Osborne and the safe size for British banks

The chancellor will speak at Mansion House tonight

There is a fine line between forcing banks to have enough capital to protect themselves and their depositors against all realistic losses, and setting that capital ratio so high that - in the short term at least - the banks starve the economy of vital credit as they build up their capital.

In a globally competitive market, there is also a question of how far an economy like the UK can force higher capital ratios on its banks than other countries impose on their respective banks, without curbing British banks' global ambitions (although not everyone would agree that those global ambitions are a thoroughly good thing).

All of which explains what some would see as the most significant watering down by the chancellor of the recommendations to reform banks that George Osborne received last year from the Independent Commission on Banking, chaired by Sir John Vickers.

The Vickers Commission, set up the chancellor, recommended that there should be a ratio of 4.06% of pure equity capital to gross loans and investments, as what is known as a "backstop leverage cap", for the biggest banks. By historical standards of what is deemed to be prudent, that leverage backstop is not desperately high. Many would argue that a 5% ratio would be sounder.

In crude terms, it would mean that a bank would have to suffer a 4% fall in the value of all its loans and investments to be wiped out - which hasn't happened that often in history, but is not unthinkable. The losses of Royal Bank of Scotland in the last crisis, over three years or so, would not be a million miles from that.

What is important, however, is that the amount of capital relative to gross assets that Vickers wanted for very big banks was significantly higher than the proposed new internationally agreed leverage backstop, enshrined in the Basel lll rules, of 3%.

Now although the chancellor has implemented most of Vickers' many proposals to strengthen banks, on the leverage ratio he has decided that the UK cannot go beyond the new international norm.

In other words, if the Basel lll leverage ratio remains at 3%, then that is the ratio which will apply to British banks.

The biggest UK banks will be breathing a sigh of relief. Capital is expensive and in relatively short supply. So they were concerned that they would have been significantly constrained if subject to a higher ratio than overseas competitors.

But critics of the banks' sheer size - and there are a few of those around, including the governor of the Bank of England and the chairman of the FSA - will be concerned that British banks will remain dangerously large relative to the size of the economy and the financial resources of the British state.

It is worth reminding you that three banks - HSBC, RBS and Barclays - each have gross loans and investments equivalent to annual British economic output, GDP, or more. Which is why part of what the chancellor calls the British dilemma is how to allow our banks to thrive but not be so huge that when they get into difficulties they risk bankrupting the Exchequer and taxpayers.

To put that into context, British banks in aggregate are well over six times bigger than American banks, relative to the size of their respective economies.

That said, today's banking White Paper from the Treasury, which translates Vickers into firm policy, contains all sorts of other measures to limit the exposure of taxpayers to our banks - such as ring-fencing retail operations, so-called resolution procedures for breaking up banks in a crisis, and forcing banks to hold more debt able to absorb the losses that are generated when things go horribly wrong.

But the leverage backstop is a simple way of reining in banks' excessive ambitions.

In his Mansion House speech tonight, the chancellor is expected to say that his aim is to "protect taxpayers in a way that does not make the UK uncompetitive as a home of global banks" (according to extracts released by the Treasury last night).

He is achieving that, he thinks, partly by tempering Vickers leverage proposal, and also by modifying another of his recommendations - namely by giving an exemption to HSBC, a very international bank, to the stipulation that all its overseas operations should be subject to the same rules as its UK business on how much so-called "loss-absorbing" capital and debt they must hold (see this blog for more on this technical but significant waiver for HSBC).

But there is a risk for the UK in remaining the "home of global banks" (in Mr Osborne's words). And here is one way of thinking about that risk.

In the event that there is a proper banking union in the eurozone, and that the eurozone's crisis subsides - which may seem an absurd idea, but stranger things have happened - international investors would at that point note that the eurozone's banks were in effect insured or guaranteed by the collective resources of all eurozone countries, including mighty Germany. By contrast British banks would only be underwritten by the more limited resources of the UK public sector.

At that moment, the hideous issue of whether British banks remain both too big to fail and too big to save would become a highly relevant one again: it is not utterly impossible that the UK and its huge banks could seem a bigger financial risk than the eurozone.