The appointment of trader/investment banker Bob Diamond to head Barclays Bank last week renewed calls for government to force a split between banking and investment banking, while in retaliation Barclays threatened to relocate its headquarters abroad. To most commentators, that seemed an overwhelming danger, but I was forced to wonder: if the behemoth “investment banking” operations did relocate from Britain, would the country actually be worse off in the long run?

There are not that many banks involved. RBC is majority owned by the government, so doesn’t have the option of relocating overseas, while Lloyds’ investment banking operations are minuscule, owing to strategic decisions taken as far back as the 1980s. Santander is now the third largest retail bank in the UK, but is already headquartered in Spain. Thus apart from Barclays the only two banks involved are HSBC, which was headquartered in Hong Kong until 1991 and has already relocated its chairman back there and Standard Chartered, the great bulk of whose operations are already outside the UK. The London banking scene of 30 years ago, full of domestic houses large and small, is long gone, bought out by continental or US behemoths.

Presumably the purpose of “splitting” legislation as advanced by Business Secretary Vince Cable and others would be to split large retail banking operations from the more dangerous “investment banking” thereby reducing the possibility that they might have to be bailed out to protect depositors (though it must be remembered that Northern Rock, the first casualty of the 2007-08 financial crash, did not itself contain a significant investment banking operation, except in the mortgage funding area.)

Such legislation would have to be draconian in order to be effective. Merely allowing Barclays and HSBC to relocate their headquarters and trading desks out of the UK while retaining their retail banking operations would not eliminate the danger of contagion; indeed it would very likely increase it. In the event of a failure by say HSBC’s investment banking operation domiciled in Hong Kong that was large enough to damage the group, a British government wishing to protect UK depositors would have the unpleasant choice of bailing out HSBC itself or relying on the Chinese government to do so. If Barclays had relocated its headquarters to a tax haven like Bermuda without a substantial government, the British government would remain effectively liable. Thus effective “splitting” legislation would have to provide that no global operation with more than (say) 10% of its revenues, assets or net income from investment banking would be allowed to own more than a small number of retail branches in the UK. Such legislation would be hard on the well-run Santander, but would otherwise be ineffective.

An effective “splitting” legislation would leave HSBC Bank PLC as a retail and lending bank separate from its global parent (which would presumably reverse its 1991 decision and return its domicile to Hong Kong) and Barclays PLC as a retail bank separate from its “investment banking” sibling, probably domiciled in New York. Both the HSBC and Barclays global/investment banks might well retain trading operations located in London, but those trading operations would be controlled by the foreign headquarters and would have no connection with the UK banks’ retail operations. Santander might also have to spin off its UK retail banking operations, as collateral damage from this legislation. Naturally other trading/investment banking operations in London without UK retail banking businesses would remain as at present, at least initially.

For Barclays, it would quickly become clear that the split merely emphasized the wrong road taken in the last decade. Having spent large amounts of money building up its BZW investment banking business after the 1986 “Big Bang” Barclays correctly decided in the late 1990s that the cultural clash between traders and retail bankers was too great, and in 1998 sold the majority of BZW to Credit Suisse First Boston, keeping only the (pretty well unsalable at that time) debt markets division. Barclays’ strategy then became one of concentrating on retail banking and investment management, in which it became a formidable global force through its pioneering of Exchange Traded Funds. However in the 2000s, overambitious Barclays management made a series of mistakes, overbidding for ABN-Amro in 2006 at the peak of the market and buying the remnants of Lehman Brothers in late 2008, a move which both reintroduced the problem of integrating retail and investment banking and forced Barclays to sell its crown jewel Barclays Global Investors in June 2009. A retail banking/investment management combination is stable and benefits from considerable synergies; a retail banking/investment banking combination is much less attractive.

