The Bank of England has warned UK banks that they face being broken up unless they consent to new plans to ring-fence assets to prevent a repeat of the financial crisis, that saw two major banks taken under state control.
Andy Haldane, the Bank of England's financial stability director, told the Parliamentary Commission on Banking Standards that a statutory law enabling bank break-up would ensure banks stay in line.
The Government is currently looking into ways to implement the proposals on banking reform suggested by the Vickers Commission, which reported to Government in September 2011.
The Vickers Commission
The Independent Commission on Banking was set up in 2010 to consider reforms to the banking sector after the financial crisis. The Commission was chaired by Sir John Vickers, an economist and lecturer at Oxford.
The Vickers Commission recommended several ways that banking could be improved, including greater capital requirements to ensure banks could weather financial storms and more competition in the retail banking sector.
The Commission also recommended that banks separate, or 'ring-fence' their risky investment banking business from their retail deposits, providing greater protection to consumers and a safe-guard against failure.
"Legislation if the ring-fence proves permeable, that struck me as quite a clever way of implementing Vickers faithfully, it creates incentives," said Andrew Tyrie, the Conservative chairman of the Commission.
Bankers have previously said that whilst they accept the idea of ring-fencing, it would need to be 'flexible' to allow capital to flow in and out of the investment side of the business. However, the Commission is against a 'permeable' barrier, believing that it will make the changes ineffective.
The Commission's proposals fall short of recommending a physical separation, which Mr Haldane believes would be unnecessary if the Vickers proposals are implemented in full.
Other proposals under consideration by the Commission include a limit on the size of a bank's balance sheet to a proportion of GDP and a new software package to centralize banking information, making it easier for consumers to switch from one bank to another.
"Technology specialists say there is no technological barrier. A cost-benefit analysis could come out in favour of radical change, not just incremental change," he said, in relation to the software proposals.
In addition to domestic financial reform, the UK is committed to further capital requirement reforms via the Basel III mechanism. Basel III is a series of proposals designed to ensure better liquidity of banks and to ensure that liquidity is of a sufficient quality to weather another financial crisis.
The Basel III reforms are to be implemented through EU law into the national laws of EU member states from January 2013. It is thought the proposals will not be totally implemented until 2021, however.
Basel III requires banks to hold 4.5% of common equity (previously 2%) and 6% of so called 'tier 1' capital in the form of risk-weighted assets. Tier 1 capital consists of common stocks and reserves of cash, in effect 'tangible' assets.
It is thought that countries implementing Basel III will lose 0.05-0.15% of GDP as a result.