Called to account: Banks await fate

With the Independent Commission on Banking poised to unveil plans to safeguard the industry, Sean Farrell looks at the options

Britain's bank bosses will be chewing their nails this weekend as they wait for Monday's initial recommendations of the Independent Commission on Banking.

The Chancellor set up the commission to look at two key questions: how to stop taxpayers having to bail out banks and how to create more competition in the sector. The commission also has to consider the impact on the country's competitiveness and fiscal position, while the banks have threatened to take their tax revenues elsewhere. Here is a run-down of the key measures Sir John Vickers and his team could come up with.

Break-up

The nuclear option would be to order banks such as Barclays and RBS to sell their investment banks and forbid retail and investment banks from straying into each other's territory. Advocates include Mervyn King, the Governor of the Bank of England.

Pros: A decisive, crowd-pleasing measure that clears up the "too big/complex to fail" question by preventing retail savers' money being used to fund risky "casino banking".

Cons: More severe than measures in other major markets and no guarantee against further banking crises: opponents argue that the common feature of Northern Rock, HBOS, and RBS was that they were badly run while Barclays and HSBC had big investment banks but did not need bailing out. This might well tip the balance to drive HSBC, and Standard Chartered out to Asia and Barclays to the US.

Chances: Very low.

Functional subsidiarisation

This "break-up within a bank" would split investment and retail banking, leaving them under the same roof but separately capitalised. The banks hate this idea.

Pros: It would, in theory, allow the investment bank to blow up without endangering retail savings or requiring taxpayer backing. Removes the implicit taxpayer subsidy of funds used for racy investment banking.

Cons: Many of the same arguments against complete break-up apply. Hugely expensive and complicated for the banks and ties up capital that could back new lending to the economy. While reducing the risk to the taxpayer, separating retail savings from investment banks will increase the group's funding costs, which are likely to hit borrowers.

Chances: Low.

Operational subsidiarisation

This version of dividing up the bank leaves features such as the payments system, retail deposits and ATMs intact in the event of a failure without formally dividing up investment and retail banking. It reflects work already done by the banks and the regulators on "living wills" to let critical functions open for business even after a bank fails.

Pros: Takes into account the complexity of splitting up a bank along business lines. Banks are a mess of systems with a legal structure on top.

Cons: Provides less clarity than break-up or functional division. Would depositors really keep faith with the remainder of a bank that had gone bust?

Chances: High.

More capital

New international bank safety rules hatched in Basel, Switzerland, have increased minimum core capital (shareholders' funds) to risk-weighted assets (loans) to 7 per cent but David Miles at the Bank of England has argued in favour of more than doubling this ratio.

Pros: Makes banks more resilient to shocks and reassures markets and customers. In line with EU thinking.

Cons: Ties up funds that could back lending. No guarantee against banks going bust: Professor Miles said a core capital ratio of 50 per cent would be needed to protect against a large but not outlandish fall in GDP.

Chances: High.

Break up Lloyds

Gordon Brown waived competition rules to allow the emergency takeover of HBOS by Lloyds TSB in a deal that created a retail banking giant with about a third of the market. The EU has already told Lloyds to sell off 600 branches but calls have built for the bank to be split.

Pros: Removes a dominant player with huge potential pricing power in the retail banking market.

Cons: As the House of Commons Treasury Committee conceded recently, this move could undermine faith in Government decisions if a major competition decision was reversed so quickly because a new party was in power.

Chances: Very low.

More branch sales

Lloyds is speeding up the sale of its branches and RBS has already sold more than 300. While Lloyds dominates consumer banking, RBS is the biggest bank for small and medium enterprises (SMEs). The Treasury Committee advocated further branch sales to new entrants.

Pros: Most customers still want their banks to have bricks and mortar on the high street – and branch contact is highly valued by SMEs. Could boost a new entrant or give a small player like Clydesdale the scale to compete more effectively.

Cons: Carving out branches is more complicated than it sounds because they are enmeshed with the systems that operate the rest of the bank. Don't forget the Government wants to sell its big stakes in Lloyds and RBS, so disrupting them and making them less attractive to buyers is not in the Treasury's interests.

Chances: Moderate.

Switching and pricing measures

The Treasury Committee wants clearer pricing and more customer switching so that consumers can vote with their feet. "Free" current accounts in fact punish the vulnerable who pay for the more affluent customers who merely forgo interest.

Pros: If put together properly, such measures could finally force the banks to stop pulling the wool over our eyes and operate in a real market.

Cons: To truly encourage clarity and competition, the commission would end "free" current accounts that are a huge barrier to new entrants. But that would mean most of us paying more for our banking – a politically difficult move.

Chances: High but will they go all the way?

The biggest losers: Goldman Sachs' risk rankings (based on scores awarded on 26 potential issues)

1: Barclays is most at risk with a 227 score in Goldman ratings

2: Lloyds also vulnerable to reforms, with score of 219

3: RBS is next, Goldman scores it at 216 on risk scale

4: HSBC's risk score is 151 on Goldman's analysis

5: With score of 144, Standard Chartered is least exposed