The unintended consequences of ring-fencing

Rules aimed at protecting UK depositors may be putting too much froth into the credit market

The UK’s ring-fencing rules were designed to protect the banking system from threats originating overseas. They may instead be fuelling a domestic credit bubble.

Rules that came into effect in 2019 require UK banks to separate their domestic retail businesses from their wholesale and investment banking activities. The goal was to insulate core banking services, such as deposit-taking, from the effects of a future global financial crisis. An independent panel appointed by the UK Treasury is now reviewing the rules, with an eye on whether they have hurt the competitiveness of UK banks in global markets.

Banks say they have – by depriving their international arms of access to deposit funding. There is some truth to this. The global arms of UK banks saw the share of deposits in their overall funding mix fall by 45 percentage points after ring-fencing was introduced, according to a study published in November 2020 by the Bank of England. But UK banks have been able to easily replace those lost deposits with cheap wholesale funding, which continues to be available in abundance at abnormally low rates. Banks such as Barclays and RBS may have underperformed compared with their US rivals over the past decade, but the UK banking sector still boasts more cross-border business than any other country.

The bigger problem may be closer to home. UK banks have used their ring-fenced deposits to increase mortgage lending, perhaps excessively. The BoE’s study found that a 22-percentage-point increase in deposit funding available to retail banking units as a result of ring-fencing was associated with a 20-basis-point reduction in mortgage rates and a 3.3-percentage-point increase in banks’ holdings of mortgage products.

The availability of cheap mortgages, coupled with a temporary tax cut for homebuyers that expired in July, has caused the UK property market to heat up rapidly. Nationwide’s UK house price index rose 13.4% in the 12 months to June – the fastest annual growth rate since 2004. According to data from the BoE, UK banks advanced £83.3 billion ($115.4 billion) in mortgage loans in the first quarter of 2021 – the highest level since 2007 and a 26.5% increase on the year before. The BoE’s chief economist, Andy Haldane, warned in June that the UK housing market was “on fire”.

When a market starts to look like a bubble, the risk grows of a dangerous pop. A housing crash could pose a serious threat to the UK’s financial stability. The BoE’s study shows that ring-fencing has contributed to increasing concentration and risk-taking in the mortgage market. The top six lenders accounted for over 70% of the market in 2020. Some smaller lenders have thrown in the towel – Tesco Bank pulled out of mortgage lending in 2019. Others are tilting their portfolios towards riskier loans, which could be badly exposed to a drop in house prices.

Loosening the ring-fencing rules could help douse some of the flames in the UK housing market. The country’s largest banks would be free to redeploy some of their deposit funding in international markets, diversifying their exposures across a wider range of products and geographies. A full dismantling of the ring-fencing regime appears unlikely, however, especially following the collapse of Archegos Capital Management in March 2021, which left global investment banks with huge losses. But even a modest relaxation of the rules could lower financial stability risks in the UK and boost the competitiveness of the banking sector, both domestically and internationally.

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