When Mervyn King turned up at Edinburgh’s swanky Prestonfield House hotel on Tuesday evening, it was not to exchange niceties or wallow in the opulence of the surroundings.

The governor of the Bank of England knew that Edinburgh, of all places, was aware of the consequences of banks that go bad, having seen its pride and joy — Royal Bank of Scotland — being forced into the arms of the government.

So King started by quoting Sir Walter Scott, who pointed out that banks could be sources of both rising and falling prosperity. Then he got off his chest something that has troubled him ever since crisis-hit banks began besieging him for cash in the summer of 2007.

Two years on from the start of the credit crisis and more than a year after the fall of Lehman Brothers, the banks remained “extraordinarily dependent” on public support, he said. The “moral hazard” he worried about when pondering whether to provide the banks with liquidity had turned into “possibly the biggest moral hazard in history”.

As long as there were banks that were “too important to fail”, which could engage in risky activities knowing they would be bailed out by governments, you could almost write the script for the next crisis.

Part of the answer was regulation, he said, but part of it was restricting guarantees to those banks that were essential to the functioning of the economy, so-called utility banks.

“Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance risky and speculative activities, would be thought rather unworldly,” he said. “But that is where we now are.”

The idea that regulation could prevent banks engaging in speculative activities that resulted in their failure was a “delusion”, he said. The answer had to be to ensure that the risk-takers could fail without threatening the system or forcing taxpayers to bail them out.

As it happened, Alistair Darling was due to give a speech on the economy the next morning. His aides were shocked by King’s “hard” language and insisted that the government’s approach — forcing the banks to rein in their risky activities by imposing tougher capital and regulatory requirements — would achieve a similar end.

Gordon Brown, who has grown irritated with King’s interventions, was more forthright in response to a question about the governor’s speech in the House of Commons.

“Northern Rock was effectively a retail bank and it collapsed,” he said. “Lehman Brothers was effectively an investment bank without a retail bank and it collapsed. The difference between retail and investment banks is not the cause of the problem. The cause of the problem is that banks have been insufficiently regulated at a global level ... We will be doing that at the G20 finance ministers’ summit.”

Even those who spend hours in regular dialogue with the governor are not entirely sure what he was proposing or why he was proposing it.

Lord Turner, chairman of the Financial Services Authority, voiced his thoughts while presenting a more detailed version of his own reform plans.

Turner said he thought King was advocating a system where the only registered banks were ultra-conservative institutions modelled on old-fashioned building societies, which lent money only to their savers. “But then there is a part of his speech that actually implies that he is not quite convinced by that,” said Turner.

The idea of these so-called “narrow banks” has been put forward by Professor John Kay, in a paper for the Centre for the Study of Financial Innovation.

King is familiar with Kay’s work. They were joint authors of a book on Britain’s tax system two decades ago. The governor read and commented on Kay’s paper before publication.

Turner dismisses the principle as fundamentally wrong — because the crash had little to do with bailing out savers.

King mentioned Paul Volcker, a former US Federal Reserve chairman, who has talked about reintroducing divisions between investment and retail banks in the same way as the Glass-Steagall Act of 1933 did in America in the aftermath of the 1929 Wall Street crash. Turner claims that even Volcker does not really believe it is possible to draw a firm line between the different activities of a large global bank.

In recent congressional testimony, Volcker said that the divide between trading for clients and the banks’ own trading was often “cloudy at the border”. Some trading, Volcker said, “is necessary as part of a full-service customer relationship”.

Turner agrees, and believes that splitting banks in two could outlaw business that should be perfectly acceptable.

“What I am saying is that when you get down to the details, you have to set things out and say ‘where are you putting the divide?’,” said Turner. “It is very difficult to do that by writing a law that says this is what you can do and can’t do. It is best to do it through capital requirements.”

Turner’s proposals would involve the regulators being permanently camped inside the banks, making case-by-case decisions on what was acceptable and what wasn’t.

Where Turner didn’t like something, he would simply tell a bank that it would have to hold more capital against that particular activity.

“If that means that some of this trading moves out of commercial banks and into hedge funds, that’s fine because that is achieving the objective by the same means,” Turner added.

In theory, forcing banks to hold more capital should have a negative impact on the economy. If banks are forced to hold on to more of their cash for a rainy day, they will have less money available to lend to businesses and households.

Turner argues that this should be traded off against the benefits of a more stable economy. In any case, he has already found a good source of additional cash — bankers’ bonuses.

“The major trading banks we know are making large profits for exceptional post-crisis reasons and we therefore believe that we are in a position to achieve capital enhancement without adverse consequences at the present time,” he said.

King’s call for a break-up of the banks is likely to fall on deaf ears even if a Tory government is elected. George Osborne, the shadow chancellor, is sympathetic to the governor’s ideas but has stressed Britain will not go it alone in breaking up its banks. Only if there was international agreement, which is hard to see, would the Tories press on.

Paul Tucker, King’s deputy, gave a speech on Thursday on the use of “macro-prudential” instruments to prevent a re-run of the crisis. He was assuming that the structure of the banking system would remain roughly as it is — though officials insisted it was not a snub for the governor.

The conservative banks King craves could emerge without new rules or legislation. Sir Richard Branson’s Virgin Money is about to get a banking licence, which would create a new bank on the high street.

Neelie Kroes, the European competition commissioner, has had her term of office extended until December to oversee the dismemberment of Royal Bank of Scotland (RBS), Lloyds Banking Group and the dozens of other banks across Europe that have received state aid.

RBS looks almost certain to be forced into selling off about 300 branches. To help sell them, it is said to be looking at resurrecting Williams & Glyn’s, a brand it abandoned in the 1980s. Any new bank will be a conservative, low-risk operation. To begin with, at least.

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