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Breaking up UK banks 'not a magic bullet': Lord Turner

Lord Turner, the former head of UK banking watchdog, has sparked controversy by warning taxpayer money will still need to be used to fund bank bailouts across Europe.

The comments come despite claims by ECB president Mario Draghi that banks that fall short of up-coming stress tests should—and—will be allowed to fail.

(Read more: Draghi: Now it's time to cut taxes in the euro zone)

Lord Turner also questioned (Labour leader) Ed Milliband's recent proposal to break up UK banks to increase competition.

"Competition is not a magic bullet," he stressed. "It is legitimate to look at banks. But competition does not have an effect on stability."

World leaders to gather in Davos, Switzerland this week for the annual WEF meetings.
Justin Solomon | CNBC
World leaders to gather in Davos, Switzerland this week for the annual WEF meetings.

Lord Turner pointed to the divergent experiences of the UK and Canada, where the latter had a resilient banking system during the crisis despite a virtual oligopoly in its banking industry.

The Labour proposals have been criticized by business leaders at the World Economic Forum who have expressed concerns about potential market interference if Labour was to win the next election.

At Davos, Lord Turner was speaking at a debate on 'Rebuilding European Banking" where he was joined by German finance minister Wolfgang Schäuble; EC economic chief Ollie Rehn, Deutsche bank boss Anshu Jain and Dutch finance ministerJeroen Dijsselbloem.

The former UK regulator said that Europe's economic recovery had been stymied by continued problems with the banking industry and the slow government response to recapitalization. This was in contrast to US, which in 2009 forced American banks to take public money, which Lord Turner said had laid the foundation for the current pick in U.S. growth.

(Read more: Barroso insists: Europe's crisis is not over yet)

However, the comments were met with a wry rejoiner from Mr Schäuble who said he took "great pleasure when an Englishman told Europeans to behave more like Americans."

"We are not American. We are the European Union. We have to solve our banking problems by fiscal discipline and banking reforms," he said.

Lord Turner, who was in charge of the UK regulator at the time of the £45 billion Royal Bank of Scotland rescue, said in retrospect, the UK government should have funded the entire nationalization of the bank rather than just dilute shareholders.

"The equity in RBS should have been written off completely. But at the time we didn't have the right tools. The best we could do was dilute equity holders."

Ultimately, going forward, even with the advances in bail-inable debt, if banks in Europe fall short of capital after the stress tests but cant raise funds privately—member states will have to plug the gap, Lord Turner said.

"The problem with European stress tests in 2010 is we couldn't say what would happen if you failed."

But, said Lord Turner, shutting banks down could create shock waves across the system and pose a threat to European recovery. Lord Turner also stressed that it was a mistake to assume that after the Asset Quality Review "lending would be magically unleashed."

His comments were challenged by Dijsselbloem and Schauble who pointed to the progress made with the European Stability Mechanism.

Dijsselbloem said that the euro group was working on rules for direct recapitalizion of banks, with strict conditionality, as a last step.

(Read more: Biggest risk for 2014? Stress tests: Van Steenis)

If a bank applied for ESM help before 2016, there would be a deep bail-in of creditors.

At the end of 2013, EU leaders agreed a high level common set of rules for managing the closure of failing eurozone banks, which includes a €55bn fund, financed by the banking industry over 10 years. The deal was aimed at building an EU banking union that should minimize the need for taxpayer-funded bailouts.

Elsewhere in the debate Jain, co-CEO of Duetsche Bank said lending to SME sector would not recover until there was more clarity about issues such as leverage ratio.

--By CNBC's Helia Ebrahimi

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