What Does Ring-Fence Mean?
The term ring-fence refers to the creation of a virtual barrier that segregates a portion of a company's financial assets from the rest. This may be done to reserve money for a specific purpose, to reduce taxes on the individual or company, or to protect the assets from losses incurred by riskier operations. Moving a portion of assets offshore to reduce an investor's net worth or lower the taxes due on income is one example of ring-fencing.
Key Takeaways
- A ring-fence is a protective move in finance that segregates some of a company's assets from others.
- Offshore banking is sometimes referred to as ring-fencing assets.
- Ring-fencing can protect a portion of assets from some risks.
Understanding Ring-Fences
The term has its origins in the ring-fences that are built to keep farm animals in and predators out. In financial accounting, it is used to describe a number of strategies that are employed to protect a portion of assets from being mixed with the rest.
Ring-fencing may involve transferring a portion of assets from one high-tax jurisdiction to another with lower or no taxes or less onerous regulations. In other cases, it may be used to keep the money in reserve for a specific purpose. It also may be done to make the money unavailable for another purpose.
This is the intent of the British ring-fencing law, which went into effect at the beginning of 2019. It requires financial institutions to ring-fence their consumer banking activities to protect customer bank deposits from potential investment banking losses. The institutions were forced to recreate their banking arms as separate entities, each with its own board.
The law intends to forestall another bank bailout like the one that followed the 2008 financial crisis. The government bailout was forced by the perceived vulnerability of ordinary consumers and their savings to a collapse of the big banking institutions.
Britain passed a law at the start of 2019 that requires financial institutions to ring-fence their everyday banking activities from their investment arms. Ring-fencing kicks in for banks that have more than £25 billion in core deposits.
Advantages and Disadvantages of Ring-Fencing
Advantages
One of the primary benefits of using ring-fencing as a strategy is that it provides a layer of protection over certain business assets. It protects these assets from market risk, volatility, taxation, insolvency, and even seizures.
This strategy also helps keep the financial system sound and helps provide banks with a safety net. That's because core assets are shielded from non-core ones to prevent any major ripple effect when the economy tanks as it did before the Great Recession. This puts less of an onus on taxpayers if banks succumb to economic pressure in the future the same way they did when the government had to bail them out after the financial crisis.
Disadvantages
The premise behind ring-fencing is that it separates core assets, such as retail banking, from those that are deemed to be non-core assets like investment arms. The problem with this is that separating groups of assets may lead to a reduction in oversight and the weakening of risk management.
Banks and other organizations that are required to ring-fence may take advantage of the fact that they must separate their assets, which could lead to a beneficial end goal. This includes more favorable tax treatment if they move their non-core assets offshore, which could lead to a drop in tax revenue for the home country.
Pros
Protects against certain risks
Leads to a safer and secure financial system
Cons
Reduces oversight and weakens risk management
Moving certain assets offshore may lead to drop in tax revenue
Offshore Ring-Fencing
The term is often used in the U.S. to describe the transfer of assets from one jurisdiction to another, usually offshore, in order to reduce an investor's verifiable income or reduce the investor's tax bill. It also may be used to shield some assets from seizure by debtors.
It may be legal to ring-fence assets to reduce taxation or avoid regulation as long as it stays within the limits set in the laws and regulations of the home country. The limit typically is a certain percentage of the annual net worth of the business or individual, meaning that the dollar amount will vary over time.
Ring-fencing can also describe earmarking assets for a particular purpose. For example, a savings account may be ring-fenced for retirement. A company may ring-fence its pension fund to protect it from being drained for other business expenditures.
What Is the Objective of Ring-Fencing?
The primary goal of ring-fencing is to separate one group of assets from another. This is generally done to keep core assets protected from volatility and other risks. Ring-fencing is common with banks when core retail banking segments are separated from their investment arms if they are deemed "too big to fail." This layer of protection shields the taxpayer (and the government) from bearing the financial burden of bailing out banks in the event of an economic crisis.
Why Was Ring-Fencing Introduced in the United Kingdom?
Ring-fencing was introduced by the British government in January 2019. The goal is to strengthen the country's banking and financial system by requiring banks to divide their core retail banking from other divisions, such as international and investment activities. Doing this helps protect the retail banking sector from the bank's riskier ventures.
What Is the British Government's Threshold for Ring-Fencing?
The British government introduced a £25 billion threshold on core deposits when it implemented the ring-fencing rule in January 2019. This means that eligible banks must ring-fence assets above this limit as of 2023. This threshold could be raised to £35 billion as the government is reviewing proposals to further strengthen the country's banking and financial sector.
The Bottom Line
Risky investment ventures and a lack of oversight led to major losses, failing banks, and bailouts during the financial crisis, which in turn led to a years-long recession in many countries. That's why ring-fencing was introduced in countries like the United Kingdom. In countries that require ring-fencing, it aims to protect the core retail function of banks, which is deemed an essential part of the financial industry. It also helps shield taxpayers from the heavy burden of having to bail out banks in the event of an economic crisis.
