Government plans to ring-fence the banks - trying to protect retail banking from the riskier investment side - "fall well short of what is required", a report has warned.
The Parliamentary Commission on Banking Standards wants the government to "electrify" the fence so banks cannot make holes in it.
The government's bank reforms will go before Parliament early next year.
The Treasury said it was committed to reforming the banking sector.
Vickers recommendationsThe Parliamentary Commission on Banking Standards, known as the Banking Commission for short, was asked by Chancellor George Osborne to study the draft version of the government's Financial Services (Banking Reform) Bill.
This follows last year's recommendation by the Independent Commission on Banking, which was led by Sir John Vickers.
Sir John concluded that ring-fencing was the best way to protect "core" retail banking activities from any future investment banking losses, such as were seen during the global financial crisis.
The government's proposed bill also spells out rules to protect depositors and prevent the use of taxpayer money for bailouts, thereby curtailing banks' perception they are "too big to fail".
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The bill hinges on three main aspects:
- ring-fencing or protecting retail banking
- ensuring that bank losses fall on bank creditors and not depositors or taxpayers
- making banks better able to absorb losses
Ring-fencing would ensure that retail services of a struggling lender can be carried on independently and smoothly even if authorities let the rest of the group fail.
For example, in the case of a failing banking group, regulators could sell off its core activities - thereby maintaining continuity for depositors - while allowing the rest of the organisation to go through a bankruptcy process.
Secondly, the proposed bill wants to rank retail deposits (but not pension liabilities) ahead of the claims of other bank creditors in the event of a bank insolvency.
Thirdly, banks are to hold a sufficient capital buffer - as outlined by global regulators - which means that if banks do fail, losses can be absorbed by shareholders and other creditors rather than the taxpayer.
"Electrification"Under the draft legislation, the Treasury would have the authority to decide which banks ring-fencing should apply to, as well as specific activities to be undertaken, within ring-fenced banks.
The Prudential Regulation Authority, which will become the UK's regulator for deposit-taking institutions in April under the Bank of England, would have the power to ensure the ring-fenced bank to carry on with its business.
But there has been much debate over whether to enforce a full separation between retail and investment activities - that is, a break-up. The recommendation by Sir John stopped short of such action.
Andrew Tyrie, chairman of the Banking Commission, said that the "electrification" of the ring fence should include the regulator being able to force the full separation of a bank's retail and investment divisions, if the lender was found to be trying to break the fence.
"The proposals as they stand [in the Bill], fall well short of what is required," he said.
"Over time, the ring-fence will be tested and challenged by the banks. Politicians too could succumb to lobbying from banks and others, adding to pressure to put holes in the ring-fence."
- The Parliamentary Commission on Banking Standards was appointed in July following the Libor scandal and other episodes that damaged the reputation of banks in the UK
- It includes MPs and peers and is chaired by Andrew Tyrie, who also heads the House of Commons' Treasury Committee
- Members include the next Archbishop of Canterbury, Justin Welby
- It heard evidence from major figures in the banking sector
- Evidence included a warning from RBS boss Stephen Hester that ring-fencing banks' retail and investment arms could increase the risk of institutions needing to be rescued
- But Barclays chief executive Antony Jenkins told the commission that his bank was "embracing" the ring-fencing proposal
- The commission has also heard from Paul Volcker, a former chairman of the US Federal Reserve, about his US proposals to ensure bank safety
He added: "For the ring-fence to succeed, banks need to be discouraged from gaming the rules. All history tells us they will do this unless incentivised not to."
"That is why we recommend electrification. The legislation needs to set out a reserve power for separation - the regulator needs to know he can use it."
Anthony Browne, the chief executive of the British Bankers' Association (BBA), welcomed the report, but warned that uncertainty over banks' prospects could have a negative impact on their ability to lend.
"The risk here is creating uncertainty. If it's perpetually hanging over the banking sector that individual banks or the whole sector could be broken up at some point, then it's going to be difficult to return to having an investable banking sector that can be customer-focused and globally competitive and do what it should be doing, which is lending to homeowners and businesses," he said.
Ed Balls, Labour's shadow chancellor said: "As Ed Miliband and I said at the Labour conference this year, if the letter and spirit of the Vickers proposals are not delivered and we do not see cultural change in our banks, full separation will be necessary.
"The Commission is clearly right to say the jury is still out and to demand a reserve power for full separation of the banks."
'Consensus commitment'
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The Commission's report comes a month after Mr Osborne urged its members not to send the government's proposed reform "back to square one" by "unpicking" the consensus on how it should be carried out.
A Treasury spokesman said on Thursday evening: "The government is committed to reforming the financial sector and putting in place a regulatory structure that learns the lessons of the past and protects taxpayers in the future."
"It has been committed to building consensus and has consulted widely on these reforms over the last two and half years. The Banking Reform Bill is the next step in that.
"The government is grateful to the Parliamentary Commission on Banking Standards for its scrutiny of the draft bill and notes that it, 'welcomes the government's action to bring forward legislation to implement a ring-fence'."
The spokesman added that the government would study the report and respond in detail when the Financial Services (Banking Reform) Bill is formally introduced to Parliament early next year.
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