Why much of the G20 debate on banking reform is futile

What do we want from our banks? The answer might seem fairly obvious.

First and foremost, we require safety for our money. That's what banks were originally for. But these days we expect more than a simple safe deposit box. We also want our money to be put to good use, so that it can generate a return. Banks attempt to do so by lending the money out. Understandably, this can never be an entirely risk free process, but the "maturity transformation" of money thereby achieved is a vital part of any thriving, free market economy.

Over the past two years, the banking system has failed in both these core functions. Will the mass of new banking regulation under discussion at this week's G20 summit in Pittsburgh succeed in recreating the expected combination of safety for our money and the easily available credit economies need for growth and prosperity? From where I sit, it looks far from assured.

Sure enough, most of what's proposed on leverage, capital and liquidity ought to ensure that banks are safer. But the measures proposed will also make credit scarcer and more expensive, as well as raising barriers to entry in an industry desperately in need of more competition.

There is a consequent trade off between safety and risk, which if it leads to permanently high unemployment and lower growth may not be as obviously desirable as it now seems. It is by no means clear how much of this stuff is really necessary, and certainly it would be counter-productive to impose it quickly. The effect would be to undermine the recovery and thereby further derail the banking system.

As ever with the G20, there is little agreement on the detail of what needs to be done. Countries still have subtly, sometimes dramatically, different views, depending on quite how impaired their banking systems are. On capital, everyone accepts there has to be more of it to cushion banks against bad debts, but how much more and what kind?

Americans generally take the view that the only true form of banking capital is equity, and want it doubled from presently accepted levels.

Europeans, more used to the idea of "risk adjusted capital" fostered by existing international convention, look at the numbers and are horrified by the implications. Many European banks would have to raise enormously more equity capital in conditions where it is still far from clear that markets will provide it. As in Britain, already overstretched governments might need to plug the gap.

In a further wrinkle to the debate, Lord Turner, chairman of Britain's Financial Services Authority, wants to see capital and liquidity ring fenced on a national basis, so as to prevent what happened in the Lehman Brothers collapse, when there was virtually no liquidity and capital to support the London subsidiary when the bank went down.

Big international banks traditionally move liquidity around the world according to where it is most needed and efficiently applied. To prevent them from doing this would be a step back to the national, utility style banking of more than twenty years ago, a wanton act of what Gordon Brown, the Prime Minister, has called "de-globalisation". Banks would come to support only their own, domestic economies.

Would investors be prepared to back such a banking system with the vast quantities of new equity demanded of them? This seems questionable. Markets have come to expect a rate of return on equity from banking in the mid teens and upwards. These expectations have been badly upset over the past two years, but investors wouldn't be recapitalising banks in the manner required unless they expected returns to go back to where they were.

Utilities don't, on the whole, deliver 15pc plus rates of return. What's more, the great bulk of what they do deliver is through dividends. Many banks are not paying any dividend at all at present, but even in "normal" times, they don't pay much. If capital and liquidity requirements are driven up, and leverage down, then banks will be turned into utilities and investors will require much higher dividend payments. In such circumstances, credit is bound to become more expensive.

The same point can be made about leverage, which G20 policymakers seem determined to cap at somewhere in the high teens. Excessive leverage is one of the primary causes of the banking crisis, so this would seem to be a case of the lower the better. Would it were so simple. The smaller the leverage, the lower the return on equity.

Never mind the consequences of imposing low levels of leverage, how is this brave new world of capital rich banks going to be achieved in the first place? Since the credit crunch started, Royal Bank of Scotland has already had tens of billions of pounds of new capital both from private investors and the Government, yet still it would have to raise at least the same again, and/or reduce its balance sheet size by roughly a half to arrive at the sort of leverage suggested by the G20.

Again, it is not clear that markets are up for providing capital on these terms, or ever will be. If they are eventually persuaded to cough up, they will extract a heavy price. Policymakers insist that none of these proposals are intended for implementation right now. To do so would only further damage an already seriously impaired system.

Instead, they will be imposed once the economy and the banking system are unambiguously set on the road to recovery.

Like everything else about the G20, the mindset is to set policy for some ill defined date down the line, but not yet. It is fairly obvious why. The ability of most UK banks and many of their overseas counterparts to access wholesale funding is still close to zero. Rather, they rely on government and central bank liquidity to keep them afloat. In theory, that's due to be withdrawn over the next three to four years.

Wholesale markets are slowly reopening, but according to the Bank of England's last Financial Stability Report, there remains a "funding gap" – the difference between customer deposits and loans which for the moment is filled by public money – of around £500bn, or about a third of GDP. The problem is proportionately bigger in Britain than most other advanced economies because of the relatively large size of the country's banking sector.

Virtually all this publicly provided liquidity is due to be withdrawn by 2013. To plug the hole, banks will either have to shrink balance sheets to match, or find alternative sources of finance.

It hardly needs saying that market funding is a lot more expensive than central bank and government support. The simple act of weaning the banks off public money will inevitably make credit a whole lot costlier, even ignoring the new G20 capital and leverage regimes. Are policymakers seriously intending to impose harsher capital and leverage regimes on top?

These apparently intractable problems make much of the present policy debate seem somewhat academic. Imposing all this stuff is so far in the future as to be hardly worth debating. The markets will in the meantime establish their own standards for capital and leverage, whatever the regulators say. We all want to see banking made safer, but if safety was all that was required, nobody would ever get out of bed in the morning.