OREANDA-NEWS. June 17, 2015. The implementation of bank ring-fencing in the UK continues a trend of dilution and flexibility by granting additional, albeit minor, concessions to the banks and remaining silent on the important subject of intra-group limits, says Fitch Ratings. The Prudential Regulation Authority's (PRA) concessions in their end-May statement follow earlier watering-down of proposed rules for ring-fenced banks (RFB) by the UK government, which allowed more activities to be included within the ring-fence.

Fitch believes that only six of the largest UK retail banks will be subject to the ring-fencing rules, and of these only HSBC and Barclays are likely to have significant operations outside the ring-fence. Ultimately, the strength of the ring-fence will have rating implications for the entities within UK banking groups.

The PRA's statement and near-final rules show that it is staying with the overall approach outlined in the October 2014 consultation. However, by clarifying that certain key aspects will be reviewed on a case-by-case basis and reminding the banks that it is possible to request waivers and modifications, the PRA has introduced additional flexibility. Banks may still have some room for manoeuvre because final rules will not be published until 3Q15 and banks will have until 2019 to comply.

Core issues such as the 'large exposures limit' on intra-group exposures between an RFB and the rest of its group and intra-group dividends are still open. UK banks argue that they need clarity to plan for future group treasury management and capital allocation. Under EU rules, the PRA could elect to limit large exposures to 10% of a RFB's capital. We believe this tight limit would strengthen the ring-fencing and protect RFBs from riskier group activities.

Banks requested clarification about what types of subsidiaries can and cannot be owned by an RFB. A prescriptive list of permitted activities will not be published by the PRA, rather banks will have the opportunity to discuss subsidiary business lines with it on a case-specific basis. This could result in a broader range of permitted activities for RFBs, helping to diversify revenues and simplify operational functions, but also widen the net to include higher-risk business lines.

HSBC indicated recently that it intends to widen the scope of activities included in its RFB. The over-riding guideline is that a subsidiary should not expose the RFB to any risk affecting its ability to provide core activities in the UK. The relative size of subsidiaries will also be considered by the PRA under its 'proportional' approach, especially if these are undertaking activities largely unrelated to the RFB's line of business.

RFBs must be able to take decisions independently and guidelines for board membership, risk management and internal audit arrangements aim to achieve this. Banks queried some of the board cross-membership restrictions and the PRA clarified that board membership rules do not apply to RFB sub-groups. This will make it easier for RFBs to fill the boards of their ring-fenced subsidiaries and affiliates.

Under its proportionality approach, the PRA can consider further waivers to governance arrangements, especially if compliance with the rules proves to be overly burdensome. Lloyds Banking Group is seeking a waiver on the requirement for its RFB, which will make up around 90% of the group, to have a different board of directors to that of its group. The PRA also clarified that RFBs are not prevented from relying on group services from other group entities, which is important if RFBs are to contain costs.

In our view, RFBs will still face some governance conflicts. The rules allow for some board members to be group employees, hold director positions in other group companies and independents can have occupied group positions subject to some restrictions. All board members can receive part of their remuneration in the form of listed shares in a group company. The practical implementation of governance rules will be important to ensure that the right balance is struck between achieving synergies between the RFB and the rest of its group and limiting the direct exposure, both financial and otherwise, to improve the resolvability of the group.

Fitch's prior comments on rating implications for RFBs are available by clicking on the Related Research link.