How Britain's banks will never be the same again

The party's over. Yesterday's extraordinary set of Government measures to bolster the banking system will change how the sector operates, firmly closing the door on the era of excess in the financial industry.

After more than a year of telling the banks to put their own houses in order, the authorities were finally forced by tumbling share prices and seizure in the money markets to come to the industry's rescue.

There will be the widely expected industry-wide recapitalisation, with the big seven banks plus Nationwide boosting their safety buffers by about ?25bn this year.

But the most important elements were the doubling of the Bank of England's Special Liquidity Scheme to ?200bn and the acceptance of a wider range of collateral and – especially – the Government's offer to guarantee up to ?250bn of their debt. Lack of liquidity was the biggest concern for the banks and if increasing their capital ratios is the price they have to pay for the Government's largesse then so be it.

The initial ?25bn capital boost would take the big eight's average tier one capital ratio from 9.1 to 10.3 per cent, Keefe Bruyette & Woods analysts calculate. All the big lenders have agreed to get their capital ratios up to the required level, but not necessarily by taking the Government's money.

HSBC, Abbey Santander and Standard Chartered all said they were participating, but that they would either raise the money internally or in the market. Barclays is also understood to believe it can raise the money from existing investors by issuing preference shares on the same terms the Government would have demanded.

But whether or not they take the Government's money – paying a reported coupon of 9-12 per cent – the banks will have to hold more capital and will face greater scrutiny of their business risk by the Financial Services Authority, which is throwing its weight around after being caught napping during the boom years.

The Government has not set a common ratio, and instead the FSA will negotiate with – or tell – individual banks about what levels of capital they should hold. They will also have to pay more for the Government's guarantee of their debt if their business models are judged to be risky – another incentive to toe the line.

Is this the socialisation of the banking system? Not really. But the measures will add to existing pressures that will constrain banks' businesses and reshape the sector.

Alex Potter, banking analyst at Collins Stewart, says the Government's drive to improve capital ratios is correct and has echoes of banking regulation under the Bank of England when each bank was given guidance over its capital levels. That system gave way to a free-for-all in recent years where both the level and quality of banks' capital buffers was allowed to slip as lenders lent more and more against their reserves, moved assets off balance sheet and replaced top-notch shareholder equity with new debt instruments.

"The Government is taking more interest in the banking system and is saying if you want access to these funds you will have to run less risky business models. I'm not sure we are going back to a more boring banking system, but we are going to a system that is not going to get any more interesting," Mr Potter says.

Banks used to act simply as middle men between depositors with excess funds and borrowers who wanted to buy houses or invest in their businesses. This "maturity transformation" plays a vital role in the economy by using short-term funding for longer term purposes.

But to boost profitability in what is naturally a mature, slow-growth banking market, Britain's lenders spent the last 10 years gearing up their balance sheets. This meant expanding lending massively and using the booming wholesale markets to offload assets and raise fresh funds. Northern Rock securitised mortgages and used short-term funding to the point where only a quarter of its loans were supported by old-fashioned deposits. Banks with big corporate and markets arms, like Royal Bank of Scotland, expanded in leveraged lending and parcelling up mortgages into structured products that could be sold to investors.

The Government wants to be seen to be bringing the banking industry into line after the years of excess. Shareholders and bosses will be penalised while ordinary taxpayers will be rewarded. The Government said it "will need to take into account dividend policies and executive compensation practices and will require a full commitment to support lending to small businesses and home buyers".

Paul Niven, head of asset allocation at F&C, says the Government intervention was inevitable and welcome in the short term but that the longer-term implications for the sector are less rosy.

"Banks will have to operate within a much tighter framework. What kinds of loans are they going to have to make and to which businesses and on what criteria? Will it be profitable lending? What is the benefit to a lot of these banks that have investment banks which have generated large profits on the back of proprietary trading? Maybe it is not in the taxpayer's interests to have them punting their balance sheets around."

Simon Gleeson, a partner at the law firm Clifford Chance, argues that in the furore over the Government's capitalisation and liquidity plans the market has missed the more important changes lurking in the banking reform Bill, published yesterday. Because retail depositors will take precedent over commercial lenders to a troubled bank, UK banks will have a far higher cost of borrowing in commercial markets.

