Cameron backs banks’ ring-fence

Business groups like the CBI and British Bankers Association are against ring-fencing

There have been a number of reports that the prime minister has deep concerns about proposals from the Independent Commission on Banking to separate retail banking and investment banking.

Apparently he is worried that these significant structural reforms would damage the UK's anaemic economic recovery and encourage some UK banks to emigrate.

However I got no sense of that when talking to one of his advisers this morning (and see the FT).

He said that the prime minister's position was "the same as the chancellor's" - which is that they back the main reforms put forward in the commission's interim report in April, but will not make final definitive decisions until they have the final report (they get it tomorrow, and it will be published on Monday).

In crude terms, it is reasonable to say, therefore, that David Cameron supports the separation of retail banking and investment banking - or a reform disliked with varying degrees of intensity by the big banks themselves (with RBS and Barclays the most radioactive in their opposition, because they have most to lose).

So let's look at the precise nature of the chancellor's commitment in respect of the establishment of a ring fence between investment banking and retail banking.

Well it is pretty clear. Here is what he said on 15 June in his speech at the Mansion House in the City of London:

"The Independent Commission on Banking has put forward two particularly important proposals.

Bail-in instead of bail-out - so that private investors, not taxpayers, bear the losses if things go wrong. And a ring fence around better capitalised high street banks to make them safer, and to protect their vital services to the economy if things go wrong.

"Today I have told the commission that the government endorses both these proposals in principle.

"Of course, the commissioners are still consulting and preparing their final report - and I won't pre-empt their conclusions. We will judge their final proposals in practice against the following conditions:

• All banks should be allowed to fail safely without affecting vital banking services; • Without imposing costs on the taxpayer; • In a manner applicable across our diverse sector; • And consistent with EU and international law."

Protecting retail side

As far as banks are concerned, this is pretty radical stuff.

The chancellor said that when a bank gets into difficulties, he wants the costs to fall on investors and creditors.

That is what he means when he says "bail-in instead of bail-out": it's jargon for saying that the debts of banks should be converted into loss-absorbing equity in a crisis.

And Mr Osborne was also completely unambiguous in his endorsement both of insulation - or "a ring fence" - around high street or retail banks, and of an increase in the loss-absorbing capital resources of retail banks to provide a better buffer against losses.

There are three essential characteristics of a ring fence: that the protective capital of the high-street operations could not be deployed in an investment bank, so that this capital could not be put at risk in what the governor of the Bank of England calls casino operations; that there would be little or no opportunity for the deposits or debt of a high street bank being used to fund the loans and assets of an investment bank; and that this legal separation of investment banking and retail banking would make it easier to physically lift out and rescue those parts of a bank deemed as vital to the smooth functioning of an economy, should the need arise in a crisis (those essential parts of a bank would be our deposits, the gubbins for making loans to households and businesses, and the system for moving money around the economy).

Now putting in place these kinds of barriers between investment banking and retail banking would be a legal and technical minefield.

It would, for example, have huge implications for the wording of the thousands of contracts between banks and those who lend to them.

Which is why, as I reported last night, the commission will propose that the ring fences would be phased in over years - though it wants the prescriptive legislation to be passed by Parliament as soon as possible.

But here's the thing. The moment the government commits to legislate, rating agencies will downgrade the credit of the UK's biggest banks - because they would see the legislation as evidence that when a bank next gets into serious difficulties, losses would not be born by taxpayers but by lenders to banks and investors.

That means the risks of lending to a bank would be seen to have increased.

Taxpayers' expense

And the moment that banks' credit is downgraded, or the moment that lending to a bank is perceived to be riskier, it is probable that banks would have to pay more to borrow.

And, as you all know by now (if you've been paying attention since I joined the BBC more than five years ago), when banks pay more to borrow, they charge more to the rest of us when we borrow from them.

Such is the anxiety for Mr Cameron and Mr Osborne. They see it as a clear priority to free taxpayers from the danger that banks' losses yet again become taxpayers' losses (for more on this read my earlier report).

But can they implement the reform on a timetable that doesn't in the short term impair the flow of cheap credit to households and businesses, who so desperately need the credit if weak economic recovery isn't to be snuffed out?