Mervyn King: 'We live in a fool's paradise'

The world is living in a financial "fool's paradise", according to the Governor of the Bank of England, Mervyn King, who has called for radical reform of the financial system and the break-up of big banks, as one of the biggest, the majority state-owned RBS, announced losses of £3.6bn yesterday.

Mr King told the Future of Banking Commission, sponsored by the consumer lobby group Which?, that the case for "narrow" or utility banks – forbidden from taking part in riskier investment-banking activities – is "irrefutable".

"We've been living in a fool's paradise," the Governor said. "We've been saying to the people who provide finance to the banking system that their money is completely safe, yet the banks have been taking risky activities."

Addressing this would mean the forcible, if gradual, break-up of the established big banking groups, many of which are now even larger than they were before the crisis after a series of forced mergers and acquisitions, but often little more financially secure.

The Bank of England and Mr King have made no secret of their impatience with the current situation, where the banks are allowed to operate highly profitable – but also risky – investment-banking activities on the back of an unlimited implicit guarantee from the British taxpayer.

Mr King added that "one of the costs of this crisis – there's many of them – is that it's very clear now that governments will step in to rescue large financial institutions when they appear to threaten" a key function such as the payments system. He advocated "fire-breaks and firewalls" to limit systemic damage.

He added: "If banks are going to insist that they are able to co-mingle highly risky activities with vital infrastructure aspects of banking such as the payment system, then I'm afraid that we have no alternative but to consider ultimately the liability structure of banks – force them to avoid taking debt finance and make them all equity. Or you end up thinking: 'Are these public-sector institutions?'"

The commercial banks have also benefited from an unprecedented injection of capital and liquidity from the state, and again Mr King has repeatedly warned the banks that, in the case of the Special Liquidity Scheme, that support, characterised by Mr King as the most generous in the world, will be withdrawn by 2012, leaving a near-£200bn funding gap.

Although he did not comment directly, RBS's plans to pay £1.5bn in staff bonuses are unlikely to win gubernatorial approval. The commercial banks have been frequently advised by the Bank of England to defer dividend and bonus payments in favour of building up capital and bolstering their balance sheets. Indeed, had they been less generous during the boom years, some at least might not have needed as much state aid as they received.

The Governor is the latest witness at the Future of Banking Commission, chaired by the Conservative MP David Davis and set up with cross-party support and the sponsorship of Which? Mr King's hostility to the present banking set-up seems unrelenting.

At the Treasury Select Committee on Tuesday, he told MPs that banks would have to settle for smaller balance sheets and lower profitability in future. His views are broadly in line with those proposed by President Barack Obama last month, which sought to insulate depositors from proprietary trading, though satisfactory definition of such trading has yet to appear.

The Chancellor, Alistair Darling, has rejected the ideas being put forward by Messrs King and Obama, though the Tories and Liberal Democrats seem more sympathetic and the Tories have said they will give the banks a lead role in prudential financial regulation. The banks themselves have pleaded for international action through the G20 processes. Most of the issues will be left unresolved until the next election.