Vickers Report: Don't Kill the Goose That Lays the Golden Egg!

21/12/2011 15:51 GMT | Updated 20/02/2012 10:12 GMT

The coalition's response to the Vickers report was a missed opportunity. A chance to reform Britain's banking sector for the better has been hijacked by the Liberal Democrats' need yearning for influence. And so George Osborne has accepted the report in full, though it couldn't be said totally against his own judgement.

The most flawed 'reform' is the ring-fencing of banks' investment and retail arms by legal firewalls. This policy is based on the fallacy that so-called 'casino banking' in banks' investment arms put retail customers at risk. This simply does not add up when one considers the fact that Lehman Brothers did not have a retail arm and Northern Rock did not have an investment arm. Yet both collapsed. Spectacularly so. The truth is that there is always risk in banking, whether you are dealing with CDOs or straightforward home loans.

Large retail banks will be forced to have capital equal to 17% of their assets, which is well above the 7 per cent required in Basel III. While it is certainly desirable that banks recapitalise, this requirement is superfluous. Equity capital is already being over-taxed, in particular at a time when Mr Osborne insists on arbitrarily increasing the bank levy without a moment's notice. Decreasing the tax burden would be a more effective policy than enforcing new regulations. Remember too that Lehman Brothers and Northern Rock did not have a problem with insufficient capital. Yet still they collapsed.

A compulsory recapitalisation of the banks also does not make sense at a time when the Treasury is putting so much pressure on them to lend more. Project Merlin, QE2 and bank rate at 0.5% form the bedrock of Mr Osborne's plan for growth: in other words, cheap credit. The Chancellor has two choices: solvent banks and low inflation, or an inflationary credit bubble. Which to choose? One hopes the former.

The overall effect of these reforms will be damaging. This is widely recognised. PricewaterhouseCoopers (PwC) has estimated that the total cost of these proposals to the banking sector could be as much as £12 billion. With an EU-wide Tobin Tax and new regulations on the way from the European Commission it is now increasingly likely that some banks will move their headquarters eastwards and out of Britain. Boris Johnson has rightly said that the government must not "kill the goose" that created £63 billion in tax revenue last year.

These reforms will create an overly capitalised and retail dominated banking sector that may struggle to compete in the global financial markets. This can only perpetuate the present situation in which our banking sector is dominated by four banks. Instead of trying to make sure banks never fail the coalition should try to ensure that banks are not too big to fail and can fail safely. The way to achieve this is to have greater competition.

In this sense there is some hope in Mr Osborne's acceptance of a Redirection Service, which would allow bank accounts to follow customers when they switch. The privatisation of the state-owned banks, with the sale of Northern Rock to Virgin Money for £747 million, and the sale of 632 branches of Lloyds Banking Group to the Co-operative Group, will also help to create a more diverse banking sector. It is important that as well as getting a good deal for the taxpayer that George Osborne can use the privatisation of the banks to make the sector more competitive.

Next year's Financial Services Bill could be the Chancellor's second chance to reform the banking sector effectively, with the abolition of the Financial Services Authority and the transfer of its powers to three new Bank of England bodies.

The new Financial Policy Committee should be able to focus on establishing a regulatory framework within which it is compulsory for large banks to deliver credible plans - or 'living wills' - for rolling up operations in the event of collapse.

The ring-fencing of investment and retail arms of banks and compulsory capital requirements could be used as 'sanctions' against banks which fail to provide a credible plan, rather than being a universal regulatory blueprint.

This would ensure that Britain's banking sector remains a competitive and productive industry and does not pose a severe threat to the rest of the economy or to the taxpayer. It's about time George Osborne listened to Boris Johnson and not kill the goose that lays the golden egg.

This article first appeared on the Egremont blog on 21December 2011.