Banks are still in the dark over repercussions of ring-fencing plan
The Independent Commission on Banking's proposed ring-fencing of retail and investment banking will increase business borrowing costs and dent economic growth, according to a leading economic forecaster.
Restricting cross-funding by erecting firewalls within banks will increase the cost of borrowing for big companies by up to 1.5% and cut economic output by up to 0.3% over several quarters, according to the Ernst & Young ITEM Club.
Ring-fencing would increase investment banking funding costs and push financial markets to demand more capital in those divisions, ITEM said.
The extra costs would then be passed on to big corporate clients of investment banking businesses, the forecaster argued.
The ITEM Club's predictions will add to debate in the run-up to the ICB's final report, due for publication next Monday.
Neil Blake, economic adviser to ITEM, said if the proposed separation proves to be tougher than expected the effects on credit costs and growth could be greater.
He said: "These predictions are not based on a worst-case scenario.
"They're based on moderate assumptions about the extent of ring-fencing.
"Depending on what is announced next week, we will need to consider the knock-on impact not only on to the banking sector but to the UK economy as a whole."
The ICB proposed an outline plan for ring-fencing in its April interim report and banks are now anxiously awaiting its detailed proposals to see which types of business will be placed where, to stop government-guaranteed deposits subsidising non-essential trading activities.
In its first financial services outlook, ITEM said banks face further pressures that could cause a drag on economic expansion.
Low growth of just 3% a year expected in the banking sector over the next four years will constrain business expansion, ITEM argued.
If the ICB reforms cause UK banks to lose lending business to foreign institutions or capital markets, British banking could become less competitive and contribute less to the economy, the forecaster added.
Mr Blake said: "The assets of the banking sector in the UK roughly doubled in the 10 years leading up to the crisis, driving the growth of the UK economy.
"For growth in the banking sector to sit at this historically low level for four years represents a substantial challenge to the wider health of the UK economy."
The report stressed the importance of the financial services industry to the British economy and underlined the dilemma the Government faces as it seeks to prevent future banking crises without choking off short-term economic recovery.
Optimism at the start of the year for banks has faded as investment banking profits and hiring reduced sharply. Shrinking confidence in the UK banking sector has been compounded by the sluggish recovery, and credit shortages could restrict the pace of growth, ITEM added.
In the past week, banks have called for the ICB's reforms to be delayed until economic recovery is entrenched.
The lenders' demands exposed divisions in the Coalition Government between the Prime Minister, David Cameron, and the Chancellor of the Exchequer, George Osborne, who are wary of the effects of punishing the banks, and hardliners such as Vince Cable, the Business Secretary, who want to bring in tough measures.
In a compromise, any changes are now likely to be made law before the next General Election in 2015, but implemented afterwards.