Tomorrow the Independent Banking Commission headed by Sir John Vickers will publish its interim report. The Commission of five economists and bankers, chaired by former Bank of England chief economist John Vickers, was tasked with considering a full-scale break-up of banks – something Liberal Democrats had called for in their election manifesto. Regulation holds the key to successful functioning of the financial services or banking industry. The main argument made until now for completely breaking up the banks is that it is unfair that ordinary retail customers should be put at risk by the investment banking arms. That is likely to be true, in that when a consumer bank – Northern Rock – adopted an investment bank style of financing in the shape of aggressive securitisation it failed horribly. This report due to be published tomorrow will not support the total break-up of Britain’s biggest banks, according to the BBC. Instead it will favour ring-fencing their risky investment banking operations, so they do not jeopardise the savings of ordinary depositors.

Most of the big “Wall Street banks” have long come off the critical list, repaid the US government every cent invested or borrowed, and are happily paying dividends. Conversely, in the UK, Northern Rock, Royal  Bank of Scotland and Lloyds Banking Group soldier on, largely on the back of the UK government. The new ‘firewall’ arrangement is intended to eliminate the possibility of losses at the investment banks being borne by the public purse. Customers’ deposits, business lending and the transmission of money would be ring-fenced within the universal banks as new subsidiaries, endowed with increased capital resources to protect against losses.

Markets are likely to see the ring-fenced investment banks as riskier credits, making it more expensive for them to borrow and undercutting their profits. Rating agencies will be looking carefully at the report to understand how it affects the chance of banks being rescued by the government in future financial crises. One of the most famous agencies, Moody’s, said on Thursday that it will review ratings for 19 UK banks this year in light of the tougher regulatory environment, with many likely to face large downgrades. What happens to banking regulation will have worldwide implications for our relative competitive advantage, say, for example, compared to New York or Shanghai.

The ring-fencing may mean that rating agencies give investment banks separate – and lower – credit ratings than their parent banks. The buzzword is banking circles now is “subsidiarization”— the idea that banks can address regulators’ concerns by creating legal firewalls between their different businesses that stop short of full separation. Santander already operates a subsidiary structure along these lines: all its major units are separate legal entities, independently regulated and with responsibility for their own capital and funding. HSBC also largely follows this pattern. Since these have been two of the most successful banks in the world through the crisis, this models are understandably attracting increasing attention as a possible solution.

However, subsidiarization is not the complete answer to the regulators’ dilemma. For example, a subsidiary structure would have enabled U.K. regulators to stop Lehman Brothers transferring large quantities of cash to the U.S. the night before it went into administration. Similarly, U.K. regulators would have been able to ring-fence the operations of Icelandic banks active in the U.K. before the crisis by forcing them to hold their own capital and liquidity. Instead, they collapsed with their parents, with disastrous consequences for the U.K. economy. Not surprisingly, regulators are keen on subidiarization as part of their efforts to force banks to maintain so-called living wills to help ensure an orderly wind-up. Any regulation has to be correctly thought through this time around.

For example, the Wall Street Journal has previously remarked (link to the article here),

“[It is considered not atogether clear] subsidiarization provides the kind of firewall between different parts of a bank needed to protect taxpayers in the parent country. After all, HSBC operates a subsidiary structure, but that did not stop it funneling billions of dollars into its troubled U.S. unit, Household, rather than allowing it to go bust. At the time, HSBC argued persuasively that allowing Household’s bondholders to bear the losses from the unit’s disastrous subprime lending would have calamitous consequences for its own credit rating. Santander argues that its decision to write down the value of its Argentinian unit to zero during that country’s devaluation crisis early in the decade shows it was willing to cut a troubled subsidiary adrift. But ultimately, it never took this step—no bank could easily survive such a breach of trust. But because banks would retain the ability to deploy their capital across the range of their activities according to the returns they perceive to be available at any particular moment, the increase in their costs of doing business would not be – in their view – prohibitive.”