Hamish McRae: Should we go back to the future to avert another banking crisis?

Break up the banks or make them have plans for their own demise? This week has seen a sharp divergence of opinion as to how banking reform should proceed. This is a global issue rather than a UK one, and there will have to be some kind of global consensus. Still, the different views here between the Treasury and the Financial Services Authority on the one hand and the Bank of England on the other are worth trying to unpick because it highlights the arguments of this global issue.

The whole thing has taken on a personal note because relations between the Governor and the Chancellor are exceptionally bad, arguably worse than any time since the 1970s. Relations between the Governor and the banking community are also pretty dreadful too. There ought to be some tension between the Bank and the Treasury because they have different roles, and there should certainly be tension between the Bank in its regulatory role and the industry that it, with the FSA, regulates. But the level of animosity is unusually high by historical standards, and that seems a shame, because it gets in the way of the arguments.

In essence, the argument of the Bank of England, or at least that of Mervyn King, its Governor, is that there should be a separation between the deposit-taking and lending function of banks and their trading and speculative functions. It is not quite the same as the distinction between commercial and investment banking as in the US under the Glass-Steagall Act of 1933, repealed in 1999, nor the split in the UK between the clearing banks and the merchant banks that existed through to the "Big Bang" reforms in 1986, but there is an element of "back to the future" about these proposals. Versions of this approach have been put forward by Professor John Kay, Mr King's co-author of their economics textbook, and by Paul Volcker, the former chairman of the US Federal Reserve.

The core idea here is that there should be closely regulated "utility" banking, where the banks' entire deposit base is in effect guaranteed by government, and any of the other financial activity can only be done by other institutions where there is no guarantee at all in the case of failure. In addition Mr King wants banks to be smaller; he feels that in the UK at least the industry is too concentrated. Ironically it has become more concentrated by the shotgun marriage between HBOS and Lloyds Bank.

This makes intuitive sense. But if you ask what would have happened during the past couple of years had there been such a regulatory split, the response is not entirely comforting. It was Northern Rock, a utility banking institution specialising in an unflashy end of the business, home loans, that triggered the start of the UK breakdown, and it was the failure to rescue Lehman Brothers, the New York investment bank, that triggered the global disaster. Gordon Brown made those points in the House of Commons very clearly.

There is a further point here. Until the Big Bang there was an implicit Bank of England guarantee not just of the clearing banks but also of the main merchant banks, the members of the Accepting Houses Committee. Allowing Barings to go under in 1995 broke that understanding, and so should have made everyone aware of the risks associated with non-utility banks – restoring the sense of "moral hazard". But self-evidently it didn't.

The alternative approach, articulated by the FSA and backed by the Government, is to not to try to split the industry into two, but rather to require them to have more capital to cover the risks they take. You might say that its aim is to adapt regulation to the industry as it is – or at least more or less as it is, as the structure of the industry would probably itself change in response to changes in regulation. The FSA has just published proposals that would require banks deemed "too big to fail" to carry greater capital requirements as a form of insurance against such dangers. The plans also would try to ring-fence different markets, so the UK taxpayer would not be responsible for risks a UK-based bank took in other countries around the world, as was the case in the Royal Bank of Scotland. It acknowledges that maybe there would be some sort of split between commercial banking and financial market trading, but that is not the main thrust of the FSA plan.

It is oversimplifying dreadfully, but one approach is to split banking into safe and risky and stop "safe" banks being allowed to do anything risky. The other is to say banks will do all sorts of different activities, and that is fine, but we will curb their excessive appetite for risk by making them stump up vast amounts of capital if they go over the top.

So what should the rest of us make of all this? Ten points.

One, there have been banking crises roughly once a generation, and there will be more. This is a bad one, but the very fact that this is so bad means that common sense will protect the system for the next cycle and perhaps the one beyond that. This is a problem for 2029 or 2039, not next year or the year after.

Two, this has to be international. The largest banks in the world, measured by market value, are now Chinese. So they (and the other emerging economies) have to be on board when the world refashions its banking regulation.

Three, we have to do better than last time, when international banking regulation encouraged banks to make do with less capital, not more. Countless hours of discussion by clever people were spent creating something that was worse than useless.

Four, central banks around the world have to accept some blame because it was their loose money policies, particularly those of the Federal Reserve, that led to the housing booms and hence the scale of the banking disaster. The Bank of England did not cover itself in glory either.

Five, it matters to the UK that we have an internationally competitive banking sector. The costs of the rescue do look very high, but quite aside from the fact that banking has remained a huge foreign earner last year (in fact our largest single export industry), the better the banking recovery is managed the greater the chance that taxpayers will end up square or ahead on our investments.

Six, it matters to UK tax revenues that banking becomes profitable. Finance generally provided about 40 per cent of corporation tax, while its employees provided a disproportionate amount of income tax revenue. I know many people find the bonus culture distasteful, but tax revenue paid by bankers is tax revenue that does not have to be collected from the rest of us.

Seven, Mervyn King bundled together in his speech the costs of propping up the banks with the wider costs of the downturn. However, even if we had a smaller banking system, we would have found ourselves needing a big fiscal stimulus. Canadian banks have come through this cycle better than almost any others, yet Canada has had to give a huge fiscal boost to keep the country moving.

Eight, even without the banking crisis, we would have a serious fiscal problem, for we have a structural deficit of at least 5 per cent of GDP.

Nine, is it really wise to call for banks to be broken up? Our strongest bank, HSBC, is also our largest.

And ten, a little noticed point: where were the headquarters of all the banks that got into real trouble? Assuming Lloyds would have been OK had it not been suckered into buying HBOS, none were in London. So maybe we have had a regional problem, not a London one.