Vince Cable leaves bankers in a bind

Cable, self-styled leader of the banker bashers, was tipped for a top job as soon as the terms of the coalition were agreed. Critics of the banks smelled blood and the financial markets nervously wondered whether he would be allowed to introduce his demands for tougher lending targets, and a clampdown on bonuses. Worst of all, would he set in train his call for the banks to be broken up?

In the event, the new Business Secretary had to settle for an independent inquiry into banking, likely to last a year. The banks had been given a reprieve, although the uncertainty created by the inquiry would weigh on the banks as investment prospects and everyone knows that Cable will be no pushover in the coming months.

Ever since the collapse of Lehman Brothers in September 2008, Cable has led the charge on the need for radical reform of the banking system. Along with Treasury Select Committee chairman, John McFall, he has issued constant warnings that most banks are "too big to fail" and the UK taxpayer remains at risk of having to bail out further institutions in the event of a second financial crisis.

While in the early days of the economic crisis, most in the City dismissed his outbursts as the tirades of a minority party politician, his ideas quickly gained traction with economists, think tanks and other parties. And even the most dismissive bankers on the Square Mile were forced to sit up and listen when on 20 July last year, Cable delivered a sobering speech to the London Stock Exchange setting out the Liberal Democrats' stall on the banking sector.

Not afraid to name names, Cable urged that big banks including Royal Bank of Scotland, Lloyds Banking Group and Barclays "must be split up" so that the British taxpayer is "totally disengaged" from the risks involved in global investment banking.

"Size matters," he said, sternly eye ing the traders on the LSE's floor. "If Barclays Capital continue their ambition to be the world's largest investment bank the British taxpayer will be left footing the bill for any future collapse. This is wholly unacceptable."

While Cable insisted that the Lib Dems remained "opened minded" as to the methods used to break up the banks – although he cited the retail and "casino" model – he made it clear that no institution would be immune from his proposed reforms.

"For existing publicly owned institutions, RBS and Lloyds, they should be broken up before they are returned to private ownership," Cable said before adding that the Lloyds-HBOS merger should be "unscrambled" and "RBS should also be split with its investment banking operations floated off".

As if his speech to the LSE did not trouble the Square Mile's biggest earners enough, his ideas appeared to have radicalised by the beginning of this year when he called US President Barack Obama's proposed reforms to US banks – the biggest regulatory crackdown on Wall Street since the 1930s – as a mere "halfway house".

Cable said in response to the Obama reforms. "We must break up British banks to ensure that taxpayers are not forced to underwrite unnecessary risks and to make the system more competitive."

Banking analysts anxious to decipher how the new coalition government's banking commission may rule in a year's time are currently pouring over recent comments from another cross-party MP inquiry, involving Cable, McFall and David Davis. The "Future of Banking Commission" is yet to publish its conclusions, but comments by Davis prior to the General Election point to how the group is likely to try and influence the Lib-Con government.

Davis said he agreed with the notion of breaking up the banks, either along size or utility lines, adding that UK banks should no longer be allowed to labour under the impression that "they are so big and important that they have to have a taxpayer guarantee whether it is offered or not". Davis added: "I don't care what the banks say, we cannot have a system where this mechanism is implicitly in place".

Nic Clark, veteran banking analyst at Charles Stanley, argues that the threat of heavy-handed political and regulatory intervention under the coalition government has seen the return of considerable market concern surrounding the banking sector.

"We have been cautious on the UK banking sector throughout the credit crisis and we have remained wary that the sector is not yet out of the woods. We maintain that there are still risks in the system that need to be unwound and when one adds to the pot the potential for significant political and regulatory intervention, it becomes a spicy stew," Clark said.

Angela Knight, the feisty chief executive of the bankers lobby group the British Bankers Association, says it might actually be an advantage that the new coalition government is looking at the industry in a more cross-party fashion.

However, she admits the flip-side is that banks will find it harder to moan about political bias or allege sector witch-hunts if the independent inquiry into the industry comes up with unpalatable change.

Knight says: "There's an opportunity now to have a fresh, clear-headed, logical review of the sector. It is not tied to decisions made by the previous government.

"We will engage positively with the independent commission. But I accept that if you have more than one party involved it's much harder to say, oh well, they are being swayed (against the banking sector] by any political group."

The BBA chief, a former economics secretary in John Major's government, says one inherent problem that the new government cannot avoid is the technical nature of the issues. Bonuses might grab the headlines but it is really about capital, liquidity, risk controls etc. It is dry but essential stuff that has to be done "It is that rather than getting a spectacular answer to a spectacular problem", she says. Many believe the BBA's members, including Royal Bank of Scotland and Lloyds Banking Group, are privately relieved that Cable is not in the Treasury as he is widely seen as the political rottweiler to the little-loved industry.

Knight seems to want to take some of the grandstanding out of the banking debate, saying she welcomes the chance for logical and dispassionate argument. "It's been easy to park all responsibility for the economic downturn on to one group. But now we have fresh government and fresh eyes."

The BBA has largely accepted the case that there must be better capital levels to support the more risky areas of wholesale banking – but that this should fall short of splitting it from the retail business. This also seems to be the way Adair Turner at the Financial Services Authority has been thinking recently.

But Knight repeats a mantra of many of her leading BBA members that it was not universal banks but rather so-called "narrow banks" such as Lehman Brothers (investment banking), AIG (insurance), Northern Rock (mortgages) and Fannie Mae and Freddie Mac (mortgage payment default giants) who were hurt most by the financial crash.

"It is correct that in the heat of the crisis it affected many more 'narrow' banks, whether that was savings and loans, or investment banking institutions," Knight says.