Diamond, Barclays’ new chief executive, is basically a debt trader who got extremely lucky, the profits of Barclays’ debt trading operation having benefited year after year from the over-expansive monetary policies run by the Fed since 1995, and the wide and immovable “gap” between short-term and long-term rates to which they led. Once US monetary policy is finally corrected with the departure of Ben Bernanke, and the 1981-2010 bull market in US government bonds comes to its well-merited end, life for debt traders will become much more difficult. Thus the investment banking side of Barclays is unlikely to be particularly profitable, and given over-aggressive trader management, exacerbated by the Lehman DNA, is likely to collapse again into gigantic losses at some point.

For Britain therefore, legislation splitting retail and investment banking should be economically beneficial. At the cost of losing income tax revenues from a small number of top executives (not including Diamond, who would presumably not choose UK domicile either way), the British government will be relieved of any obligation to bail out the likely losses of the Barclays/Lehman investment banking combine. HSBC’s relocation will be more damaging, but since the group sees future growth mostly in its Asian heartland, it may well be inevitable. The behemoth trading desks will not immediately relocate, because much of the business will remain in London, but over time will decline in relative importance as decisions are made by a distant corporate headquarters.

The most interesting effect of their exile would come on the behemoths. If Britain’s decision to separate retail banking and investment banking were followed elsewhere, there would gradually be a relocation of global investment banking to the least regulated centers, notably Hong Kong, but probably also including Dubai and some Caribbean tax haven. More stable centers, such as Switzerland, Singapore and Canada, would be rejected by the traders themselves, who would be uncomfortable with those places’ conservative lifestyles and tight regulation. Initially, there might be a boom, as trading desks flourished free from either restrictions or tax. Inevitably at some point the traders’ insouciant attitude to risk management would bear fruit in a gigantic crash.

When that happened, there would be no bailouts. The world’s deposit taking institutions would remain safe, protected by careful risk management and tight position restrictions from more than moderate losses. The “investment banks,” much of whose trading activity would still be taking place in London and New York, would beg for bailouts but would not get them. Instead of just one failure, the entire “investment banking” edifice would collapse, causing a major world downturn, as in 2008, but bringing the denouement that should have occurred in 2008: a period of much more restrained financial activity and a much shrunken global financial services business.

Even before the crash, much of the advisory work of the behemoths, in which their true economic power lies, would have migrated elsewhere. The best advisors would not wish to relocate to Hong Kong, Dubai or the Caribbean, and would find alternative openings for their services in the medium sized houses that had largely avoided both retail banking and the trading business. Their clients would find the quality of their advice improved by their move, and the risks of gigantic conflicts of interest in capital raising and merger activity greatly reduced. This process would still be by no means complete when the crash came – there would still be many companies getting their advice from Goldman Sachs (Cayman) or Deutsche Bank (Dubai) – but the crash itself would accelerate it. Any gigantic trading operations that survived the crash, or that grew up after it, would find their status reduced to that of mere hedge funds, a source of great if unstable wealth to their proprietors but of little financial influence within the global economy as a whole.

For Britain, the departure of first the top brass and then the trading desks would bring a severe downturn at the top end of the London property market, with the Russian mafia alone having insufficient wealth to keep it afloat. That in turn would cause immense financial difficulties for the likes of Tony Blair, who had prospered in the fat years and recycled their wealth into overpriced real estate. However for the rest of the country the change would be a distinct improvement. Top graduates would no longer migrate onto trading desks, but would direct their attention to true wealth creation or, if they were fascinated by finance, to the advisory houses. Wealth would be more evenly spread across the country, and industries would be more capable of facing international competition, because the exchange rate would no longer be overvalued by the earnings of finance. Overall, the country would take its proper place as an upper-middle income society, with a particularly international outlook and expertise in numerous scientific and trade-related fields. Even education might improve, as the casino attitudes of 1986-2007 receded further into the past and students realized hard work and qualifications were the true path to success.

So split retail and investment banking – and institute a Tobin tax while you’re about it. For the disgruntled trading behemoths, the message should be simple: don’t slam the door on your way out!

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)