The creation of ring-fenced and non-ring-fenced banks in the UK as proposed by the Independent Commission on Banking is likely to lead to increased issuance of secured debt by non-ring-fenced entities, according to Fitch.

The rating agency today (Wednesday) said that the ICB’s proposed rules mean that banks’ increased use of secured debt in volatile markets will persist beyond the crisis, and that unsecured funding will “find it hard to regain widespread support” and will comprise a smaller proportion of a bank’s funding than before the crisis.

A ring-fenced bank is highly likely to issue structured finance debt in order to fund mortgages or loans that it elects to put in the ring-fenced bank, said Fitch, while non-ring-fenced banks – in the absence of a wholesale funding limit and potential state support – could increase their use of secured funding to lower borrowing costs.

“The introduction of depositor preference for ring-fenced banks will also play a big role in changing the funding mix,” said Gerry Rawcliffe, managing director, Fitch financial institutions group. “Effective subordination for senior unsecured creditors will push banks towards doing as much secured funding as they are allowed.”

It will also be appealing to non-ring-fenced banks to resort to secured funding, added the rating agency, because of the existence of a developed market for covered bonds and traditional structured finance, such as credit card receivables and residential mortgage backed securities.

Ian Linnel, group managing director and global head of structured finance and covered bonds at Fitch, said the rating agency expects structured finance and covered bonds to play a much larger role at non-ring-fenced banks, where “the most dramatic change” will occur.

The ICB, chaired by John Vickers, on 12 September released a final report setting out recommendations on reforms of the UK banking sector, including the separation of retail banking and wholesale/investment banking.

Fitch said that there will be a regulatory cap on the amount of wholesale debt a ring-fenced bank can issue, but that this is not stipulated in the ICB report.

Royal Bank of Scotland analysts said that the most interesting question for covered bonds stemming from the report is: “Where do covered bonds end up?”

They noted that UK banks have good reasons to include residential mortgage loans in the ring-fenced retail banks, but that the funding advantage provided by secured funding would be higher in the non-ring-fenced entity.

It may also be possible to issue covered bonds out of the ring-fenced and non-ring-fenced parts of the bank, they said, which would require two separate cover pools.

“At this stage it is not clear if these covered bonds will be ring-fenced and we would not be surprised if the various UK issuers treat covered bonds differently reflecting their diverse business models,” they added.

Moody’s and Standard & Poor’s last Wednesday (14 September) commented on the ICB proposals, with Moody’s stating that if implemented in their prevailing form they would likely have credit negative implications for bondholders of the largest UK banks.

This was because of the introduction of enhanced resolution powers, such as the ability to bail-in senior unsecured creditors, and higher funding and operating costs, according to the rating agency.

However, it said that high capital requirements set out in the proposals and a simpler structure imposed on ring-fenced entities are credit positive and could mitigate some of the negative credit impact, at least for ring-fenced entities.

Moody’s also noted that the proposals will lead it to reduce the systemic support it incorporates in its senior debt ratings of the ring-fenced and non-ring-fenced banks.

S&P said if the ICB’s recommendations are implemented exactly as proposed it would expect to assign lower ratings to entities that are not ring-fenced on account of reduced government support and lower quality funding.

It noted that Barclays Bank, Royal Bank of Scotland and HSBC are the institutions that will be most affected by the ring-fencing proposals because “these banks have major UK businesses that would be divided either side of the ring-fence”.