Ring-fencing in financial networks

The Prudential Regulation Authority, PRA, has published a new working paper titled „Ring-fencing in financial networks“ in which it presents the findings from an analysis of the impact of ring-fencing on systemic risk in the UK banking system, particularly on the risk of solvency contagion among banking institutions. Ring-fencing was brought about by the Financial Services (Banking Reform) Act 2013 in an effort to reduce systemic risk of large banking organizations. It requires large banks to separate their retail banking services from other activities of the group, such as investment banking.
Specifically, the paper looked into the risks of ring-fenced institutions (RFBs) and non-ring-fenced institutions (nRFBs) and the impacts of ring-fencing on banking institutions‘ balance sheets and the balance sheet of the industry as a whole. It shall be noted in this context that risks for banks‘ balance sheets primarily come from two sources: external assets (investments in the real economy) and interbank assets (investments in other banks). Implementing ring-fencing insulates RFBs from risks arising from interbank assets, leaving them exposed only to risks from external assets.
What the analysis found is that the shift towards ring-fencing makes RFBs safer, with less assets allocated to external investments. On the other hand, such practice makes nRFBs riskier which may lead to a reduction of interbank assets, a reduction of exposures to external asset risks, the raising of additional capital for resilience, or the re-allocation of assets from RFBs to nRFBs. Such actions – in turn – may then lead to a reduction of overall equity of individual banking groups and the aggregate equity of the banking system due to the fact that other nRFBs are exposed to the nRFB, lowering their assets accordingly. Furthermore, a shift of external assets from RFBs to nRFBs would additionally increase the leverage of RFBs, again making them riskier with a greater chance of default.
In the end, the analysis shows the complex nature of risk allocation in the context of ring-fencing and of the interconnection of the banking system and the impacts of such upon the assets of the entire industry.