Bank defies the Treasury again as it seeks new powers

Financial Stability Report set to challenge Chancellor as Bank of England insists banks should be smaller

The Bank of England today launched its play for increased powers over the banking system, just days before the Government publishes its own White Paper on banking regulation.

The latest Financial Stability Report from the Bank is likely to heighten the tensions between Mervyn King and the Chancellor, Alistair Darling, who yesterday said the Governor's views on banking regulation had been considered, despite his claims earlier this week that he had not been consulted on the content of the White Paper, which is published next week.

The Bank's report, meanwhile, said that "banks should not be too big or too complex" – a view rejected by the Chancellor in his Mansion House speech last Thursday – as well as warning that the UK's financial system is still "vulnerable to high leverage" and that the "funding gap" between retail deposits and loans was currently being filled to a large degree with taxpayers' money.

The Deputy Governor for Financial Stability, Paul Tucker, said: "The policy debate now underway matters enormously if we are to achieve a more stable financial system in the future."

The Financial Stability Report sets out in detail some of the powers the Bank deems necessary to manage systemic risk, including:

*Greater disclosure of the risks that institutions run, possibly including public disclosure of their regulatory capital positions;

*A "credible threat of closure/wind down for financial institutions";

*A pre-funded deposit insurance scheme;

*Higher capital and liquidity buffers to "self-insure" against stress;

*Enhanced capital requirements for banks that pose a systemic risk to the system;

*A debate on whether banks that are "too big to fail" should be broken up.

The Bank said that the larger banks should be forced to become smaller and simpler in their legal structures, warning that it may be impossible to regulate groups that comprise as many as 2,000 separate legal identities.

The report marks another stage in the Bank's campaign to establish the philosophy of "moral hazard" to the centre of banking oversight. "If banks, shareholders or creditors are protected from losses, banks are more likely to take excessive risks and their incentives to monitor and discipline management are weakened," it said. "A credible threat of closure is inherently more difficult for firms which are large, complex or which have international reach."

The Bank also persisted in its preference for "narrow" or "utility banking", which has been ruled out by the Treasury. "Possible measures could include limiting the scope of banks' businesses to a narrower range of relatively low-risk activities, or imposing higher capital and liquidity charges." The Treasury is thought to view these ideas as unrealistic.

Many of the report's proposals are relatively uncontentious, but the desire of the Bank to intervene to vary the capital requirements of banks both to manage systemic risk and to tame the credit cycle is proving an increasingly bitter point of contention between Threadneedle Street and Downing Street, which is suspicious of it.

Some believe that the Bank's proposals would simply mean that commercial banks would be faced with two possibly conflicting sets of regulatory demands.

There is also the belief in some quarters that granting the Bank its wish to manage the credit cycle, on top of its existing control of interest rates, would mean turning over the management of the British economy to an unelected figure in Threadneedle Street – politically impossible. And while the Conservative Opposition appears more sympathetic to Mr King's wishes, the Government does not.