Banks face biggest shake-up for decades

Bank share prices have fallen globally due to further fears about the eurozone and its debt crisis

The most radical reform of British banks in a generation, and possibly ever, has today been proposed by the Independent Commission on Banking, set up by the Treasury.

What is recommended is as close to a formal break-up of Britain's biggest banks as it is possible to get without obliging the likes of Barclays and Royal Bank of Scotland to physically separate their retail and investment banking operations.

In that sense, the reforms are at least as significant for the City of London as Big Bang was in 1986, when banks were allowed to buy stockbrokers. Arguably there has been nothing quite as significant for banks in more than a century.

All of Britain's leading banks would have to put their retail banking operations behind a new ring fence or firewall. This means that vital services for small businesses and individuals, looking after their deposits, making loans to them, and moving money around, would be in these new ring-fenced subsidiaries.

Wide scope

These ring-fenced operations would also be able, if they choose, to look after the savings of big businesses and make loans to big businesses. So in that sense they would be wide in scope.

Outside the ring fence would be what the commission calls "global wholesale/investment banking", such as trading in securities and derivatives.

To give an idea of the scale of the reform, the commission estimates that up to £2 trillion of banks loans and investments - or up to a third of their total loans and investments - would end up behind the ring fence.

The biggest structural changes would be faced by Barclays and Royal Bank of Scotland, whose investment and wholesale banking activities are very substantial and would not be allowed inside the ring fence.

Lloyds and Santander would be able to put most of what they do inside the ring fence. And HSBC would face less reorganisation than Barclays and RBS, but more than Santander and Lloyds.

The new protected retail banks would have their own boards, where there would be a majority of independent non-executive directors. And they would be forced to hold much more capital as a buffer against losses - capital equivalent to at least 10% of so-called risk-weighted assets - than the new international minimum.

Arms-length

The banking commission also wants the firewall to be relatively high. So capital could only be moved from the retail bank to the investment bank if that did not mean there was a risk of the retail bank's capital resources falling below the 10% minimum.

And the retail bank could only lend to the investment bank in the way that it would lend to any arms-length third party.

In other words, the retail bank could not lend more to the wholesale bank than would cause dangers for it in the event that the wholesale bank were to face difficulties repaying the loan.

Another major proposed reform is that all big banking groups, whether in retail or investment banking or both, should have what is known as total loss-absorbing capacity equivalent to between 17% and 20% of their respective risk-weighted loans and investments, or assets.

This would mean that long term loans to banks would automatically incur losses in a crisis.

The big idea behind the ring fence, the increase in capital requirements and the stipulation that providers of long-term unsecured loans should suffer losses when disaster strikes is to protect taxpayers.

The hope is that the costs of rescuing banks would fall on investors and lenders - rather than on taxpayers, as happened to the tune of many tens of billions of pounds in the meltdown of 2008.

The ring fence would also help regulators ensure that in another crisis, services deemed vital to the functioning of the economy, those inside the ring fence, could be lifted out and kept running.

Prepare for change

The commission also wants greater protection from losses for individuals' deposits, or at least those insured under the Financial Services Compensation Scheme. These insured deposits would in future rank ahead of other unsecured creditors in any resolution or wind-up of a bank.

As for implementation, as I said last week, the commission would like the relevant legislation enacted as soon as practicable - and it would like to see banks starting to prepare for the change immediately.

However, because there are costs for banks in raising new equity and in changing the terms of loan contracts so that unsecured loans become more capable of absorbing losses, the commission accepts that implementation may need to be gradual.

It recommends that all the changes should be implemented by the beginning of 2019 at the latest, which is when new global rules on capital held by banks - called Basel lll - have to be in force.

The big UK banks, especially RBS and Barclays, are likely to be highly critical of the reforms. They will argue that the effect will be to both increase their costs and also the costs of credit for their customers - thus putting in danger the UK's anaemic economic recovery.

Costs and savings

To the extent that the commission accepts this argument, it says that the increased costs for banks and their customers will be massively outweighed by potential savings to taxpayers - in that it believes that the reforms would protect taxpayers and the economy from the calamitous costs incurred in a financial crash (such as that of 2008).

The commission says:

"The cost of capital and funding for banks might increase. Insofar as this resulted from separation curtailing the implicit subsidy caused by the prospect of taxpayer support in the event of trouble, that would not be a cost to the economy. Rather it would be a consequence of risk returning to where it should be - with bank investors, not taxpayers - and so would reflect the aim of removing government support and risk to the public finances."

The commission also challenges the idea that such reforms would damage the City of London. It says:

"Structural separation would help sustain the UK's position as a pre-eminent international financial centre while UK banking is made more resilient. The improved stability that structural reform would bring to the UK economy would be positive for investment both in financial services and the wider economy."

That said the commission recognises the risk that banks may chose to try to dodge the reforms by relocating some or all of their operations to other parts of the world. It says about this threat that:

"By restoring funding costs to levels that properly reflect risk, the proposed reforms may be contrary to the private interests of wholesale/investment banking operations of some UK banks. But the public interest is another matter. It is best advanced by removing the prospect of government support. The fact that some other countries may implicitly subsidise their wholesale/investment banks does not make it sensible for the UK to do so."

Finally, the commission makes a number of proposals to stimulate competition between banks.

It regards as vital that the sale being negotiated by Lloyds of more than 600 branches and £35bn of deposits should create an effective and credible new competitor.

The commission also wants a new "redirection" service to be offered by banks, so that when any of us switch from one bank to another, we can be certain that there will no glitches in the regular and sporadic payments we make and receive.

Naturally I will be gauging reaction to all this - from banks, politicians, businesses and you - as the day progresses.

Update 0720: The chancellor will commit to legislate on banking reform during the lifetime of this parliament. That approach has already been agreed with Vince Cable, the business secretary.

And the government also agrees with the commission's timetable of full implementation by 2019.

A Treasury source says that the chancellor is broadly supportive of the commission's proposals and will give a detailed response by the end of the year.

Update 1020: Deep in the commission's report is a very interesting analysis of the costs and benefits of the reforms.

It estimates the social costs of its proposed reforms - the costs for all of us, rather than just for banks' creditors and investors - as between £1bn to £3bn a year.

That compares with the annual £40bn costs per year of lost output that follows periodic financial crises.

If the commission's calculations are even vaguely in the right ballpark, it will be very hard for banks to resist the changes.