Its White Paper on Banking Reform (86-page / 878KB PDF) proposes to 'ring-fence' "critical banking services" in order to protect them from wider economic shocks. It also sets out proposals to make banks more resilient in the event of failure.
Draft legislation will be published this autumn, the Government said, with a view to completing the arrangements by the end of the current Parliament in May 2015. Banks will have until 2019 to comply with the new rules although smaller banks, holding less than £25 billion of mandated deposits, will likely be exempt from the requirements.
"The Government is delivering a major piece of reform," said Business Secretary Vince Cable. "We are leading the world in establishing the principle that investment banks should be separated from traditional banking, as part of a regulatory system in which the public do not subsidise banks and banks are allowed to fail without a threat to the system at large."
However banking law expert Tony Anderson of Pinsent Masons, the law firm behind Out-Law.com, warned that taxpayers, as bank customers, would ultimately pay for the reforms.
"Market reaction and confidence in these initiatives in the UK as a global financial centre will be monitored closely by other jurisdictions," he added.
The ring-fence, as recommended by Sir John Vickers' Independent Commission on Banking (ICB) in its report on banking reform last year, 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. In addition, ring-fenced banks will not be able to carry out any activities through subsidiaries or branches based outside the European Economic Area (EEA).
Only ring-fenced banks will be able to accept deposits from and provide overdrafts to retail customers, the Government said, with the option of more 'mandated' activities being included later. Similarly, ring-fenced banks 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, ring-fenced banks may be permitted to provide "simple" derivative products to their customers provided that a number of conditions are met.
"The Government's expectation is that where banks carry out other functions important to the domestic economy, such as the provision of domestic credit to households and SMEs and payment and transaction services, these will as a matter of practice be undertaken by their ring-fenced entities," the paper said. "However, the Government will continue to consider this matter."
The Government may later create more ring-fenced 'mandated' activities if it established that a short-term interruption of that activity would have a "significant impact" on UK households and small businesses, and where no short-term replacement for that service could easily be substituted, it said.
The paper reiterates the Government's "strong commitment" to the implementation of global capital and liquidity requirements for banks under the international banking agreement known as Basel III which will begin to take effect from next year. The Basel III commitment provides that banks hold high quality assets of at least 7% of their risk-weighted assets, meaning that for every £7 that banks lend out they must hold £1 in reserve to cover potential losses. The Government has proposed that large-ring fenced banks be required to hold an additional 3% equity buffer on top of this minimum, ensuring that they are "more resilient to shocks".
Ring-fenced banks would usually be expected to meet these requirements on a "standalone basis", regardless of how many of these banks were included within a single banking group, according to the paper.
Banking law expert Tony Anderson said that the 'location' and 'height' of the proposed ring-fence – covering which services and for whom should be included as well as the relationship between the ring-fenced bank and the wider banking group - would present "significant logistical issues" for banks.
"For example, the monitoring of SME annual turnover or individuals' net worth, to determine whether their deposits remain in or outside the ring fence, will present challenges for institutions," he said. "Similarly, introducing limits and collateral requirements on the credit or liquidity that a ring-fenced bank provides to other banks will create further hurdles and is likely to increase the cost of liquidity."