Leading article: Politicians and regulators need to show their mettle

If ring-fencing is rigorously applied it might deliver some of the benefits of a total separation

Ring-fencing and gold-plating are words that tend to make bankers uncomfortable. The first, as recommended by the interim report of the Independent Commission on Banking, is that large banks' retail and investment divisions should be separately capitalised. The second is that national regulators should be able to impose a capital buffer on domestic banks over and above international minimum standards. George Osborne gave his backing to both in his Mansion House speech last night.

The Chancellor told his audience of City of London grandees that he will accept the Commission's ring-fencing proposals. He also said that UK banks should hold more capital than the international minimum of 7 per cent of their assets. But does the fact that these pledges will cause bankers to sweat (Stephen Hester of the Royal Bank of Scotland and Bob Diamond of Barclays both criticised ring-fencing last week) mean that we are finally on the road to a safe banking sector? Sadly, that remains just a hope.

The previous government found that it had to rescue the entire UK banking sector in 2008 with taxpayers' money because it was dominated by institutions that were so important to the wider economy that they could not be allowed to go under. The bad had to be bailed out along with the good. What is needed – but most unlikely to be delivered – is a total separation of retail and investment banking in order to eliminate the too-big-to-fail problem and wipe out the "moral hazard" that the implicit expectation of a state rescue has created in the banking sector.

Ring-fencing is an effort to dispel the impression that banks are too big to fail. The separate capitalisation requirement for the retail and investment departments is intended to send a strong message that one arm could fail without bringing the whole bank down. The ordinary depositors in failed retail banks could be rescued by the state. But failed investment banks could be safely left to collapse.

The problem is one of credibility. Ring-fencing will leave banking empires under the same unified management team. If these managers do not feel they are in charge of two distinct institutions, they will not behave as if they are. As for capital, the 10 per cent levels mooted by Mr Osborne, while better than those mandated by the international banking authorities, are probably insufficient to guarantee banks' safety in the event of another massive crash. The US investment bank Lehman Brothers had capital reserves of 10 per cent when it went bust in spectacular fashion.

Yet half a reform loaf is better than no loaf. If ring-fencing is rigorously applied and policed it might be able to deliver some of the benefits of a total separation. If there is a perception among banks' creditors that lending to different divisions of the same institution involves different levels of risk, that will mean that the reform is working. So the key test is a practical one. Will regulators be proactive in preventing banks from finding ways around the fence? Will ministers, so susceptible in the past to the lobbying of the financial sector, ensure that the reforms are not diluted?

The same applies to capital. In the decade running up to the 2008 disaster, our largest banks steadily ran down their capital cushion in order to boost their reported profits. The regulatory and political authorities did nothing to stop this. Will they be any stricter with the banks in the years ahead? The words "this time it's different" have always been a curse in financial markets. But if we are to avoid a disastrous repeat of the economic cataclysm of three years ago, those words will have to be true when it comes to the financial regulation of our giant banks.