The success of the UK government's plan to separate banks' deposit and investment businesses will depend on whether 'simple' derivatives are included in ring-fenced activity.
On Monday UK chancellor George Osborne unveiled the Banking Reform Bill, the government's plan to reform the banking sector in light of the financial crisis. The Bill is based on recommendations made by Sir John Vickers in the Vickers report unveiled last year, which included the separation of everyday banking activities from more volatile investment bank activities.
However, banks that have been lobbying to include the sale of interest rate swaps and other hedging products within the scope of everyday banking activity - a point the Vickers report advised against - appear to be gaining traction with policymakers.
Brussels-based public interest lobby group Finance Watch, which is composing a submission to the Independent Commission on Banking (ICB) this week, believes the current draft of the bill has avoided forming a clear position on derivatives. It added the inclusion of derivatives within ring-fenced activity would negate the initial aims of the legislation.
"We're concerned about the details surrounding derivatives trading because it is unclear how a ring-fenced entity would be affected if it is part of a group that contains derivatives or prop trading activities that default or run into financial trouble," a Finance Watch spokesperson said. "Also, it is not yet clear how far the legislation backs the ICB's initial objective of curtailing the provision of government guarantees for banking activities through the too-big-to-fail status."
In a report that accompanied the bill's introduction yesterday, the Treasury stated the details of the bill - including the treatment of derivatives - would be determined after it passes through both houses of the UK parliament. Osborne has indicated this process is likely to begin a year from now.
"There is a good case for placing technical detail in secondary rather than primary legislation, in particular because of the importance of 'future proofing' to allow a flexible response to developments in the banking sector," Treasury's report read.
If derivatives products are included within the ring-fence, the legislation may not eliminate the possibility that banks could be bailed out to protect deposit-taking business -a central aim of the Vickers report.
Guy Sears, director of wholesale at UK buy-side trade body the Investment Management Association, said excluding all derivatives from the ring-fence would strengthen the industry as a whole.
Sears cited the mis-selling of swaps products to SMEs by several UK banks in the lead-up to the financial crisis as a chief reason why such products should remain on the investment banking side of the fence.
"If the compensation related to the sale of derivatives to SMEs were borne on the deposit-taking side when there was stress on the whole financial system it may have led to the public bailing out these banks simply because they were doing the wrong thing," Sears said. "The industry needs this clear separation as an implicit guarantee from the state that they will not use public money to bail out investment banks."
The UK government plans to enact the banking reforms by 2015, will full implementation envisioned by 2019.
In terms of their practical implementation, market participants believe enforcement of the ring-fence will require adjustments to infrastructure that could prove costly.
Daniel Mayo, practice leader, global financial services technology for consultancy Ovum, said UK banks must seriously evaluate the system and process implications, in addition to legal structure and capital demands
"While the primary core banking systems that run these lines of business are typically quite separate, IT infrastructure and systems that support payments, risk management, finance and other back-office functions are often shared," Mayo said. "Banks will need to prove that the operational integrity of support functions can be maintained in the event of separation from commercial, governance and direct operation al perspectives."
The UK joins Germany and France as leading EU economies establishing national rules that protect the deposit-taking business of banks ahead of a decision to create Europe-wide changes based on findings from the Liikanen Group. In a report published last year, the group suggested ring-fencing banks' trading operations if trading assets exceed €100 billion or 15-25% of total assets. The European Commission will decide if recommendations put forward by the Liikanen Group will be used to enhance current rules or draft new proposals.