“Living wills” for banks judged too big to fail could force them to hive off their riskier activities, the City watchdog said today.

The Financial Services Authority (FSA) said banks may have to remove serious obstacles to an orderly wind-down – such as risky “proprietary” trading arms where banks play the markets with their own cash.

“Restructuring could include clear separation between retail deposit taking business and businesses involved in proprietary trading activities, with the latter able to fail even if the former were supported in crisis conditions,” the FSA said.

Bank of England Governor Mervyn King this week also said he favoured separation of activities in living wills to avoid “ever increasingly detailed” oversight of the financial system.

The FSA said some banks are currently working up wills as part of a pilot scheme to develop the policy.

Chairman Lord Turner said: “The FSA has to reduce the danger that authorities in future will be faced with only one option – using public funds to rescue whole groups with only equity holders suffering loss.

“And we must also limit the extent to which implicit government guarantees support unnecessary levels of risky proprietary trading.”

But he also warned there was no “single silver bullet” for dealing with the problem.
The FSA said that bumper investment banking profits should be used to bolster balance sheets rather than paid out in bonuses to staff.

Systemically important banks will have to hold more capital with more emphasis on the strength of national subsidiaries in global banks “with overt understanding that home country authorities will not be responsible for the rescue of entire groups”.

The FSA also wants more central arrangements for derivative trading to reduce the inter-connectedness of the global system, as well as more capital held by banks as a buffer against riskier activities.

Lord Turner added: “The direction of travel is clear: the overall level of capital required in the banking system must be significantly increased over time, while liquidity standards must be significantly tightened.

“These changes are required to create a more stable financial system for the long-term.”