A UK government-sponsored report urges lawmakers in the UK to "ring-fence" retail banking from other functions and prevent a repeat of massive taxpayer bailouts in future.

The retail functions of UK banks should be “ring-fenced” from riskier aspects of financial activity to ensure that taxpayers do not have to bail out stricken firms in future, according to a government-sponsored report today.

The Independent Commission on Banking’s recommendation on structural change to the banking industry had been widely expected. A controversial measure, ring-fencing is expected to cost the industry as much as £10 billion (around $15.8 billion) although the sector has until 2019 to adapt. The ICB also recommended tougher capital rules on retail banking that go beyond the international requirements under the Basel III standards.

"The recommendations...this morning will bring about significant restructuring of the financial sector, but are as good a compromise as we could have hoped for at this stage. The calls for retail banks to be ring-fenced from their investment banking arms, as well as higher capital requirements, will defend UK taxpayers from future bail outs, given that UK banking liabilities are highest amongst developing countries," said Andrew Shrimpton, member of Kinetic Partners, a financial advisory firm. 

Ever since financial markets slumped in 2008, with a number of banks having to be bailed out by governments, there has been debate on whether retail, deposit-taking banking should be split from functions such as investment banking and trading, and therefore prevent future huge bailouts when deposits of the public are at risk. Some critics argue this idea is misconceived, as several relatively conventional bank lenders which did not engage in investment banking, such as Northern Rock, were also hit hard by the mortgage market crisis when interbank money market rates skyrocketed. It has been feared that draconian reforms will push some banks, such as HSBC, out of the UK.

In its recommendations today, the ICB drew back from supporting the idea of completely splitting off such functions into a separately listed, corporate entity.

“The objective of such a ring-fence would be to isolate those banking activities where continuous provision of service is vital to the economy and to a bank’s customers. This would be in order to ensure, first, that such provision could not be threatened by activities that are incidental to it and, second, that such provision could be maintained in the event of the bank’s failure without government solvency support,” the 363-page report said.

“This would require banks’ UK retail activities to be carried out in separate subsidiaries,” the report continued. “The UK retail subsidiaries would be legally, economically and operationally separate from the rest of the banking groups to which they belonged. They would have distinct governance arrangements, and should have different cultures. The Commission believes that ring-fencing would achieve the principal stability benefits of full separation but at lower cost to the economy,” it said.

The ICB pointed out that the collective balance sheet of UK banks is more than £6 trillion, equal to more than four times annual gross domestic product, which means that if the reforms are implemented, between one sixth and one third of this would be within the retail ring-fence of banks.

Among other key points, the ICB said UK retail banks should have equity capital of at least 10 per cent of risk-weighted assets, going beyond the Basel III minimum level. The ICB also called for retail and other activities of large UK banking groups to both have primary loss-absorbing capacity of at least 17 per cent to 20 per cent.

“The degree of insulation that retail ring-fencing provides for vital banking services, for which customers have no ready alternatives, gives them some protection from problems elsewhere in the international financial system, and also makes them easier to sort out if they get into trouble…Greater loss-absorbing capacity – from equity and otherwise – for both retail and wholesale/investment banking means that banks of all kinds can sustain bigger losses without causing serious wider problems, and curtails risks to the public finances if they nevertheless do get into trouble,” it said.

The ICB argued that without ring-fencing, banks will have to put aside more risk capital to ensure the financial system is stable.