Economic Life: Can a shrinking financial industry survive the regulatory backlash?

Whatever the form of the rescue that the US eventually puts together for its banking system, the industry will be utterly different for a decade, maybe a generation. Regulation will be tighter and the industry will be smaller and less profitable. The rest of the world will tighten up too, though maybe not in the draconian way that seems likely in the States.

This is because voters will demand it. Since governments have had to take responsibility for failing financial institutions and underwrite the debt of others to help them keep going, taxpayers are being forced to take on huge additional liabilities. Politicians would not be doing their fiduciary duty if they were not to require financial institutions to submit to closer regulation. So it will happen.

Quite how it happens is not clear. In the US this week there has been a barrage of criticism of the $700bn bailout proposed by Henry Paulson, the US Treasury Secretary – not to be confused with John Paulson, who runs the hedge fund that has been betting against British banks. Henry Paulson's plan has been attacked by the Republicans as a form of nationalisation of the banking system and by Democrats for bailing out greedy Wall Street, and it not clear quite what can be done ahead of the election anyway. The details of the re-regulation of the US financial system will have to be worked out by the next administration.

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Elsewhere in the world there will be re-regulation too. Here in the UK the principal explicit liability being carried by taxpayers is Northern Rock, and the inclusion of this enterprise into the National Debt has pushed the latter through the Government's 40 per cent of GDP ceiling. In addition there are the implicit liabilities, mercifully unquantifiable, that the Government has incurred by guaranteeing the deposits of the entire British banking system. The Bank of England, like all other central banks, is also pumping funds into the market, taking to be sure assets held by the banks in return. So they aren't just giving away the stuff.

However, the point here is that were the central banks not doing this, the entire world banking system would have collapsed. The interbank market, on which banks borrow from and lend to each other, is still barely functioning, with banks with spare cash hoarding it rather than lending out to others. Banks have to balance their books every day: they have to borrow enough to fund their loans. So the only source for some has been the central banks. Leave aside for the moment all the stuff about banks having been irresponsible and having created complex monetary instruments that even they don't understand. Leave aside the fact that to some extent the regulators are culpable for a box-ticking approach to regulation, while missing the big dangers. Even leave aside the blame that must to some extent be placed on the US Federal Reserve for driving rates down too low and thereby helping top create a global housing boom.

Leave all that aside. Forget about blame. The plain fact is that if the banks don't have the money, they can't lend it. That is why the supply of mortgages is running at one-third the level of a year ago. The danger is that the British mortgage famine will be replicated around the world and become a global loans famine. So far the world economy has come through the banking turmoil in pretty good nick. Yes there has been a slowdown but that was inevitable. There has been no general meltdown of economic activity, although some sectors are obviously in trouble. But were there to be a global loans famine, that would be one thing that could push things beyond a "normal" post-war dip.

So there has to be more regulation, and it has to be done in such a way that banks can continue to function effectively. But the industry will be smaller and less profitable and it would be naive not to admit that the economic recovery will be slower as a result. The more the financial markets can heal themselves the less onerous the regulation that will be imposed but so far they have hardly begun their convalescence.

You can catch some feeling for the way financial pressures have an impact on the world economy looking at the way the post-2000 disruption hit international investment. The top graph, from the latest UNCTAD World Investment Report, shows how foreign direct investment boomed in the 1990s and was hammered after 2000. It has recovered but it is inevitable that it will be hammered again. Cross-border investment by companies is only one measure of the vibrancy of the world economy but this form of investment is not a bad proxy for it.

I am afraid that we here in the UK will suffer more seriously than other places if international banking does indeed go into a decline for a while. The top set of bar charts shows the principal locations for financial trans-national companies. As you can see the UK tops even the US on this measure. It is a way of saying that in the international aspects of finance London tops New York. It will be fascinating to see how many of the Lehman employees in London are snapped up by other houses, for though investment banking will shrink, it may not shrink that much. It will to some extent relocate, in particular to Dubai, Mumbai and Shanghai, which may be fine for the global industry but will not be good for us.

Most people don't realise quite how big international banking is, and the bottom bar chart shows an estimate by industry of the stock of international investment. As you can see investment in finance is second only to business services (which may in any case include a financial element) and much larger than the motor industry, what most of us would think of as the typical form of cross-border investment.

A further point comes out of this. Because finance is so global, what the US does in regulation will affect the world. Gordon Brown talked of the need for a global approach in his conference speech and is now in New York on this quest. But the US will do what it feels it has to do and on past performance will not be very interested in what the rest of the world thinks. There may be some opportunities for the UK to do things better; indeed it is more in our self-interest to do so, given our greater reliance on international finance both proportionately and in absolute terms.

Banking, securities trading, insurance and all the other financial service industries are remarkably durable. They predate the Industrial Revolution and they have survived world wars. Their role has been changed by the growth of central government and it will be changed again. Actually governments have rarely liked finance as an industry but they need it. One side effect of the surge in public borrowing will be that they will have to issue a lot more debt, which will have to be sold via the financial institutions. Thus ironically the British Government needs the support of the City more now than it has at any time since the early 1980s. If you include debt that has to be rolled over, the Government will have to sell some £100bn of stock in the next year. The taxpayer rightly will require closer supervision of the industry, but the Government still has to sell its debt.

700 billion

Potential cost in dollars to the US taxpayer of Henry Paulson's bailout plan.