Why it makes sense for banks to do the splits

The Square Mile: There is a growing recognition that a break-up of banks such as Barclays between retail and investment banking is the way to make things safer

At last, more of the world's most senior policymakers and top financial analysts are starting to acknowledge the obvious; that a complete break-up of banks such as Barclays between their retail and investment banking operations is by far the best way to make our banking system safer and fairer to the taxpayer. It could also be the quickest and most effective way to get lending to the real economy going again.

One convert to splitting Barclays in two is Neil Shah, the head of global research at Edison Investment Research, one of the few global independent research houses, so he has no axes to grind. Mr Shah says that so long as Barclays has retail and investment banking, the government will never let it go bust which means the bank will always leverage up, taking more and more risky bets. And that, he says, is inherently wrong for the taxpayer.

But there's a bigger prize, which is that by splitting banks like Barclays, the retail part would be able to reduce its capital buffers as it will be perceived as less risky. So, in turn, the retail bank would be able to lend more to customers and it will also be easier for new banks to compete as they will not need so much capital as the current regulations require.

Mr Shah's colleague, Martyn King, has looked at what Barclays might be worth split in two and predicts that the parts would be worth more than the whole, plus "the consumer, the borrower, shareholders and the economy would all be better off".

Ring-fencing is flawed because both parts of the bank would still need high capital ratios, he says, giving us the worst of both worlds. But when you take the risk away from the retail side, the capital goes down, the multiplier goes up and so does lending; just as it used to when retail and commercial banks were separated from investment banking and securities before Big Bang here in the UK, and the abolition of Glass-Steagall in the US.

It's interesting that Mr Shah and Mr King are making such a powerful economic case for splitting the banks as well as the broader public-interest grounds. But it seems that the sheer scale of the Libor scandal is making many people think the unthinkable again. Their analysis also blows a hole through the arguments put by the Vickers report, and backed by so many politicians and regulators, who agreed that ring-fencing would be enough. Mr King also believes fears that splitting the banks would cost billions has been exaggerated.

My view has always been that ring-fencing isn't sufficient and that a Glass-Steagall-type split is the simplest and safest means to get the banking system working again; if the retail banks were released from their tough capital ratios they probably wouldn't need to be coaxed into lending with fancy gimmicks such as the latest Funding for Lending schemes. Vickers was always a bad compromise, one only reached because the wealthy banking lobby, led by men such as Bob Diamond at Barclays, persuaded the politicians that it was not in the public interest despite the views of heavyweights such as Sir Mervyn King, the Bank of England governor, Vince Cable, the business secretary, John Kay, the highly-respected economist and Lord Lawson to name a few. It's time they turned up the heat and widened the debate to look again at reform, including proposals such as those from the US economist, Professor Laurence Kotlikoff, for limited purpose banking.

There's also a change of mood towards banking reform across the Atlantic being led by bright sparks such as Sheila Bair, one of the US's top law enforcers, who stepped down from chairing the Federal Deposit Insurance Corporation. Ms Bair was one of the first to warn the US Treasury about the subprime crisis before the crash, and one of the most trenchant critics of Wall Street's decision to bail out the banks, which she describes as flagrant "crony capitalism".

She puts the problems well: "I think we lost our way in the mid-2000s between free markets and free-for-all markets. We forgot you need some basic rules and standards to regulate financial markets. We deferred too much to bank judgement. Libor is one example where we left it to banks to set important benchmarks."

Politicians didn't listen to her then. But they should listen now. She has just launched the Systemic Risk Council, a private watchdog group whose aim is to speed up the post-crash reforms that have become bogged down in legalities and inertia. She's got some toughies alongside her – the ex-Federal Reserve chairman, Paul Volcker as a senior adviser as well as the ex-Commodity Futures Trading Commission chairman, Brooksley Born, and former Citibank chairman, John Reed, who is also a splitter.

If you have the chance, watch a TV interview Ms Bair did with US journalist, Bill Moyers, to hear what she says about how politicians and regulators lack the will to punish the bankers because they are too cosy with them, and how she understands the public's lack of interest because no one trusts the politicians or the bankers. (Moyers didn't ask whether she has political ambitions but if the Republicans are smart they should be after her.)

As Ms Bair says, derivatives and securities trading, investment banking and all such activities should be done outside banks with deposits: "At least make people who want to do those types of high-risk activities go to the market, convince private investors to fund it. Don't use insured deposits that are government-backed as there's no market discipline whatsoever in that. Don't use those government-backed funds to take these kinds of risk." She's so right; let them put up their own capital and not depend on the taxpayer to bail them out.

It's time to ignore the investment bankers who say a return to Glass-Steagall is a red herring; that Lehman was only an investment bank but it collapsed or that many of the problems were on the retail side, like at Northern Rock. Both examples are true but it's a disingenuous claim since Lehman only became a risk because the entire banking system was clogged up with leverage and bad loans, while Northern Rock pretended it was an investment bank.

If the coalition is serious about changing the banking culture then it should have the political courage to look again at the Vickers reforms.