David Prosser: Will Darling's plan pass the litmus test?

Outlook Once you have finished arguing the toss over who has snubbed who, the real test of the White Paper on the reform of banking regulation, finally unveiled yesterday, is a pretty simple one. Will the changes it proposes mean we can be confident about not having to endure another financial crisis like the one we have just been through? The answer to that question – annoying and predictable though it may be – is that we don't yet know. And that's because, for all the technical detail and new ideas published yesterday, we have yet to hear precisely what this Government intends to do with the two most crucial aspects of future regulation.

True, the Chancellor has told us that a new Council for Financial Stability, bestriding the current tripartite regulatory system, will ensure that asset bubbles such as the expansion of credit that caused this latest crisis, do not begin to inflate all over again. What Mr Darling doesn't say, however, is how the council will fulfil that brief – the now famous "macro-prudential" regulatory objective – because we don't know what powers it will have to burst such bubbles early on.

Similarly, the Chancellor, while rejecting calls for a Glass-Steagall separation of retail and investment banking, does want to address the idea that banks can become too big to fail. He will expect banks to produce plans for an orderly wind down with no systemic risks in the event of a collapse and, more significantly, the capital and liquidity requirements for each bank will be tailored to fit the context of its size, complexity and potential for failure. But, again, we don't know the detail of how the tailoring will be done.

Not that those who insist breaking up large banks is the way to tackle this sort of systemic risk are right in their simplistic world view. Mr Darling, quite correctly, points out that small banks can and do fail too. Sometimes their failures cause a domino effect just as dangerous as the collapse of one massive institution.

Why has the Chancellor refused to give us the detail we need to make a judgement on the likelihood of future crises being prevented? Well, to be fair to him, for two good reasons. On the question of the macro-prudential toolkit, Mr Darling does not appear to be telling Mervyn King he cannot have any new powers with which to fulfil his new statutory duties for financial stability – just that the nature of these powers is still being debated, both in this country and internationally. There is no rush. The current worry is about how to get banks to lend more, not less, so we have a little time to think about what the most effective tools might be in the battle against bubbles.

As for how banks will have to meet capital and liquidity requirements tailored to their size, Mr Darling understandably wants to wait and see what approach to this question is taken internationally – in particular in the US, where the Treasury Secretary Timothy Geithner is proposing something very similar.

It is possible regulators will eventually break up big banks by the back door, by imposing draconian requirements on the largest institutions, but Mr Darling still has an eye on the international competitiveness of our financial services industry which, whether we like it or not, will remain fundamental to the UK's economic performance. As such, he would be daft to offer up much greater restrictions on British banks than their international competitors are facing.

You might say Mr Darling is ducking the issues by not yet settling on a final blueprint for the shape of future banking regulation – the Shadow Chancellor George Osborne certainly thinks that. But in truth, while we all enjoy stories about infighting, a loose consensus is emerging about how supervision will change. Most of the recommendations made by the FSA chairman Adair Turner are being adopted. Mervyn King, though widely perceived as having been sleighted, will eventually get at least some of the powers he has been seeking.

Consensus, of course, is not in itself a guarantee of success. And the Chancellor has plenty more difficult work to do before we judge whether the right balances have been achieved. Mr Osborne, meanwhile, will hope he doesn't get time to complete that work.

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