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More radical bank reform

The Independent Banking Commission has published its interim report. However, it does not go far enough.

We need to look at more radical reform of the banks. The Independent Banking Commission's interim report is a significant step in the right direction but arguably does not go far enough. We need to protect our economy from the folly of a few.

The IBC is clear about the impact of the financial crisis on the UK economy: national output has fallen by 4.5 per cent from the pre-recession peak and unemployment has risen over 800,000 since 2007. Meanwhile, the public sector deficit exceeded 10 per cent. Some of the loss in output may be permanent.

The IBC could have added that the banking sector has proved unable to reform itself. Indeed, if reports over the past few months are to be believed, the negotiations with banks designed to sort the problems out once and for all were dominated by the banking sector resisting substantial reform. Some banks have suggested they might leave the UK. Meanwhile, bank remuneration continues to appear out of touch with reality especially since banks are being helped by easy monetary conditions provided by, ultimately, taxpayers. In an interesting section in the report, the IBC notes that we should not simply equate the City (our financial sector) with British banks. It might be in the banks' interests for us to do so, but the report's potted history of the development of the City shows this would be wide of the mark.

The proposed solution from the IBC is to ringfence retail banking within the universal banks. Banks should have higher capital ratios than before the crisis and the commission recommends a ratio of 10 per cent. The retail subsidiary should have ringfenced capital which should not fall below a certain level and there must be mechanisms to protect it if it gets into trouble. By protecting retail banking, the IBC believes the systemic risks of a banking failure will be minimised.

The commission does consider full separation of retail banking from wholesale and investment banking, despite calls for it from such diverse sources as the Bank of England Governor Mervyn King and the Christian Socialist Movement. While it believes that the division between activities would be clearer, it suggests the costs would be too high. However, the report does not analyse the costs or benefits from a clear separation of banking activities. Separation, with tighter regulation, reduces the risk that as regulation relaxes over time the capital requirements are eased. While this will not happen immediately, it is a characteristic of financial cycles. Moreover, the clear distinction helps prevent a run developing on a bank: a bank panic is not necessarily rational at first and if people are not clear about how exposed their deposits are to riskier activities they may withdraw funds.

The Tory-led coalition has given up the leadership role the UK had on financial and economic reform on the global stage. That makes it more difficult to push through the reform we require to prevent another disaster the next time the banks make mistakes. Nevertheless, banking separation should be given more consideration by the IBC and by Labour, perhaps being achieved through the market via tax and regulatory incentives.

This article was first published on the Progress website on 11 April 2011.
Progress, 11 April 2011, 12/04/2011

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