What could ICB's plans mean for the future of UK banking?

April 11th saw the release of the long-awaited interim report from the Independent Commission on Banking (ICB) headed by Sir John Vickers - but what does it mean for the UK's financial services sector?

It would appear the industry itself largely welcomed the report, with banks gaining on the FTSE 100 share index following its release - which may suggest that shareholders were not scared off by the suggestions.

Indeed, many commentators have noted that the commission made the decision to steer clear of some of the more radical routes it could have chosen to head down in setting out the future of UK financial services, with Sir John himself revealing that the group favoured a "moderate" approach of combining capital and structural reform.

So what exactly were the commission's suggestions?

Sir John explained that the need for reform within the industry became apparent following the economic crisis of 2007, which exposed "fundamental weaknesses" - not only in the UK's financial system, but also on a global scale.

Key factors in this had been that the banks were able to operate with inadequate liquidity shored up against assets that had grown to twice the normal levels compared to capital bases. This meant that when the crisis broke, the balance sheets of lenders were not equipped to deal with the losses and successfully absorb them.

As a backdrop to all of this, the commission also accused lenders and borrowers of taking "excessive and ill-understood risks". The result was that the government and central bank felt obliged to inject financial services providers with a "vast" sum of capital in order to ensure that basic fiscal services could continue.

It was this situation that the ICB sought to address in its interim report by suggesting the necessary reforms that could potentially ensure that a similar crisis does not happen again.

Of course, these are not the first in-depth proposals that have been made on this subject. Confirmed in September 2010, Basel III - drawn up by the Basel Committee on Banking Supervision and announced by the Group of Governors and Heads of Supervision - has already set out the obligation that lenders must raise their minimum common capital reserves from two per cent to 4.5 per cent by January 1st 2015. By 2019, an additional capital conservation buffer of 2.5 per cent will be required.

In addition to this, the UK has begun the long process of overhauling the framework of bodies that oversee the financial services sector. Upon taking up the position of chancellor of the Exchequer, George Osborne said in 2010 that the three-tier model consisting of the Financial Services Authority, Bank of England and the Treasury would come to an end. In its place will be the Financial Policy Committee, the Financial Conduct Authority and the Prudential Regulation Authority, with work currently underway to establish these.

But what of the banks themselves? According to Sir John, there is a need to make the UK's financial services sector more stable, while also increasing competition within it.

In order to make the banking industry safer, the ICB has proposed an approach that ensures lenders are better able to absorb losses, that it is made simpler and less costly to "sort out" those banks that do find themselves in trouble, and that incentives for risk taking are curbed.

Building on these foundations, the report has suggested that systemically important banks hold equity of at least ten per cent - higher than Basel III's baseline ratio of equity to risk-weighted, which is set at seven per cent by 2019. In addition, the commission has called for "genuinely loss-absorbent debt" in line with this in order to create a more positive balance between lowering the impact and frequency of an economic crisis and raising the cost of lending.

"The commission's view is that the ten per cent equity baseline should become the international standard for systemically important banks and that it should apply to large UK retail banking operations in any event," the report notes.

Turning next to more structural reforms, the ICB has proposed the idea that retail banking be "ring-fenced". By limiting lenders' freedom to diminish their capital, this would enable risks to be reduced, while still preserving universal banking by ensuring that such financial services providers maintain the UK retail capital ratio. This should mean they would be unable to exhaust this reserve by directing it towards global wholesale or investment banking.

Rather than a full break up of the banks - which some industry insiders had feared - this more moderate approach is believed by the commission to offer a number of advantages, including that should a large bank get into trouble, its various divisions can be treated in different ways.

The report suggests that a commercial solution could be found to address some issues, while at the same time the essential retail elements of the bank would continue to run. In addition, the risk to the taxpayer that they may be called upon to bailout an institution would also be minimised. Because of their differing natures, national policies would therefore have a more direct bearing on retail banking, while wholesale and investment banking - which operates in a more international market - must be subject to a globalised policy. In addition, the report noted it was "vital" that the groups be allowed to fail safely.

Competition was also a key area of the commission's focus, as it noted this was damaged by the economic crisis. It suggested that this could work better for customers if divestiture of Lloyds Banking Group - proposed by the European Commission and also affecting Royal Bank of Scotland - helped to create a more effective challenger to the big banks. In addition, the ICB claimed that customers should see the ease with which they can switch lender with confidence improved, while finally the ongoing reform of the country's regulatory system should ensure that competition is at the core of its agenda.

As a further round of consultation gets underway - due for completion in July - what has been made of this interim report?

The British Bankers' Association responded by pointing out it will "take time" to consider the impact on the wider economy of the proposals, along with the cost of implementing them. It added that UK banks have already undergone "significant change" since the start of the global crisis, raising their capital and liquidity while witnessing the regulatory framework that oversees them undergo dramatic reform. "As such, due consideration must be given to where the ICB's interim recommendations fit within this ongoing programme, some of which remains work in progress, with further changes due before the final report is due," it noted.

However, both Chancellor Osborne and shadow chancellor Ed Balls welcomed the report, with Mr Osborne saying: "Our goal is to make sure that in future we have safer banks, but also that millions of pounds of taxpayers' money is not spent again bailing out those banks."

For the time being, however, the financial services sector will be eagerly awaiting to hear the final recommendations the commission put towards the government in autumn 2011.

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