Bank ringfencing is not only a false hope – it is nowhere near ambitious enough.

I know Stephen Beer would be embarrassed if I called him one of the Labour party’s most valuable and underused resources, but there it is. His pamphlet on the economic credibility problem should be required reading for every CLP and it is no surprise that he has raised another important debate in his piece on this website yesterday.

Since the crisis, the scale of risk operated by banks has changed immeasurably. In the case of the majority of institutions, the amount of leverage – in essence the amount of exposure to the amount of assets backing them – has halved. So severe is the de-risking that the Labour shadow financial secretary has led calls to make sure regulation doesn’t further force banks away from the business lending activity so fundamental for growth.

In truth, the challenge of making banks resilient against crises has been largely achieved, perhaps even too aggressively in some areas. What is still unsolved is how to make sure that banks are able to be safely folded inwards if they do fall apart, and how, as Stephen puts it, businesses can have access to finance.

This brings me to Stephen’s call for structural reform, through a separations of utility banking from the more esoteric activities of investment banks. This ringfence idea has been part of the debate since a similar plan was enacted (and subsequently repealed) in the States through the marvellously named Glass-Steagall Act.

There are two basic claims for ringfences, both of which, I believe, are wrong.

First, that they improve the systemic safety of banks. The premise is that by separating the riskier investment bank, you improve the safety of the utility bank. But in practice banks with only one of these two functions will be smaller and less diversified, and therefore less able to survive a shock. As a strange truth, no ‘universal’ bank with both of these businesses failed during the crisis. The failures were from the monoline banks with almost all retail or investment, or mortgage businesses. It may be counterintuitive, but ringfences make us less rather than more safe.

The second is that they protect the customers from abuse. I don’t believe that stands either. The mis-selling of interest rate swaps and PPI both originated in the utility section of banks, and the Libor issue making the news at the moment, although arising in the investment bank, would not have been prevented by a ringfence.

Instead, universal banks have an ability to reach across the various sorts of finance to give businesses access to a wider range of support beyond the traditional bank lending model. We would do well to think carefully before putting that at risk.

So ringfencing isn’t the solution.

The solution – or part of it – is found in two other proposals. First, don’t ringfence banks; create corporate structures so that any individual bank can collapse without taking the utility elements with it, and without causing a system-wide panic. That is entirely possible and some of the more enlightened banks are well on the way to achieving it.

Second, and more deeply, we need to look beyond the traditional banking sector for our future growth finance. The UK has an almost bizarre over-reliance on bank lending as a means of funding small business. Bank lending is cheap and efficient, but it is also very cyclical and therefore shrinks with the economy during recessions. And, of course, back to my initial point about banks being far less leveraged post-crisis, there is simply going to be less traditional lending around in the future.

Regulators require banks to consider a small business loan as representing four times the risk of a mortgage, spreading the already-reduced leverage even more thinly. The macroeconomic picture looks equally changed; the chunk of credit that we were borrowing from the east before crisis is steadily drying up as countries there start to turn their incomes toward consumption. The picture overall is of a growth model that no longer functions.

The alternatives are to be found in non-traditional markets like venture capital, and yes, in some of the activities of investment banks such as equity, private placements and bond issues. We have much to learn from other countries in all of these areas, and we shouldn’t be afraid of active industrial policy to make it happen, whether through risk subsidies or tax relief to redress the fundamental economic imbalance in the economy.

Stephen calls for leadership from Labour. In people like him, Ed Balls and in Chris Leslie, we have the right people to do that, but I would encourage them to set aside the false hope of a ringfence and think bigger and bolder. Let Labour be the first party to fully grasp the key lesson from the credit crisis – that the old way of delivering growth no longer applies and we need to start planning for an entirely new form of economy.

Let Labour be the first party to truly understand the post-crisis economic challenge.

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Allen Simpson is a former Labour party researcher and former political adviser to the London Stock Exchange. He tweets @Allen_M_Simpson

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Photo: dystopos