I’ve not yet had the chance to read all 214 pages of the Independent Commission on Banking’s interim review, which was published yesterday. But going by initial impressions, I’m not convinced that their main proposal – requiring banks to ring-fence and separately capitalize their ‘retail’ (as opposed to ‘investment’) operations – deals with the fundamental problems in the banking sector.

Basically, the big problem is that the government effectively subsidizes bank risk-taking by guaranteeing (implicitly or explicitly) that banks cannot go bust. That gives shareholders (whose liability is already limited) an increased appetite for risk, and means they are unlikely to impose any restraints on bank activity. It also means banks can borrow far more cheaply than other corporations, and that its bondholders are unlikely to pay much attention to what is being done with their money. Finally, it means that depositors pay no attention to the stability of the institution they are entrusting with all their hard-earned cash. In short, government guarantees mean there is no market discipline to keep bank risk-taking in check.

Governments then inadvertently compound this problem by setting 'risk-weighted' capital and liquidity requirements. This is intended to offset the problem created by government guarantees by created minimum ‘safety standards’. In fact, these requirements tend to have two unintended, harmful effects. Firstly, they basically involve regulators setting a single cost for various risks. This drives market concentration – in order to comply with the regulations, everyone goes for the same investments at the same time, ensuring that the risks, should they materialize, are systemic. Secondly, these regulations create a strong incentive towards regulatory arbitrage – banks investing in order to ‘game’ the regulations. As well as perverting the allocation of capital, this creates opacity in the market, which also increases the potential for systemic risk.

In short, despite best intentions, government intervention first encourages banks to take more risk, and then ensures that those risks are likely to be both systemic and opaque. It is a recipe for disaster.

On that basis, I’d argue that banking reform should have two key aims. Firstly, it should ensure that banks can fail without triggering a wider financial and economic crisis. In doing this, the reform should make clear to market actors that banks will be allowed to fail if they get themselves into trouble. Secondly, reform should ensure that regulation does not distort capital allocation or drive market concentration.

The Commission’s proposals deserve a more in-depth assessment against these principles than a blog post will allow, but it does seem clear to me that the interim report released yesterday provides – at best – no more than a partial solution to the banking system’s problems.