Osborne is wrong to experiment now

To hear George Osborne talk, you would think ringfences were the panacea of financial regulation. Putting a barrier around the bits of a bank you, as a government, are prepared to bail out will make it easier the next time a financial crisis grips the country. Is he right?

On the face of it, the arguments are compelling. A ringfenced business that contains all the essential banking services and is forced to hold higher levels of capital can surely only be safer. As a handy knock-on, forcing higher risk investment banking operations to stand on their own two feet will inflate their funding costs and cut profits and, who knows, maybe bankers’ bonuses will be cut as a result – the politician’s dream scenario.

But here is why Mr Osborne is wrong to endorse the ringfencing concept.

First, his timing is terrible. In his enthusiasm to make the political point that he is tougher on the banks than Vince Cable, he is backing a concept that has yet to take shape. Sir John’s 208-page interim report, published in April, was thorough in many ways but contained little detail on what ringfencing might actually mean.

Sir John specifically said that he would need to consult widely and research properly before deciding on the two key definitions of a ringfence – how tightly it should be constructed; and how impermeable it should be. Only in September, when the final report is published, will the real recommendation be clear

To endorse the concept without knowing the definition could amount to endorsing virtually no change at one extreme, or at the other a de facto break-up of the banks into high street banking and riskier investment banking.

A key problem is that one size does not fit all. Big deposit takers do not want their funds marooned inside a narrow ringfence that is barred from cross subsidising other parts of the business. However groups that rely on big investment banking operations want a narrow definition that would limit the effect.

Mr Osborne should not be so eager to slap down industry opposition – particularly the argument put forward by Stephen Hester, RBS’s chief executive, last week at the Treasury select committee. Mr Hester believes a ringfenced entity would carry a small, but intensified, government guarantee. Yet if you force the ringfence to hold an excess of moribund deposits, you give bankers an incentive to take extra risks in an effort to keep up profitability – a point worth heeding.

The investment banking operations, outside such a ringfence, would be left to fend for themselves far more. But far from containing risk taking and profits, the possible credit rating downgrades, and resultant higher funding costs, could well prompt a shift into higher-risk activity in this area, too.

Perhaps the most obvious criticism to make is that Mr Osborne is backing a regulatory overhaul that is in direct contradiction to the government’s stated goal of making banks lend more to small business. Building artificial barriers between parts of a bank can only increase costs, and hence the availability of funds.

Such fallout might be a price worth paying if ringfencing were sure to make the financial system safer. But as bankers repeat ad nauseam, it could well prove a dangerous experiment – damaging the banks, the City of London and the British economy. Of course, Sir John’s final report may address many of these concerns. He should be allowed to get on with it, unencumbered by political point-scoring.