Leading article: The blatant need for closer regulation

Among the factors contributing to the present turmoil in Western financial markets – the greed of investment bankers, the over-lax monetary policies of the central banks – a failure of regulation appears uncomfortably high on the list. That is what the internal investigation by the Financial Services Authority into the handling of Northern Rock collapse conceded yesterday.

Responsibilities for supervising the financial sector in Britain were split between the FSA, the Bank of England and the Treasury in 1997 – but the FSA was made specifically responsible for retail banking. As its latest report admits, the regulator should have seen that the Newcastle-based mortgage lender's expansionary and aggressive business model was vulnerable to a collapse of inter-bank lending. The Rock should have been told to take out some insurance against such a contraction of wholesale credit markets.

Last week, the managing director of the FSA's retail banking division left the regulator, along with a handful of other officials. At the same time, the FSA is planning to hire 100 more staff. Yet it is important to make some distinctions here. Learning the lessons of this crisis will require a good deal more than firing the culpable and hiring more employees for the FSA. It will mean a fundamental overhaul of the regulatory structures of the international financial system.

Though Northern Rock has become an emblem of the crisis in Britain, the lender itself was not involved in the root cause of the credit turmoil, namely unsound lending and opaque financial innovations by globalinvestment banks. Northern Rock's management was irresponsible, but the bank might well have survived had it not been for the shockwaves generated by the wider financial earthquake. Even if the FSA had been more alive to the risks facing Northern Rock, it could not have done anything to avoid the global credit crunch. And being firmer with the Northern Rock management might not even have stopped the lender collapsing.

This is why the question of regulatory reform cannot be dominated by the Northern Rock episode. There are far bigger gaps to fill in the regulatory framework. And, in truth, it is not for the FSA but for national governments and multinational institutions to take a lead on this. There are at least two areas that demand major reform. Banks must be forced to retain greater capital reserves to ensure they are able to bear the cost of bad lending without going to the central banks for a bail-out. And the pay structure of bankers needs to be controlled so that it ceases to incentivise vast and irresponsible risk-taking.

This is not an issue that can be ducked. One of the lessons from this crisis is that banking is not a conventional private industry that can be left to look after itself. The banks provide what is, in effect, a public service by moving money around. When this function breaks down, as it has in the present crisis, entire economies are imperilled.

And then there is the matter of the downside costs of the banks' mistakes. As we have seen with the collapse of Northern Rock and Bear Stearns in the US, the state has no option but to assume responsibility for their bad debts and other liabilities when they collapse. In other words, banks and their shareholders reap the rewards in the boom times but, when things go bad, it is taxpayers who must step in and take the strain. This is an untenable situation.

It goes against the trend of a quarter of a century of deregulation, but it is time for our politicians to co-operate to bring the global financial industry under control.