David Prosser: The financial reform grudge match is going to continue for some time yet

Outlook Sir Mervyn King's testimony yesterday to Parliament on financial regulation will not have done much to change the view of some bankers that the Bank of England Governor has it in for them. Sir Mervyn effectively said the Bank and the new Prudential Regulation Authority should have an absolute right to exercise their judgement when applying their powers, rather than being expected topolice a rulebook that the banks and their well-paid lawyers always find it so easy to dance around.

The example the Governor gave was that he wants to be allowed to tell a bank that has increased its leverage to cut it back even if it has stayed within the rules, if he feels that it is taking on too much risk. He wants, in other words, to return to the system of regulation that the Bank of England ran until its powers were given to the Financial Services Authority in 1997: a system in which regulators used their discretion rather than referring to the whistle.

One can quite see the point. It's not just the problem with set rules, as Sir Mervyn points out, that banks find a way round, but more fundamentally that they can't be designed to cover every base. To use Sir Mervyn's example, a certain level of leverage for a bank might be quite appropriate in one set of market and economic conditions, but very dangerous in another. And given that the new system of regulation is all about policing for the prevailing times, that seems reasonable enough.

The Financial Policy Committee (FPC), for instance, has been given a remit to pursue countercyclical policies. In boom times, it will be expected to rein in excesses before they begin to inflate bubbles, while during a downturn, it will be required to be more accommodating, by relaxing capital and liquidity requirements, say.

There are problems, however. First, a degree of flexibility is one thing, but financial services companies do need to have some clarity on where they stand. The director-general of the Council of Mortgage Lenders complained yesterday that while mortgage controls were always given as an example of how the FPC might want to intervene, his members had not been given the "terms of engagement". He has a point.

The more fundamental difficulty is that many in the City do not trust Sir Mervyn, a campaigner for ring-fencing within the banks, or Lord Turner, the chairman of the Financial ServicesAuthority, who has described banks as "socially useless", to exercise their discretion. That may be quite unfair, but it is the truth. Senior bankers simply cannot imagine, for example, either man ever believing a downturn wasserious enough to countenance relaxed rules on capital buffers.

Where does that leave financialreform? Still at a crossroads. Sir Mervyn told MPs yesterday that he does not want more regulatory powers if he is expected to go by a narrow rulebook – and that regulators should be accountable to Parliament and the public, but not to the financial services industry. You can expect many in that industry to kick up a stink.