The big question about a ring-fenced retail bank

My sense talking to bank bosses recently was that they retained a faint residual hope that the government would not force them to put a ring-fence around their retail banking operations in order to insulate them from their respective investment banks.

Such a hope has been dashed by the recent statement given by the Business Secretary Vince Cable to the FT, that he is not persuaded ring-fencing would be adequate: he remains to be persuaded that a formal dismantling of the giant universal banks, Barclays, Royal Bank of Scotland and HSBC, would not be preferable.

Which means the Lib Dem wing of the coalition will provide no wiggle room to the chancellor, George Osborne, to back away from his commitment made just a few weeks ago to implement a retail ring-fence, to put a firewall between retail banking and investment banking.

But that is the beginning of a debate, not the end of the discussion.

Radical makeover

Because the Independent Commission on Banking, set up by Mr Osborne and which came up with then ring-fence plan, will not define which bits of a universal bank would go into the new insulated retail bank until 12 September.

Strikingly, even if most of the banks are agreed they would prefer there were no ring fence at all, they are implacably split on what kind of ring-fence would do least harm.

On the one hand, Lloyds and Santander - which do relatively little proper investment banking - would like retail banking to be defined as broadly as possible, so that they would avoid almost any structural reform.

Interestingly HSBC is more-or-less in their camp, largely because it operates on the basis of relatively little mingling between its investment banking and retail banking operations.

By contrast, Barclays and RBS would like the narrowest possible definition of retail banking, so that their investment banks continued to serve the largest possible number of customers.

The simple big point at issue is whether companies that have turnover of £20m a year or more should be permitted to put their money on deposit with a ring-fenced retail bank.

Barclays and RBS want a formal ban on retail banks being able to manage companies' cash - because they fear that businesses would tend to see retail banks as safest, and would tend to place their cash with them, thus depriving the important investment banking arms of RBS and Barclays of vital funds.

Barclays and RBS fear that if companies are not prohibited from placing cash with retail banks, their respective investment banks could whither.

But if retail banks were banned from taking corporate deposits, Lloyds and Santander would have to radically reconstruct themselves: individuals and small businesses would be served by one Lloyds subsidiary, for example, and bigger businesses would be served by another Lloyds operating subsidiary.

British ingenuity

To summarise: the upheaval for almost the entire British banking industry would be immense, if retail banking is defined narrowly, and would be restricted to Barclays and RBS (and to an extent HSBC), if retail banking is defined broadly.

So where will the banking commission end up on this question perceived as so material to the banks' respective futures?

Well my hunch would be that the commission will end up closer to the Lloyds/Santander/HSBC view of things.

Why is that?

Well, I think it stems from an internal contradiction in the arguments put forward by Barclays and RBS.

They always insist that there is nothing intrinsically riskier about investment banking over retail banking. And if they really believe that, then they should have no difficulty persuading companies to lend to their investment banks, in preference to depositing funds in the retail banks.

Some might also argue that there would be an infringement of basic liberties, if companies were restricted in where they can place their funds.

Such an infringement of their liberties might be justified, if the chancellor were to formally rule that retail banks are much more likely to be rescued by taxpayers than wholesale banks - because companies should invest their money on a caveat emptor basis, and should not benefit from taxpayer-provided insurance.

But George Osborne is never going to make that ordinance. In fact, his view is that the thrust of the ring-fencing reform is to make it easier for banks to be dismantled, or resolved, in a crisis, with the costs heaped on shareholders and creditors rather than taxpayers.

So the likelihood is that Barclays and Royal Bank of Scotland will face quite a challenge in having to run their investment banks as largely standalone entities.

But since Goldman Sachs appears to have run itself on that basis quite nicely for several generations, it cannot be beyond the ingenuity of our great British institutions.