Envisaged in the wake of the financial crisis, ring-fencing reforms will tie up banks and legal advisers for years. Legal Business asks if the process is on track
Experienced financial regulation partner Bob Penn, who moved to Cleary Gottlieb Steen & Hamilton last year and advised HSBC on the controversial bank ring-fencing reforms while at Allen & Overy (A&O), is clear on whether those reforms are fit for purpose. ‘This is a hugely unwelcome and disruptive process, and frankly yet another distraction from running a profitable bank at a time when they are already facing a cascade of regulatory reform and the prospect of Brexit.’
He is not alone. Although the January 2019 deadline for implementation is still two years away, the bank reforms have already increased anxiety levels among the City’s regulatory and transactional lawyers. While many feel the balance between the complexity of the task and the time needed to complete it has not been struck, some are even questioning the relevance of implementing the reforms years after the global financial crisis.
‘This is most unwelcome from the point of view of running a business; it’s highly disruptive, extremely costly and ultimately makes banking less profitable,’ says Latham & Watkins partner Rob Moulton. Conversely, others criticise this view as betraying memories of the financial crisis and argue that with those losses in mind, it is easier to justify the current measures.
The process of putting the ring-fencing reforms into action, which will see retail banking separated from riskier investment bank activity, is now being pushed vigorously by the Prudential Regulation Authority (PRA). City partners tell Legal Business that the reforms have reached an operational phase and according to Norton Rose Fulbright (NRF) global head of financial services Jonathan Herbst, who advises HSBC, banks are now deploying ‘huge amounts of resources into the appointment of experts and their relationship with the regulator. The process is now ramping up, exactly as expected’.
The most recent PRA consultation opened on 11 October, three months after the last statutory instrument was introduced in July. The upshot is clear: banks should now have finalised their ring-fencing strategies and implementation should be under way. Partners say most banks will be expected to have begun complying with the new regime by next autumn and have engaged in the two-stage court process by which they will move deposits from one part of the bank to the other. With three to six months between the preliminary and final hearings, and an accountancy report due in the interim, most banks hope to complete the transfer by around spring to mid-summer 2018.
‘Maybe we should give ourselves more time. Two years is not long enough for this sort of exercise and the complexity involved.’
Khasruz Zaman,
Simmons & Simmons
But some partners argue that the intent is far removed from the reality. Simmons & Simmons partner and former Barclays M&A chief Khasruz Zaman says: ‘Maybe we should give ourselves more time and defer the implementation. Two years is still not long enough for this sort of exercise and the complexity involved.’
‘Microsurgery’
In 2011 the UK’s Independent Commission on Banking, chaired by Sir John Vickers, delivered a decisive verdict: following the banking crisis, according to UK Financial Investments, taxpayers spent more than £65bn bailing out Lloyds Banking Group and The Royal Bank of Scotland (RBS) and so any damage of this kind to the banking system had to be contained in the future.
Today’s ring-fencing reforms were the result of Vickers’ report, requiring the separation of the retail banking activities of UK banks (both in the UK and EEA) into a legally distinct, operationally and economically separate entity unable to undertake any of the ‘casino’ activities associated with investment banking.
The affected banks, which each had to have balance sheets of more than £25bn, have had to engage a range of top-tier legal advisers in the City to carry out the intricate work. Barclays instructed Slaughter and May, while HSBC chose A&O and NRF. Among the lenders with smaller investment banking operations, Lloyds and RBS are both advised by Linklaters, while Santander UK instructed Slaughters. There is also work being carried out for smaller banks like TSB by Herbert Smith Freehills (HSF), as its projected growth means it would exceed the threshold by January 2019.
While a majority of partners say that banks are now advanced in scoping out which parts of their business will fall within the ring-fence, some argue the distinction is not that simple. According to Linklaters banking partner Benedict James, who advises RBS: ‘At each end of the spectrum it is obviously easy to put activities into each category but, like all perimeter issues, drawing a line can raise difficulties with definition and cause apparent artificial distinctions.’
‘Less paralysis than expected’: Brexit and the financial markets
Following the recent postponement of the O2 IPO and abandonment of the Misys float as a result of the devaluation of sterling and fears of a hard Brexit, investor sentiment is currently still fragile. However, overall spirits are noticeably higher than they were in the summer, when Legal Business canvassed partners in the immediate aftermath of the referendum vote on 23 June.
Unsurprisingly the biggest concern remains single market access post-Brexit and the loss of the passporting rights on which financial services rely so heavily.
