Andreas Whittam Smith: We cannot safely say that the Great Crash has passed

Financial markets are akin to living systems, driven by animal spirits

Seeing that stock markets have just completed their best three months for at least 25 years, one could be forgiven for supposing that the Great Crash of 2007- 09 had finally reached its natural end. But it hasn't. Financial markets are still in self-healing mode, and we shall have to see how far that goes. Some banks have repaid rescue funds obtained from governments, but many have yet to do so. And governments for their part are making slow progress in devising better regulation. Only when all this is done will the episode be truly over.

It is because financial markets are akin to living systems, often driven by animal spirits as Keynes recognised, that one can attribute to them a self-healing capacity. As an example of this, banking has rarely been so profitable as it is now. The cost of money is incredibly low. And by rationing credit so that only the strongest borrowers qualify, margins are wide and this profitable business rebuilds capital. That is what is meant by self-healing.

In addition, banks are raising large sums from their shareholders. In the US, 10 large banks have reeled in $68bn between them. Earlier this year, HSBC secured a record £12.5bn. And now this week the French banks have followed suit with equally large calls on shareholders.

Self-healing, however, requires abstinence as well as regaining strength. In other words, it requires financial institutions to turn their backs on the highly risky, seemingly profitable business they once greedily snapped up. Whether there is restraint is harder to detect. We know mistakes are rarely repeated while the memory remains painful.

There is no sign in the mortgage market, for instance, that banks are lending the same high multiples of borrowers' salaries as they did at the height of the last bull market. After all, it takes two to speculate and the public just isn't in the mood. And then if we look at a global market leader such as Goldman Sachs, its balance sheet shows that $1 in capital now supports only about $14 in loans and investments compared with $24 a year ago.

The problem for regulators is that excess takes a different form in each successive boom. The authorities are at pains to make sure that what has just gone wrong won't happen again. On the whole it doesn't. Instead a new type of reckless behaviour appears. Right now, however, there are difficulties in dealing with known weaknesses.

The chief of these is the "too-big-to-fail" problem. It is described as the "heads I win, tails I'm bailed out" model of banking. The argument is that by demonstrating that the larger banks will be rescued, governments have in effect extended a guarantee to them for which they pay nothing. Whatever their mistakes, they won't be put out of business. So they will go on behaving badly. Letting go of Lehman Brothers is seen as a perfect example of the exception that proves the rule, for central banks won't want to go through such a traumatic event ever again.

One solution that is being adopted is to require banks to put more capital behind each line of business they undertake so that the chances that customer defaults will bring them down are much reduced. But then there comes a fork in the road.

Some argue, among them Alistair Darling, the Chancellor of the Exchequer, that regulators should go further and force banks to draw up "living wills" that describe in good time what steps they would take to reduce their liabilities should disaster strike. Others want to be even stricter. They would divide the big banks into two legally separate entities, albeit owned by the same shareholders.

One would be a "narrow" bank or a sort of banking utility, doing everyday banking business, highly regulated and guaranteed. The other entity would do all the exciting, highly profitable stuff, albeit still regulated, except that in a crisis it would not be able to call on the government for help. It would be allowed to fail and depositors, customers, shareholders and staff would have been pre-warned.

But it is not up to Mr Darling or any other finance minister to determine what happens. The globalisation of financial markets means that governments will only do what everybody else agrees to do. Otherwise business would flow to the least regulated market.

So not the least important result of the crash of 2007-09 is that finance ministers and central bankers have each lost power to a body that can only take lowest-common-denominator decisions – the G20 nations that held a meeting last month in Pittsburgh. Clearing up after the crash this time is a messier business than usual.