Banks have made easy targets in recent years. Whether politicians talk about the evil retail banks that profited by selling mortgages to unqualified buyers or investment banks that broke up those mortgages to sell as collateralized debt, merely mentioning the word "bank" is enough to get people to gnash their teeth. While few would disagree that something must be done about banks, the precise regulations and mechanisms that should be deployed is a sticking point: how do you create more stable banks that can still compete in the global market? (For more on the changes of Mortgages, read The New Mortgage Business: More Than Just Loans.)

TUTORIAL: Mortgage Basics

Britain has jumped feet first into bank regulation with the release of a report by its Independent Commission on Banking (ICB), dubbed the "Vickers Report" after the last name of the commission's chair, Sir John Vickers. The report makes several key suggestions. First, banks build up more capital in order to absorb losses. Second, a bank's investment banking and retail banking operations be kept separate. Third, banks with both retail and investment banking operations put up a "ring fence" around retail operations in order to isolate domestic customers from a potential collapse.

To historians, the suggestions laid out in the "Vickers Report" look strikingly familiar. Shortly after the Great Depression struck the United States, Congress passed the Banking Act of 1933 - widely-known as the Glass-Steagall Act - in order to reform the banking system. The Act created the Federal Deposit Insurance Corporation (FDIC) and introduced rules designed to reign in the sort of speculation that many blamed for the crisis, the latter of which is strikingly similar to the blame being directed at investment banks for creating derivative-based investments. The Act was repealed in 1999. Within a decade, the banking system found itself in trouble. Some in Congress have called for the Act to be reinstated.

What of the report's reinvention of Glass-Steagall? The idea that banks should have equity capital equal to at least 10% of risk-weighted assets could reduce the odds that public funds would have to be poured into banks to prevent them from failing. This is above the Basel II requirement, and if in place before the financial crisis would have prevented the bailout of Northern Rock and the Royal Bank of Scotland. On top of this 10%, retail banks will have to set aside an additional 7-10% of capital. Pure investment banks won't be required to adhere to the ring fencing requirements (they have no retail operations), but will have to issue capital to pad themselves against losses. (To learn more about the FDIC, check out The History Of The FDIC.)

Case in Point
Critics of the "Vickers Report" argue that the investment banking operations make banks with retail operations profitable, and that diversification is a good thing. Shares of bank stocks would not have performed as well as they had in recent years without the profit injections brought in by investment banking. Additionally, several of Britain's larger banks, such as Northern Rock, may have been able to weather the recent financial downturn had it been more diversified.

By increasing capital requirements to create a deep ring of protection around banks - a scene reminiscent of cowboys circling the wagons in a movie - banks may see their costs increase. After all, they won't be able to lend out as much money if they are required to keep more on hand or in highly-liquid assets. This removes money that would otherwise be lent out from the market, which in turn could make credit more expensive for everyone at a time when economies need people spending.

With increased regulations all but guaranteed, can British banks remain competitive in a global market? Perhaps the most salient point of all the proposed regulation is that it will make British banks adhere to requirements that most of the world's big banks won't have to follow themselves. This will increase the cost of doing business, especially for stand-alone investment banks, and might force some banks to exit the market altogether. However, businesses have to be able to adapt to the environment in which they operate, which may require some banks to re-examine how they operate. It should not be the role of government to protect businesses unwilling to adapt to a changing world. Fortunately for banks, the ICB wants them to be involved with determining which operations are placed within the "ring fence." It also set the timeline for adopting the new requirements fairly far out - way off in 2019 - giving banks ample time to raise the capital required under the new structure.

The Bottom Line
With the phrase "too big to fail" becoming an integral part of modern financial vocabularies, the idea that separating the "good" (retail banks) from the "bad" (investment banks) gets a lot of traction. Of course, this begs the question: how do you know which banks to cut loose, and can you afford to let investment banks implode just because they don't have retail operations? One need only look back to America's willingness to let Lehman Brothers collapse in 2008 to see how good intentions can lead to incredibly dire, and unintended, consequences. (For more on how banks have evolved in the past, read The Evolution Of Banking.)

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