Chancellor promises banking system "re-set" in first major speech of 2013

George Osborne was addressing staff at US investment bank JP Morgan as draft laws to implement the recommendations of Sir John Vickers' Independent Commission on Banking (ICB) were published. The 'ring fence' will protect a bank's essential retail activities from wider economic shocks, ensuring that customers' money will be protected even if the whole bank fails.

The change will see financial regulators given the power to fully separate certain activities. So-called "electrification" of the ring-fence was proposed by the Parliamentary Commission on Banking Standards, in its first report, published last month.

"The work that Sir John Vickers and his Commission has done has won respect all around the world, and has already influenced the European debate," Osborne said in his speech. "My message to the banks is clear: if a bank flouts the rules, the regulator and the Treasury will have the power to break it up altogether - full separation, not just a ring fence."

Osborne said that he expected the new laws to be approved by this time next year as part of a "re-set" of the UK banking system. Other changes due this year include a new system of financial services regulation and more powers of choice for consumers, including seven-day switching for those who want to change bank account provider.

As previously announced, banks will have until 2019 to fully comply with the ICB's recommendations. The ring-fence will ensure that retail banking activities are provided by a separate subsidiary of a wider banking group. Ring-fenced banks will need to be legally and operationally distinct entities from non ring-fenced banks, and will not be able to own or hold the capital of other non ring-fenced entities within the group.

Only ring-fenced banks will be able to accept deposits from and provide overdrafts to retail customers. They will not be able to carry out certain pre-defined activities including international and wholesale and investment banking services, and dealing in investments as principal. However, they may be permitted to provide "simple" derivative products to their customers provided that a number of conditions are met.

In his speech, Osborne said that the rules would see high street banks having "different bosses" from those of their investment banks, while retail banks will "manage [their] own risks, but not the risks of the investment bank". Investment banks will not be able to "use [consumer] savings to fund their inherently risky investments", he said.

Banking law expert Tony Anderson of Pinsent Masons, the law firm behind Out-Law.com, said that much of the detail of what would have to be contained within the ring-fence was still to be finalised. However, he warned that the banks would lobby hard to reduce the size of the ring-fence if the Government pressed ahead with its 'electrification' proposals.

"The UK is currently the only jurisdiction in the world which is specifically ring-fencing retail banking activity from other banking operations," he said. "Other jurisdictions are focussing on separating only certain parts of investment banking activity such as the trading of the bank's own assets. These measures will only reinforce this differentiation making it harder for universal banks with global operations to continue to maintain the same operations in the UK in an already difficult trading environment."

"The nature of the proposed reforms impact directly on a vast number of day to day banking operations," Anderson said. "Determining whether a bank has failed to implement the ring-fencing measures will require a more aggressive, intrusive approach from regulators than currently exists as well as significantly more internal banking resource to ensure continued compliance. It may well force banks to establish ring-fenced operations which can be hived off more easily to lessen the impact of a breach."

Current regulator the Financial Services Authority (FSA) will be dismantled from 1 April 2013 and most of its day to day regulation and supervisory powers in relation to banks, building societies and insurers will be transferred to a new Prudential Regulation Authority (PRA). The PRA will be established as a subsidiary of the Bank of England. A new Financial Policy Committee (FPC), also within the Bank, will address wider 'macro-prudential' issues that may threaten economic and financial stability.

A new Financial Conduct Authority (FCA) will take over the FSA's conduct and compliance functions, as well as the prudential supervision of those firms not supervised by the PRA. Its objective will be to ensure that the relevant markets "function well" while seeking an appropriate degree of protection for consumers and protecting and enhancing the integrity of the UK's financial system. It will also have a duty to carry out its general functions "in a way which promotes effective competition", as far as is compatible with its consumer protection and integrity objectives.