‘I am pretty negative on the long-term prospects after Brexit, as I cannot foresee a circumstance where the City manages to retain existing passports; the equivalent regime is far from fully developed and it’s all an entirely political process anyway,’ says Rob Moulton, a financial regulation partner at Latham & Watkins.
Dentons finreg partner Michael Wainwright agrees that there will be considerable challenges for financial services, including ‘the loss of the access to the single market that is so massively facilitated by the passporting regimes; the firms that relied on that convenience need to think in new ways about how they manage cross-border business’.
Not everyone is as pessimistic. Shearman & Sterling’s Barney Reynolds says: ‘If the UK moves to regulate in a more sophisticated and focused way, and away from the “regulation for the sake of regulation” approach of the EU, I’m very optimistic’; while Simmons & Simmons insurance partner Pollyanna Deane argues: ‘The insurance and reinsurance markets are renowned for their adaptability, long-term foresight and ability to innovate – all very important skills to have as the consequences of Brexit play out.’
The majority of partners who responded conceded they anticipated more post-vote disruption than has so far materialised. Freshfields Bruckhaus Deringer global head of finance, Simon Johnson, says: ‘The European capital markets have been remarkably resilient. We’ve acted on several large-scale M&A deals and financings across the credit spectrum from investment grade to high yield, and since the vote some investors see opportunity in the uncertainty.’
Echoing the sentiment, Kirkland & Ellis finance partner Michael Steele adds: ‘In some ways, I expected a bit more paralysis than what we’ve seen.’
Risk and opportunity
While many refer to the overall negative impact of Brexit that will make it harder for regulated financial institutions to operate across borders, Reed Smith structured finance partner Nick Stainthorpe points out ‘the reducing competition and raising yields may create new opportunities for alternative capital providers and structured finance solutions’.
And, adding to the opportunities list, Bob Penn of Cleary Gottlieb Steen & Hamilton also stresses that Brexit will drive plenty of regulatory work. ‘In the short to medium term, there will be plenty of work assisting on strategies for continuing to access the EU after Brexit. Longer term, much will depend on the settlement and reaction from the UK government, but I expect to see continuing opportunities as the UK diverges from the European rulebook.’
And that feeling is matched by Simmons partner James Bresslaw, who says in the longer term, and from the perspective of a finance lawyer operating in the private debt market, he is optimistic. ‘Lending in the UK remains an unregulated activity unless it is mortgage, consumer or peer-to-peer lending and so passporting issues may not necessarily be so significant for corporate lending.’
There is broad agreement that certain products and services that rely on passporting into the EU are likely to move to other financial centres, especially if there’s a hard Brexit, but it is unlikely to end up exclusively in an alternative market such as Frankfurt or Paris. While Brexit is seen as weakening London’s position as the financial hub of Europe, the belief that other European cities are a long way behind London persists.
As Slaughter and May’s Jan Putnis comments: ‘What the City arguably has in greater amounts than other European financial centres is ingenuity and a survival instinct. It has faced many challenges before and this is another one. For now it has the people and the instincts to find solutions to tough problems. That’s what many bankers and lawyers in the City do for a living.’
And while the migration of certain products and services to Europe will lead to more expensive operational costs for UK businesses, partners remain confident that the City and English law will remain pre-eminent. Ropes & Gray outgoing senior partner Maurice Allen says: ‘Brexit isn’t going to impact our finance law, it remains attractive, which is why I think English law will win out ultimately, even if you might be doing the deals in Frankfurt or Paris.’
Negotiation priorities
Asked to identify the key point of negotiation that the UK should look to deal with immediately if and when article 50 is eventually triggered, partners prioritise an orderly transition, avoiding a ‘cliff edge’ effect causing significant market disruption. ‘A commitment on both sides to solving continuity of law and enforcement of judgment issues should be a priority,’ comments Johnson.
However, on specific points of negotiation, there is also some disagreement on what is most relevant. According to Moulton, trying to get an in-principle determination of (future) equivalence at the very early stages of the negotiations is the most vital target. ‘That will be the sign that people need to realise that they don’t need to leave [London] and unlike other points of negotiation, it is achievable,’ he says.
However, Putnis disagrees, arguing determination of equivalence would be a very limited resource and would not cover the same range of services. ‘It can be withdrawn at short notice by the European Commission, so doesn’t really provide the basis for long-term investment in a business model. It also doesn’t cover any banking activity, including deposit-taking or lending.’