"What we end up doing is breaking up the industry," Mr Gleeson says. "You will have deposit takers which do little else but take deposits and make personal loans, and separate unregulated or lightly regulated entities which do what used to be called investment banking. The 1980s have been declared a mistake."

The change could threaten the universal banking model in the UK, which is back in fashion in the US after JPMorgan bought Bear Stearns and Merrill Lynch was forced to sell itself to Bank of America. The main British banks that will have to grapple with this problem will be Barclays and Royal Bank of Scotland, which have built up large debt-focused investment banks on top of their core retail banking activities.

Experts warn the Government's intervention could backfire if it does not secure a similar response from other major global regulators in a new international settlement for the financial system. Giorgio Questa, professor of Finance at Cass Business School, says: "The Government is trying to get political mileage out of using the taxpayer to make good for their mistakes in the last 10 years. They have been abysmal in the conduct of supervision and now they want to interfere again. If England tries to do its own regulation separately from global regulation, it can kiss goodbye to London as a global financial centre."

Bosses' pay to be curtailed

After years of cosying up to the City of London, the Labour Government is clamping down on pay in the banking sector. The Treasury said explicitly yesterday that the authorities would look at banks' pay when deciding whether to support banks with capital injections.

Financial authorities in the US and the UK believe the high pay and bonus culture at banks contributed to the sector's reckless practices by offering massive rewards for short-term profit. Bonuses in the millions for chief executives and traders alike helped turn the stolid industry of banking into a casino of proprietary trading, overstretched balance sheets and warehousing of dodgy securities.

Those practices created massive profits for banks in the boom years but many have now lost all the gains and the wider economy is paying the price. Yet though their companies may have gone to the wall or come close to oblivion, individual bankers have kept the bonuses that rewarded their excess.

Sir Fred Goodwin, the chief executive of Royal Bank of Scotland, earned ?4.1m last year, including a bonus for the bank's acquisition of ABN Amro, which the bank now admits it overpaid for. Andy Hornby, the boss of HBOS, earned ?1.9m in 2007 but his bank was forced to sell itself to Lloyds TSB last month to avoid going bust.

Lloyds own chief executive, Eric Daniels, was paid ?2.4m last year.

The Prime Minister said yesterday that the Financial Services Authority would draw up a code covering executive pay at the banks. The move will formalise measures announced earlier this year when the FSA said it would include pay schemes when assessing the riskiness of a bank's business model.

Watchdogs already exercise control over pay in regulated industries such as the energy sector, Stella Brooks, director at Inbucon, the pay consultant, says. It is easier for those regulators because they control pricing and companies know that excessive pay can be punished with lower prices.

Banks are also more complicated because their chief executive's pay is often vastly outstripped by earnings of top traders or merger advisers. The most high-profile disclosed bonus in the City is that of Bob Diamond, the president and investment banking chief at Barclays. Mr Diamond earned ?250,000 in salary last year but was paid a ?6.5m cash bonus, with share options taking his total remuneration to ?18.5m.

Peter Hahn, a fellow at Cass Business School, argues that changing banks' pay structure to ward against short-term excess is simple. Simply align chief executives' pay more closely to risk and they will do the rest of the work to make sure they get a bonus at the end of the year.

The banks have insisted for years that they operate in international markets and that their chief executives are in constant danger of being poached by US banks for far higher rewards. But that argument is harder to make with banks in the US reporting massive losses and a big backlash against excessive pay and pay-offs for chief executives.

"If banks try to use that argument now, that is when the regulator turns round and says, 'Fine'," Ms Brooks says.

Critics of the Government have said that its claim to be clamping down on City pay is political posturing that will be conveniently forgotten because the country relies on financial services' pay to drive the economy and provide tax revenue. The Centre for Economic and Business Research has forecast that City-type bonuses will fall to ?5bn this year, from ?8.5bn in 2007. That spells bad news for the UK's finances, which CEBR calculates could have received about ?3bn from last year's bonus pool.

Sean Farrell