Bank reform: Ringfencing retail banking

Counting bank notes 12 September 2011

The Independent Commission on Banking (ICB) has published its final report on banking reform, proposing to ring-fence retail banking activities to shield them from losses in investment banking.

Under the recommendation, ring-fenced retail banks would be the only ones allowed to provide services such as taking deposits from small businesses and individuals. The retail arm of the bank would form a legally and operationally separate unit, while investment activities such as buying shares and derivatives trading would be kept outside the ring-fence.

The commission, led by Sir John Vickers, also proposes a 10 per cent equity baseline as a standard to ensure banks have sufficient equity to absorb losses. This is a tougher demand than the seven per cent recommended by the international Basel Committee on Banking Supervision.

The reforms are estimated to cost between £4 billion and £7 billion for the banks, with minimal costs for individuals.

The ICB's recommendations have been informed by research on the financial sector. Several research projects examining the banking sector and different reform options have been funded by the ESRC.

In the Centre for Economic Performance (CEP) paper Bank Bailouts, International Linkages and Cooperation (November 2010), Friederike Niepmann and Tim Schmidt-Eisenlohr outline a model of international linkages between banks allowing for bank bailouts, with cross-border government co-operation.

The CEP report The future of finance (Peter Boone November 2010) recommends a radically simplified and slimmer financial system, arguing that the financial system has become unnecessarily (and dangerously) complicated.

A paper from the Spatial Economics Research Centre, Bank Location and Financial Liberalization Reforms: Evidence from Microgeographic Data (Marieke Huysentruyt, Eva Lefevere, Carlo Menon, October 2010), examines how bank deregulation affects local bank branches across regions, looking at the case of Belgium in the late nineties.

Relaxing the regulations led to radical change in the branch network, with branches closing down in poorer areas and more branches being established in well-off neighbourhoods.

Dr Brian Bell and Professor John Van Reenen examined Bankers' Pay and Extreme Wage Inequality in a CEP report (April 2010), and how the growth in wages among the highest earners in recent years has been primarily in the financial sector - due to annual bonus payments.

"All the gains for the top five per cent of workers since 1998 have been as a result of substantial increases in bonus pay, and again these accrued substantially to workers in the financial sector. Thus, about 60 per cent of the increase in extreme wage inequality is due to the financial sector," concludes the researchers.

In The doomsday cycle (February 2010) Peter Boone and Simon Johnson argue that far greater reform than is currently under discussion is needed to stop a cycle of irresponsible risk taking, market collapse, central bank bailouts and return to business as usual – with each successive collapse requiring greater and greater public intervention.

The researchers recommend very large capital requirements, legislation that recoups past earnings and bonuses from executives of bail-out banks, and limits on the size of financial institutions relative to the economy to avoid the 'too big to fail' problem.