least half of a RFB's board, excluding the chair, must be independent non-executive directors (NEDs), while no more than one third of its board members may be current employees or directors of other group entities. Again, these are expected outcomes, but there are several new pieces of detail:

  • The chair of an RFB must be independent during his or her tenure as chair, and must not chair any entity elsewhere in the group;
  • An RFB executive board member would not be permitted to hold executive directorships at any entity in the group that carries out excluded activities;
  • An RFB executive director would still be able to hold executive positions in the parent entity;
  • An RFB must have its own risk, nomination, audit and remuneration non-executive board committees.

One particular area of interest to industry has been how board members of the RFB will manage their duties towards the RFB and their parallel duties under company law to their parent companies. This is a problem industry will have to solve on its own – the PRA says simply that RFBs must set out "arrangements to identify and manage" any such conflicts.

It is important to note that there may be some flexibility with respect to governance arrangements, depending on the relative size of the RFB in relation to its wider group. The PRA does not commit to granting waivers or modifications of the rules in any particular circumstances, but makes it clear it is open to applications for waivers or modifications in some situations. Some of the above requirements may create challenges for a number of banks subject to ring-fencing in the absence of such flexibility. These firms will want to gain clarity on the PRA's approach sooner rather than later.

Risk management and internal audit

An RFB must have sufficient risk management and internal audit resources "identifiable as dedicated to it". However, the intention "is notto restrict the cross-utilisation of resources", but rather to prevent dependencies from arising. Systems and resources could therefore be shared with other parts of the group, while risk and internal audit could still operate within the lines of group policies. However, RFBs will need their own heads of risk management and internal audit – these senior personnel cannot be shared, and will be prohibited from being in charge of those functions in any other group entity. This is clearly another area in which some firms will want to explore the PRA's openness to waivers and modifications.

The Chief Risk function and Head of Internal Audit are both Senior Management Functions under the PRA and FCA's new Senior Managers Regime (SMR). It is notable that the PRA has reflected on how ring-fencing interacts with the SMR, and proposes to introduce a new 'prescribed responsibility' for RFB Senior Managers making them responsible for ensuring compliance with ring-fencing in their area of the business. As with the SMR in general, this puts the onus squarely on the individuals in question to take reasonable steps to prevent breaches, and to make sure those steps are documented.

Continuity of shared services

The PRA's aim is not to sever all ties between ring-fenced and non-ring-fenced parts of the group – it is simply to make sure the RFB is not dependent on the fortunes of other group entities. And when it comes to the continuity of shared services, resolvability is the main driver, making the PRA's new discussion paper on operational continuity in resolution (published simultaneously with the ring-fencing consultation) essential reading.

The PRA is not looking to force banks to duplicate services such as data processing, IT, or back office functions, on each side of the ring-fence. This means that services and infrastructure can be shared across the group. However, an RFB may only receive shared services from an entity within its own subgroup, or from a "dedicated intragroup service entity" (also known as an 'OpSub'). An OpSub need not sit within the RFB's subgroup, so long as expectations for operational continuity in resolution can be met. In general, an RFB need not actually own and manage all the services which it requires, so long as the arrangements meet the general requirements of the regime, such as insulation from insolvency of other group entities.

Open questions

There are several issues which the PRA has left for future consultations. These include:

  • The framework for intragroup transactions and exposures, including for payments;
  • The size of the large exposure limit to be applied to the relationship between the ring-fenced and non-ring-fenced parts of the group – a range is being considered, of between 10% and 25% of the capital of the RFB;
  • The application of prudential requirements to an RFB's 'subgroup', where this subgroup contains other entities;
  • Disclosure and reporting requirements; and
  • Exemptions to the requirement that RFBs be direct participants in interbank payment systems.

The PRA did not specify how many more consultations will be issued in order to deal with these open issues, and nor did it set out timelines for providing the additional information.

This first CP is open for comment until 6 January 2015, which also serves as the deadline for submission of the preliminary plans, which the PRA says will be used "to help the PRA and FCA decide the approach to implementation." On that account, we might expect further details to begin emerging in spring next year.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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