On banking reform, the governor of the Bank of England, Mervyn King, has marked himself out as a wallflower in the government and FSA’s elaborate dance around the obvious. King has argued that the problem of banks that are too big to fail can only be resolved by separating their day-to-day activities from high-risk speculation. The government and the FSA, however, are content to re-jig the regulatory tools that failed spectacularly. In doing so, they accept a system where banks use the taxpayer as a safety net and the depositor as human shield.

King argued that government guarantees should be restricted to ‘utility’ banking activities such as deposit-taking and lending to businesses, activities that are as essential to the ‘real’ economy as the railways and the water supply. This cannot be said for ‘casino’ operations, where the bank gambles on financial instruments to make a profit for itself. If these go wrong, it should be the bank’s problem, not ours. What’s more, they are less likely to go wrong if banks know that bankruptcy could result. The notion of too-big-to-fail perversely incentivises banks to pose maximum systemic risk.

King’s comments echoed those put by Oxford economist John Kay in a paper for the Centre of Financial Innovation. Both King and Kay concede that it would be quixotic to resurrect the defunct Glass-Steagall Act, which prevented US consumer banks from combining with investment banks following the Wall Street Crash. However, Kay argues that the Act’s aim of preventing banks from leveraging their deposit base for high risk counterparty activities could be achieved by imposing a ‘firewall’ between utility and casino activities. This would involve the creation of separately capitalised or stand-alone ‘narrow banks’ whose deposit base would be guaranteed by the state, provided that it was backed 100% by government bonds or similarly liquid assets and provided that the bank’s wholesale market activities were tightly restricted.

The obstacles to these ideas are, sadly, formidable. The banking sector will fight them tooth and claw. It suits banks to have a large deposit base to use as collateral for their speculative activities and the government guarantee this brings lowers borrowing costs. It also gives members of the existing cartel a commercial advantage over smaller competitors not yet considered too big to fail. Banks that do not have retail arms will want conglomerates that do to preserve them because the exposure of that conglomerate to their activities could secure their status as too systemically important to fail.

Although the government plans to break up the banks it bailed out into three new retail banking chains, this falls short of requiring all banks operating in the UK to divide utility and casino operations. Gordon Brown responded to King’s remarks by saying that such a division would not have prevented the crisis: ‘Northern Rock was effectively a retail bank and it collapsed. Lehman Brothers was effectively an investment bank without a retail bank and it collapsed.’ Meanwhile, Chancellor Alastair Darling and the head of the FSA, Adair Turner, have argued that King’s proposal would be too impractical. Lord Turner said ‘when you get down to the details you have to set things out and say ‘where are you putting the divide?’. It’s very difficult to do that by writing a law that says this is what you can do and can’t do.’

It’s worth noting, however, that Northern Rock was up to its eyeballs in the credit default swap and securitisation markets and the collapse of Lehman Brothers’ wreaked such havoc because of exposure of utility banks to Lehman’s through counterparty trades that narrow banks would not be allowed to undertake. In any case, King was not suggesting that narrow banking would rule out the possibility of banks failing. Rather, he argued that since bank failure is a fact of life, we need to protect depositors in a rational and sustainable way.

The impracticality argument against narrow-banking takes one of the central problems of the banking system – it’s baffling complexity- and uses it as a reason not to reform. Moreover, the FSA’s preferred policy of making banks draw up ‘living wills’ (wind-down plans for in case a bank fails) is predicated on the idea that the unraveling of complex balance sheets is both possible and desirable. Something which apparently is not possible for narrow banking actually turns out to be a bit possible for living wills.

The living will is a less radical approach than bank separation as it pulls the punch of the explicit refusal to guarantee casino activities. The same could be said for the other crisis strategies being backed by the government and the FSA: bonus restrictions and making banks hold more capital against riskier assets. These have the additional flaw of being easily circumvented. Curb bonuses and banks will hike fixed salaries. In theory, capital requirements make high-risk transactions more expensive, but they are nothing new and bankers ran rings around them during the boom years, shoveling risky assets into complex off-balance-sheet structures and bundling dodgy loans up with good ones in order to inflate credit ratings. Regulators and ratings agencies often did not understand what the banks were doing. No wonder King thinks it is ‘delusional’ to believe that regulation alone will be sufficient.

Why does the government prefer timid tinkering to radical reform? I don’t think the government is deluded, but I do think it may be desperate enough to prioritise revenue-raising over long-term financial stability. Breaking up banks would antagonise the sector, curb its profitability and thus weigh on Treasury tax receipts in a way that a near-restoration of the status quo ante would not (The real engine behind the Lloyds and RBS disposals was Brussels rather than London). This would not be dissonant with the way in which banks are being encouraged to borrow at next-to-zero percent interest, while under no real obligation to lend that money to businesses instead of pouring it into the equity, debt and derivatives markets. The banks can probably sense that cash-strapped governments such as ours may not, in the end, force the regulation issue. Banks are already siphoning off for bonuses cash that could be have been used for recapitalisation – the Centre for Economic and Business Research expects the City bonuses to hit £6bn this year- and those that are raising equity are mostly doing so to raise the minimum required to pay back state aid (e.g. Lloyds, ING) not in anticipation of the new, more stringent capital buffers heralded by the G20 at Pittsburgh.

Even if the government embraced the principle of root-and-branch institutional reform of the banking sector, it would not carry it out unilaterally in case this put the City at a competitive disadvantage. That countries with major financial centres fear being undercut is understandable, but it is also the reason why international banking regulation is such a lowest common denominator affair.

Since the collapse of Lehman Brothers, we’ve had a year of self-consciously ‘historic’ summits – ‘Bretton Woods II’, G20 London, G20 Pittsburgh – held in windowless, bomb-proof halls, where world leaders have jostled to declare the end of this and a new era of that. There is still more summitry in store and from this shall spool forth reams of requirements and ratios, protocols and accords. All of these will be declared ‘unprecedented’ and all of these will fail to confront the bleak reality that we emerge from this crisis much as we entered it: held at the throat by a financial sector that is out of control.