Separation of retail banks 'will take years'

The Independent Banking Commission is expected to recommend ring-fencing retail and investment banking

The Independent Commission on Banking is expected to recommend that the government should legislate almost immediately for big banks to put a ring fence or firewall around their retail banking operations - but the implementation of the ring fence, to separate retail banks from investment banks, should then be phased in over a period of years.

The Commission, set up by the Treasury, recognises there would be great technical difficulties for big banks, such as Royal Bank of Scotland and Barclays, in insulating their retail activities, that concentrate on providing services to households and smaller businesses, from investment banking.

So they have concluded that the establishment of the ring fences should take place over a long period.

However the Commission members also believe that it would be damaging for investors, creditors and taxpayers for uncertainty about the structural reforms to persist, which is why they want there to be precise, prescriptive legislation as fast as is practicable.

The point of the reforms is to make it less likely that when a giant bank gets into difficulties it would need to be bailed out with massive loans and investments from taxpayers, as happened in the autumn of 2008.

The hope is that the ring fence, combined with other reforms, would make it easier and cheaper to rescue the parts of banks vital to the economy, and would force the costs of the rescue on to shareholders and creditors.

Lending difficulties

However if banks were reorganised such that there was less need for taxpayers to prop them up in a crisis, the risks of lending to banks would be perceived to have increased. That would make it more expensive and potentially harder for banks to borrow. And when banks have difficulties borrowing, they have difficulties lending.

Partly as a consequence, there has been criticism of ring-fencing by the business lobby group the CBI, and by the British Bankers Association. They have argued that the reform, which would be unique to the UK, could lessen the supply of loans to households and businesses and further weaken the economy.

Last month, the prime minister indicated he too was worried that ring-fencing could undermine Britain's anaemic economic recovery - and that he might take steps to ensure that any such overhaul of banks would not happen till after the next general election in 2015.

Some members of the government are also worried that the reforms could prompt banks to move their headquarters abroad.

However the Treasury regards these anxieties as grossly exaggerated.

Borrowing costs

What is not clear is whether the Commission's proposal for immediate legislation combined with staggered implementation would meet David Cameron's concerns.

As I understand it, the Commission reached its view on delayed implementation before the prime minister displayed his anxieties about the reform.

The big banks are likely to argue that the costs for them of borrowing would rise almost the moment that the government commits to the ring fence, even if the actual insulation of investment banking doesn't take place for years.

When the ring-fence is guaranteed to be erected - as opposed to the moment of its erection - creditors would see British banks as riskier.

So almost immediately there could be an increase in what British banks pay for finance.

That said, there is an argument that if Britain's banks were forced to manage their retail operations as segregated, independent operations, there would be an increase over time in the availability of loans for two vital segments of the economy: consumers and also companies that are too small to borrow directly from investors on markets.

Here is why: Separation of retail banking and investment banking, which effectively removes a subsidy provided by taxpayers to investment banking, would make investment banking significantly less profitable.

So there would be a big new incentive for banks to deploy more of their capital in retail banking, or the operation perceived as more vital to the UK's prosperity.

The Banking Commission's report will be published on Monday. The Treasury expects to be given a copy on Friday.