Overall, it seems that from the perspective of the financial markets lawyer in London, Brexit is still a tremendous opportunity in the short term. According to Moulton ‘everyone will need advice on how to structure themselves and what rules apply over how to use passports. But if the City is diminished in the medium term, then it may impact on the ability of people in London to provide advice in a pan-European capacity.’
Many City partners are still betting on economic pragmatism to triumph over political pressures. Not that 2016 has offered much support for that conclusion.
Meanwhile, Herbst notes: ‘The dynamic between the existence of separate legal entities and the need for a degree of inter-group servicing and co-operation is the main challenge. It’s how you balance those two things.’
The PRA has also proposed allowing ring-fenced banks to pay dividends to their parent groups, as long as the regulator is informed in advance and the payments will not harm the bank’s stability. However, lawyers at the coalface argue the process is particularly convoluted and further interference from the regulator is the last thing financial institutions need in the current environment.
Overall, the most substantial challenges for banks are practical rather than philosophical. Moulton argues they are ‘struggling in a fairly unseemly scramble’ to comprehend the extent of the resources needed to reorganise themselves. Logistical concerns, such as rebuilding IT systems and merging technologies, are seemingly posing the biggest headache.
‘This is effectively the reverse of combining legacy systems when two banks merge – getting them to operate separately is incredibly challenging,’ he says.
Penn agrees: ‘Demerging a bank is like microsurgery – it’s a difficult, time-consuming, resource-intensive process.’ Jan Putnis of Slaughters notes the process is imposing a significant layer of legal and compliance complexity on the banks affected. ‘This will continue to be the case after the banks complete their ring-fencing reorganisation,’ he says.
As each bank is affected differently by the reforms, partners agree that there cannot be a one-size-fits-all approach. However, some argue there is a disproportionate impact on the likes of Lloyds and RBS, which have negligible investment banking activities.
In the words of a partner close to the matter: ‘It’s a nuisance and fairly disproportionate that the smaller banks have to implement it. The point was to insulate deposits from banks’ casino activities. If you don’t have that, what are you ring-fencing from? On the high street, Lloyds and Barclays look like similar banks but Lloyds now does very little investment banking, so while Barclays is splitting itself in two, Lloyds is splitting into 99% and 1%.’
Current assessments by legal advisers put HSBC as arguably the best prepared in terms of having its teams of external counsel in place, while Barclays has the toughest challenge, given its European exposure and size of its investment arm.
‘Barclays definitely has the biggest problem with branches across Europe and it doesn’t have the infrastructure to deal with Brexit,’ argues one financial services expert.
Cost v benefit
Aside from the firms that have helped banks devise their ring-fencing strategies, there are also roles up for grabs for other external advisers as the process moves to the implementation phase. Banks are now employing a series of other firms in so-called ‘third spot’ positions, which are stepping in either through existing panel appointments or have been newly engaged.
‘The relevant [banks] have appointed a key adviser to look at the strategic piece, and are now employing other firms to help with the different aspects of the implementation process,’ says Pinsent Masons head of financial products and payments, Tony Anderson.
Within firms themselves the extent of involvement is diversifying, with corporate and regulatory financial services partners taking the lead roles and, as one partner comments: ‘You probably have pretty much any other specialist team involved, such as tax, employment and pensions considerations, depending on whether you are moving people around or not.’
Whether this work can attract significant fees, or whether it has to be done as a value-add to allow firms to strategically deepen their relationships with the banks, is unclear. One partner describes it as ‘an important regime, which will continue to apply in different parts of the banks, and influence the way these will do M&A in the future’. But does it present an opportunity for the firms, or just an extra burden for those not at the forefront of the process?
According to one City partner: ‘It’s an extra consideration that we need to take into account when doing work for banks. If you are doing work for a bank within that timeframe, you have to think whether there is a ring-fencing angle to it.’
‘It will be very expensive to implement, and will redefine the way British banking is carried on for generations, in the same way the Glass-Steagall Act changed American banking,’ adds James.
In October 2015 the Bank of England released two consultation papers estimating up to £3.3bn in one-off costs for each bank for the restructuring, while in Q3 2015 Barclays reported that it foresaw spending £1bn implementing the ring-fencing rules, including the cost for the first time in its financial results. HSBC told the House of Lords Economic Affairs Committee in June 2015 that it is facing a bill of around £1.5bn to £2bn after announcing it will base its ring-fenced retail bank in Birmingham, shifting at least 1,000 staff out of London. The ring-fenced operation constitutes between 30% and 40% of HSBC’s business.
