Britain's banks in the line of fire

AS HE heads off across the City tomorrow morning, Sir John Vickers will be preparing for the onslaught of phonecalls, e-mails and meetings that are likely to continue well into the night as the City digests his long-awaited report into the UK banking industry.

The contents of the 200-page document have been a closely guarded secret and even the heads of Britain's biggest banks, including Royal Bank of Scotland chief Stephen Hester and new Lloyds Banking Group boss Antnio Horta-Osrio, will be pacing nervously as their best strategists calculate how the report's recommendations will hit their businesses.

Ever since George Osborne announced the creation of the Independent Commission on Banking (ICB) shortly after the General Election last year, the banks' share prices have been beholden to any gossip or hints about which way the report might go.

Analysts are already hailing tomorrow as one of the most significant days in the City of London's history as the ICB's recommendations - even though they will not be finalised until September - have the scope to radically reshape how banks are structured and operate in this country.

Initial fears that the commission would pursue a heavy-handed approach and take an axe to the Lloyds-HBOS merger have dissipated. But all the banks still have their brightest advisers and lawyers on call as the industry braces itself for shockwaves.

Simon Willis, banking analyst at broker Daniel Stewart, said: "While more recent signs have been that the report might be more benign, I still wouldn't rule out there being some sort of sting in the tail."

The City expects the recommendations to fall into two main categories: steps to overcome the "too big to fail" problem and measures to improve competition.

According to Evolution Securities analyst Arturo de Frias Marques, the markets' reaction tomorrow will be "largely dependent on one key perception: whether the ICB is being more hawkish with the too big to fail issues or with the promoting competition issue".

ICB member Clare Spottiswoode suggested last November that an unscrambling of the HBOS-Lloyds merger may be one of the options the ICB would consider, but Vickers and other members of the commission have since distanced themselves from her comments during a presentation in Leeds, together with other seismic proposals, including forcing banks to split their retail and investment banking operations.

What the City does expect is something known as "subsidiarisation" or ring-fencing of certain functions. The nature of this process will be key, and the banks are believed to have already offered the ICB a compromise by proposing to ringfence services such as customer deposit accounts, business credit lines, cash machine networks and payments systems so that savers and firms would still be able to access their money in the event of a bank's collapse.

Although this so-called "operational subsidiarisation" would come at a cost, the sums involved are small compared to the option most feared by the industry: "functional subsidiarisation" - or ring-fencing retail and investment banking operations.

The five biggest banks claimed in a confidential submission to the ICB last month that ringfencing their retail and investment banking businesses would cost them as much as 15 billion a year. This option would be particularly punitive for the likes of Barclays, HSBC and RBS, the report claimed, as they would have to access expensive and complex multiple sources of funding to support their global structures. It's no surprise that the research, by management consultants Oliver Wyman, was leaked at the same time as rumours flooded the market that Barclays and HSBC are examining options behind the scenes to move their headquarters abroad.

Although most in the City dismiss this gossip as little more than muscle-flexing, financial experts say a full-scale functional subsidiarisation would seriously undermine many of the industry's biggest players, particularly Barclays.

One City banker said: "It would take away the economies of scale the big banks enjoy. Separating the capitalisation of a bank's different subsidiaries is far from a cost-free exercise for them."

Evolution Securities argues that an increase in funding costs would be "inevitable" were the ICB to recommend a high degree of separation. De Frias Marques said: "As an example, Barclays Capital (BarCap] has around 100bn of wholesale debt. If the cost of funding for BarCap was to increase by, say, 100 basis points due to this, the impact could be 1bn."

Analysts at Cannacord have calculated that Barclays alone would take an extra 1bn hit a year from functional subsidiarisation. To add to the problem, many in the industry admit they are unsure how subsidiarisation would work in practice. The banking industry operates in silos and insiders concede that not even they would know where to draw the dividing line between companies' various functions, essentially what defines investment or wholesale banking.

Rob Cormie, Scottish managing director of corporate advisory firm Quayle Munro, says: "It's not easy. If you went on the street and asked someone to explain the difference between a retail bank, a merchant bank and an investment bank, they wouldn't know. In fact, most bankers wouldn't know. Certainly ask a politician and they don't know."

While Barclays, HSBC and RBS would have the most to lose from subsidiarisation, analysts warn that Horta-Osrio at Lloyds has much to fear from the ICB's expected "highly politicised" announcements on market competition.

The bank is braced for the possibility that Vickers could force it to sell further branches to add to the 600 it is already being forced to offload by the European Commission as a condition for accepting a bail-out.

It was also rumoured last week that the commission would refer certain services, notably personal accounts, to the competition authorities, which would have particularly damaging consequences for Lloyds.

"That's quite pertinent when you look at Lloyds-HBOS," says Alan Davis, a partner at City law firm Pinsent Masons. "They are leaders in most parts of the market now."

However, the City warns that a referral to the Office of Fair Trading and subsequently the Competition Commission would be a cowardly route for the ICB. It would effectively be passing the baton on to someone else and delaying an outcome for a further 18 months. "It would strike me as just a move into another investigation," says Davis.

But even if the banks avoid a competition probe, they are anxious about punitive recommendations on how to make it easier for customers to switch banks.

Discussions held between ICB members and senior bankers have included the prospect of a portable personal current account number that would allow customers to swap banks as easily as they do mobile phone operators. The industry warns that the costs of this scheme - at around 5bn - are high and would not necessarily improve the situation as Britons are notoriously reluctant to change financial providers.

Nevertheless, analysts point out that it would be an easy political hit for the commission. Simon Willis of Daniel Stewart says: "Focusing on the ability to switch accounts, pricing and transparency of costs would be a vote winner for the politicians. And yet it would not destabilise the banking industry, and would have a ring of pragmatism in pursuing consumers' interests."

One senior banking source said: "We fear this is still on the table, but we hate it. Quite apart from the cost it would be an awful logistical exercise.

"It's not how the present current account system is set up, which is really based as an address for a person, an electronic box so to speak, rather than the person themselves."

All of the banks, industry organisations and members of the public will have the opportunity to respond to tomorrow's report in a further round of meetings ahead of the ICB's final recommendations to the Chancellor in September.

Even so, industry insiders say there is "extreme twitchiness" about what tomorrow will hold and whichever way the commission goes, there will no doubt be some very stern faces in banking boardrooms when the report is finally released.