Disputes and litigation risk in bank ring-fencing

Out-Law Guide | 18 Dec 2013 | 4:12 pm | 3 min. read

This is one of a  series of guides  on issues connected to ring-fencing and banking reform faced by banks. Other guides cover issues such as tax, real estate, employment, pensions, third party contracts and competition considerations.

This guide was last updated in December 2013

The separation of retail banks from the wider group gives rise to some risks for large existing banking entities, and for the separate ring-fenced and non ring-fenced banks.

The areas with potential for disputes can broadly be characterised as follows:


Bargaining power

Like all key purchasers to a market banks have historically been able to use their size and their financial significance to their business partners as a means of brokering favourable deals, and, in many cases, this also acts as a disincentive for the other party to insist upon strict contractual rights in the event of a dispute. Whilst ring-fenced banks will remain significant businesses, their operational independence may dilute this effect somewhat.

Supplier disputes

The Group has to ensure that its arrangements with suppliers will allow the ring-fenced bank to have continuous access to operations, staff, data and services in order to continue its activities, regardless of the financial state of the Group. The principle is one of operational independence.

This is going to create a period of contractual chaos. The transfer or novation of existing third party supply agreements, or their necessary renegotiation affords suppliers a renegotiation opportunity, and if negotiations stumble or fail then parties inevitably look for the leverage of prior breaches as a justification for termination. Prudent banks will be reserving their rights now.

Customer complaints

Recent thematic litigation and regulatory enforcement action has consistently highlighted specific failings in systems and controls (SYSC) which have allowed bank activities to stray inadvertently into activity that was not permitted. Examples include much-publicised mis-selling 'scandals' linked to PPI or interest rate hedging products.

For a ring-fenced bank there are SYSC challenges associated with 'excluded activities', which might be tested most at the point where activities are exempted from that definition. For example, it is not currently known for certain how 'simple derivatives' or trade finance will be treated (Article 6 of the (currently draft) Excluded Activities and Prohibitions Order).

One thing is for certain: any failing will inevitably prompt action by claims management companies and consumer law firms to bring group claims against the relevant bank, and given the prohibitions, such claims may be difficult to resist.

Bank-on-bank?

The Vickers Report emphasised that ring-fenced banks should only be allowed to enter into transactions with affiliates on an arm's length basis "in line with sound and appropriate risk management practices".

However, such an approach only bites if there is a corresponding willingness to enforce contractual rights in a similarly commercial way. Will one bank in a group really sue another? It might seem outlandish and the assumption must be that they will not, but a question mark would remain over whether a failure to do so could lead regulators to conclude that such arrangements are not truly arm's length.

The relationship between litigation and regulation will be fundamental. If bank-on-bank litigation were to become a reality, financial institutions may need to consider whether the group and the ring-fenced entity need separate legal panels.

Corporate crime

Times of immense change inevitably bring opportunity for the white-collar criminal. The transfer of new customers from one part of the business to another creates opportunities for the would-be fraudster and appropriate vigilance and due diligence will be required from compliance functions.

It seems entirely plausible that there will be a period of 'contractual chaos' as ring fenced entities renegotiate agreements with third party suppliers or enter into new arrangements. All of these arrangements, suppliers – and in some cases the procurement processes themselves - will require appropriate due diligence.

At a structural level, the requirement to separate functions out of the group business will mean the implementation of separate corporate governance arrangements. Failing to take action to ensure appropriate systems and controls are in place can result significant fines for the bank - and enforcement action against employees and officers.

The Parliamentary Commission on Banking Standards has recommended the development of a dedicated risk committee, and a suitably empowered and independent chief risk officer role, in 'new' institutions. Whether or not this proposal is enshrined in law remains to be seen, but it may be wise to assume that this model will become considered best practice at the least.

Irrespective of this, autonomous and robust compliance functions will need to be established and tasked with the implementation of comprehensive anti-corruption and anti-money laundering systems and controls. Overarching group policies that previously applied may need to be reviewed in light of the specific business of the ring fenced bank.

The customer impact

Claims management companies, the media and politicians will doubtless seek to capitalise on any failing in process or practice that affords an opportunity for 'bank bashing' and disputes. Systems and controls breaches are, in some senses, an easy target and yet such claims represent a risk which is equally straightforward to mitigate.