Various City partners estimate legal costs to run into the tens of millions per major bank affected. While figures released by banks refer to the overall cost of ring-fencing, it is commonly understood that advisers’ fees and internal management time will be a significant part of that cost.
‘The penny may drop that by crippling the UK investment banks through ring-fencing the government might be exacerbating the problems UK plc will face as a result of Brexit.’
Bob Penn, Cleary Gottlieb
Britain’s largest retail bank, Lloyds, told the committee that it would cost the bank ‘several hundred million’ to set up the ring-fenced bank, alongside annual ongoing costs in the ‘tens of millions of pounds’, despite 97% of its operations sitting within the ring-fence. Therefore, some City law firm partners continue to question whether other structural reforms already underway within banks, such as more stringent capital and liquidity requirements, have made the need for ring-fencing redundant. In addition, others note the irony that when these measures were envisaged, the UK’s domestic banks were involved in a wide range of risk-laden financing activities, and many have now withdrawn from these markets, rendering reform irrelevant.
‘Ring-fencing suddenly becomes much less relevant, and it just makes UK banks unable to compete with those outside of the UK,’ argues Moulton.
And other partners tell Legal Business that perhaps it is worth pausing and evaluating whether the basis of implementing ring-fencing justifies the cost and the upheaval it will involve anymore. Shearman & Sterling head of global financial institutions Barney Reynolds says: ‘It will be important to ensure systemic risk and taxpayer liability for “too big to fail” instances are dealt with, but there are other ways than ring-fencing to achieve that and matters could be examined afresh.’
However, Herbst is not convinced there is a best solution. ‘Projects like these are large and time-consuming, and we have to make the right approach to them pragmatically,’ he says.
While it is seemingly hard to find an upside, some suggest banks can use this as an opportunity to look at the operations of their business more closely and, through this process, external advisers can strengthen their relationships with them.
‘There are banks who see this as an opportunity to modernise their offering, and to go forward with an independent management who can, within overall capital limits set at group level, find new and innovative ways of offering banking services,’ says Putnis.
In tandem
Aside from the obvious logistical impact of running ring-fencing reforms and Brexit simultaneously, if the government triggers article 50 next spring, the loss of the EU passport system seems to unsurprisingly be the main concern for City partners, followed by the banks’ reliance on the single market (see box, ‘Less paralysis than expected’, above). The focus now seems to be on working out ways of going ahead with ring-fencing while maintaining those relationships with Europe.
‘Brexit will change what ring-fencing looks like. The UK may have more freedom in terms of banking reform and may not be so tied to EU requirements.’
Tony Anderson, Pinsent Masons
‘Outside the structure of the European passport, Brexit might provide an opportunity to rethink ring-fencing,’ argues Reynolds, while Anderson says: ‘I don’t think that the reforms will be scrapped as a result of Brexit, but it will change what ring-fencing looks like. For example, the UK may have more freedom in terms of its implementation of banking reform and may not be so tied to EU requirements.’
Financial services partners are also looking closely at Scotland and the risk of another independence referendum. If Scotland were to separate and remain in the EU, that would require some further restructuring of banks’ UK businesses part-way through the implementation of ring-fencing reforms.
‘Brexit requires another large reorganisation and that’s certainly unhelpful, but the Scottish exit is probably more dangerous to UK banks than Brexit itself,’ says one partner.
Penn concludes: ‘At some point the penny may drop with the government that by crippling the UK investment banks through ring-fencing they might be exacerbating the problems UK plc will face as a result of Brexit.’
But aside from all the uncertainty that surrounds the ring-fencing reforms and the criticism that the aims envisaged by the Vickers report no longer apply five years on, banks and their advisers are now at the stage where procrastination over how to meet those aims strategically is no longer viable. Whether it is the right time and the right circumstances to make wholesale changes or not, it is now time to get on with implementation. Recent financial regulatory hires between major players only confirm the importance of these reforms and their future impact on law firms. Last year, Gregg Beechey moved from King & Wood Mallesons to Fried, Frank, Harris, Shriver & Jacobson, while Penn moved to Cleary Gottlieb in April this year after 17 years at A&O. More recently, Moulton and Nicola Higgs left Ashurst for Latham, while A&O announced last month that it has hired Nick Bradbury from HSF.
Demand for senior banking regulation lawyers in the City is greater than it has ever been. The risk business is booming. LB
georgiana.tudor@legalease.co.uk