So how are we going to cope with risk? We are moving from the first leg of the financial crisis to the second, both provoked by an incorrect pricing of risk. The financial markets priced packages of US sub-prime debt wrongly, with all the consequences for the banking collapses. And they priced sovereign risks wrongly, certainly for some European countries but probably elsewhere. But the consequences of that are not yet clear.
There has been, inevitably, a huge focus on the failures of financial regulation and we have just had confirmation of the new government's approach to that with George Osborne. As we have seen, Gordon Brown's structure will be junked, with most of the functions of the Financial Services Authority (FSA) moved to the Bank of England. But it seems to me that the changes in formal structure will be much less significant than the changes in attitude and culture that seem likely to take place.
As it happens, the chief executive of the FSA, Hector Sants (who will retain his role under the new structure), gave a speech about this yesterday to the Chartered Institute for Securities and Investment, "Do regulators have a role to play in judging culture and ethics?"
The nub of his argument was that many of the causes of the financial crisis were rooted in behaviour. "Even after all the supposed lessons learned exercises," he said, "we are still seeing some decisions by management in major firms that we would judge not to be prudent."
As a result, greater intervention would be needed from regulators to ensure decisions made by firms deliver the outcomes society expects.
"Historically," he said, "regulators have avoided judging culture and behaviour as it has been seen as too judgemental a role to play. However, given the issues we continue to see over time, I believe this one-dimensional approach has to be questioned. Every other aspect of the regulatory framework is under scrutiny and we should not shy away from debating the culture question."
Well, he is right, of course. And you might think that we are moving more generally to a society that is likely to be become more judgemental about behaviour in many other fields. But when you try to apply different principles to financial market behaviour you do surely run into practical problems.
It is easy to see now that greater judgement should have been applied by the banks when buying so-called AAA debt that was merely a bundled-up wodge of sub-prime US mortgages. But apply this question now to judgements about this next stage of the financial crisis, the problem of country debt.
Have a look at the map. It comes from the Royal Bank of Canada's European division – and you might note that this bank was one that came unscathed out of the sub-prime crisis and I would assume is well-positioned to weather the sovereign debt one. The team there has calculated a risk indicator for a number of OECD countries, assessing each on a variety of indicators: the amount of debt and the extent to which it is increasing; the cost of debt service; the country's economic strength; and the response of financial markets. The bank produces an overall indicator, shown here.
Some of the points are obvious enough. Greece is top of the risk league and Ireland, Portugal and Italy don't look great either. Spain has become more risky since the bank did the same exercise in February but the UK has improved, perhaps because we now have a government that is taking the issue seriously – or at least is perceived by the markets to be more determined to get the deficit under control than its predecessor.
But think of the consequences of applying this risk map to bank supervision. On the one hand, you would have to accept that banks would be severely restricted on buying most sovereign debt.
Obviously, they would not be able to touch the debt of the "Club Med" group but they would also have to be careful about their credit lines to banks from those countries. Mr Sants criticises "decisions by management in major firms that we would judge not to be prudent" and probably rightly so.
But looking at that map, I would suggest that no prudent investor would lend a cent to Italy or any Italian enterprise. Tough? Sure, but if you value prudence you don't muck about.
There is a further twist. Mr Sants quite rightly focuses attention on the culture and ethics of the regulated but in doing so he opens up the issue of the culture and ethics of the regulators.
I was talking the other day with a very senior regulator and he made the point that ultimately the banking crisis was a failure by the authorities, not the banks.
His point was that people in any community are liable to make mistakes and the job of the authorities is to maintain a framework that curbs those mistakes. The central banks, particularly the US Fed, held interest rates below the level of inflation during much of the boom: if you give people free money they are liable to invest it badly.
Here in Britain we had money supply rising at 14 per cent a year, housing prices rising at more than 10 per cent and people supporting their spending by remortgaging their homes. Yet the Bank was very tardy in choking off this monetary growth by raising interest rates. This was, I suggest, a cultural failure by the central banks.
Finally, there was the culture and ethics of the politicians. I don't want to bang on about Greece or indeed our own last government here but a lot of us have felt for some time that governments, including our own, have made "decisions ... that we would judge not to be prudent".
One of the problems surely was not that the markets went mad but that they were not tough enough on the miscreant governments and central banks. But culture will change. It has changed radically in the personal sector, for consumers as a group are now saving again. It has changed in governments, most of which are now re-imposing fiscal order. It has not, perhaps, changed much in central banks, which have maintained their policies of near-zero interest rates, but expect that to change from the autumn onwards.
Indeed, one of the few groups where culture seems hardly to have changed at all is some economists, who believe that governments should carry on borrowing to "support" economic growth, despite the dangers for investors, as sketched in the map above.
But then economists aren't in charge of other people's savings and thank heavens for that.
Looking ahead, the guiding task for financial regulation should surely be to make sure that risks are taken by people and institutions that are prepared to take them and have the resources to do so, and risks are not taken by organisations that are ill-suited to carry them.
But that means less risk capital will be available. That is what a change in culture and ethics will lead to, and there is no getting away from that.Reuse content