Leading article: A battle in danger of being lost

The announcement from the G20 summit over the weekend that banks around the world will be gradually required to hold more capital gives the impression of progress on banking reform. But beneath the surface a larger battle is in danger of being lost.

The Toronto commitment from world leaders makes broad sense. Though banks were manifestly undercapitalised in the boom years the time is not yet ripe to impose drastic new capital requirements, since this would result in a savage contraction of lending at a time when the global recovery is still very fragile. A phased introduction of the new rules is the only sensible way for governments to proceed.

Yet to focus on new capital requirements and their timing is to miss the bigger, more alarming, picture on banking reform. The fact is that banks are already contracting lending, even without the new capital rules, as they rush to shrink their balance sheets in the wake of the heavy losses endured in the bust. Banks are discarding unprofitable business loans while ploughing resources into trading activities which generate high short-term gains. This picture, of profits being driven by trading revenues, was confirmed by the latest report from the Bank of International Settlements yesterday.

The failure of governments to put their national banking sectors under temporary national ownership at the nadir of the financial crisis in 2008 – separating out their toxic assets from their sound loans in the process – was a grave mistake. This left a host of weakened banks, each with a powerful incentive to constrict credit to the real economy and to generate profits through trading. The ongoing credit crunch is a legacy of that fateful error.

The mistakes have not ended there. Barack Obama managed to get his financial reform bill through Congress last week. But while the legislation introduces some welcome and necessary new controls, in the final analysis it is inadequate. The bill does not confront the "too big to fail" problem of American megabanks. There is no firm separation of retail, commercial and investment banking functions. This is an invitation for Citigroup, JP Morgan and others to continue expanding, safe in the knowledge that they would have to be rescued by the state if they were ever to get into serious difficulties again.

Reform has been just as inadequate in Europe, which is also home to a significant number of sprawling banking empires. And the European banking sector is in an even more fragile state than that of the US. Continental banks are widely believed to be short of capital, with many yet to recognise their losses on loans that have gone bad. This uncertainty about the health of Europe's banks is helping to drive the eurozone bond market crisis. European governments have reluctantly agreed to perform stress tests on their banks. But there has been no commitment to recapitalise and restructure institutions which fail these tests. Once again, the authorities are doing too little, too late.

The G20 summit agreement to enforce higher capital requirements on banks in due course is to be welcomed. But unless this effort is accompanied by structural reform of the sector it is likely to prove ineffective in preventing another financial crisis further down the road. We have tried putting our faith in the good judgement of regulators before and the approach failed catastrophically.

Moreover, none of this addresses the more pressing problem of an international banking system that is still too weak, or short-sighted, to provide the international economy with the credit it needs to sustain a healthy recovery. Until world leaders recognise the importance of this front, the battle to reform finance will not be won.