UK to force banks to build wall between retail, investment units

COMMENTARY Hats off to our cousins across the pond. Moving to shore up the country's fragile financial system, Britain's top economic official said Monday that the U.K. will force banks to separate their investment and retail banking units. Said Chancellor of the Exchequer George Osborne in a speech to Parliament:

"We want to separate high street (retail) banking from investment banking to protect the British economy, protect British taxpayers and make sure that nothing is too big to fail," Osborne said.

Under the plan, U.K. banks will be required to build a so-called ring-fence between these divisions by 2019, when the regulations fully take effect. These institutions will also have to hold more capital as a cushion against financial losses.

In effect, Britain wants to insulate a bank's safer deposit-taking and lending business from its investment and wholesale banking operations, which engage in a range of riskier businesses. As with Wall Street firms, it was these units at Barclays (BCS), Royal Bank of Scotland (RBS) and other large British banks that rolled the dice in the years leading up to the financial crisis and that nearly took down the country's economy. Also as in the U.S., British taxpayers had to bail out the country's largest banks. 

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Will such rules deter British financial giants from reckless speculation? No. It also remains to be seen how banks will ultimately be partitioned -- will, say, a company's wealth management unit lie on the retail or investment banking side of the fence? And as we saw during the dot-com crash, bankers also have a way of knocking holes through any "Chinese walls" set up to discourage conflicts of interest.

In principle, though, firming up such barriers in Britain should make it harder for investment bankers to borrow big bucks against the bank's government-protected balance sheet to go gambling. 

British banking groups squawk that the government's reform plans will lower profits and curtail lending. Some banks, such as HSBC, have also made thinly veiled threats about leaving London for greener -- meaning less regulated -- pastures.

This is the standard financial industry tactic when confronted with new regulations. Yet the U.K. puts the total cost for banks to comply with the rules at 3.5 billion to 8 billion pounds, a small fraction of the roughly 6 trillion pounds in assets held by U.K. banks. For borrowers, the impact on interest rates should be negligible. 

The British government estimates the initial hit on GDP from the plan at 0.8 billion to 1.8 billion pounds -- not peanuts, but surely worth the price if it means strengthening the financial system. In time, as financial markets reward the U.K. for creating a safer banking environment, the reforms should more more than pay for themselves. Osborne said:

Even a relatively modest reduction in the likelihood or impact of future financial crises would yield an incremental economic benefit of 9.5 billion pounds per year.

In the U.S., by contrast, Congress continues to dicker over the modest financial reforms laid out last year under the Dodd-Frank Act. The so-called Volcker Rule, which is supposed to prevent Wall Street firms from exploiting their federal guarantees to trade for their own accounts, remains incomplete, unimplemented and, at least for now, useless. Republican lawmakers continue to block the appointment of a director for the new Consumer Financial Protection Bureau. Even without financial lobbyists pushing to blunt Dodd-Frank, the law is at best a first step in safeguarding our financial system.

We can learn from the Brits.