Leading article: Fatalism is not the way to react to the credit crunch

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It is a year since confidence in the Western banking sector suddenly evaporated, precipitating what has become known as the credit crunch. And it is perhaps appropriate that the anniversary coincided with the announcement from Northern Rock that it has recorded losses of £600m this year. The sight of ordinary depositors queuing to withdraw their money suddenly illuminated the connection between the tumult in global financial markets and our own savings.

We still do not know how long the crunch will continue, or how it will end. But, a year later, we have a much clearer picture of how it all began. The trigger was the pricking of the American housing bubble. But the underlying cause was a fatal collapse in bank lending standards in the years before the summer of 2007.

A few years ago, Wall Street investment banks began buying up the risky loans made to poor Americans and packaging them into opaque financial instruments known as collateralised debt obligations (CDOs). They would then sell these CDOs on to private investors, or simply add them to their own balance sheets. The theory was that the risk was so diffused as to make the investment rock-solid. Wall Street big names, such as Merrill Lynch and Bear Stearns, were at the forefront of this business. But our own high street banks, from the Royal Bank of Scotland to Barclays, joined in. Some less prudent European banks became involved too.

The problem was that this business model was only sustainable so long as house prices were rising. As soon as they went into reverse, CDOs collapsed in value. They turned out to be full of risk after all. In fact, they were even riskier than normal loans. Because there were so many of these poisonous products in the global financial system, no one knew exactly which banks or investors had lost money. And because these instruments were so opaque, no one could accurately gauge the scale of anyone's losses. The banks panicked and abruptly stopped lending to each other. They also cut back their lending to ordinary customers. The credit crunch had begun.

For the past year, banks around the world have been writing off billions in bad debts and raising new capital to repair their balance sheets. But it has been a slow process. And still no one knows the full extent of the losses because house prices in America, to which the value of these toxic investments are mostly linked, continue to fall. Confidence has yet to return.

There are some who argue that little can be done about this sort of thing; that banking crises are inevitable in free markets and that it is futile, even counter-productive, to try to prevent them. This is misguided for several reasons. One is the involvement of the taxpayer in sorting out the mess. We have seen with the nationalisation of Northern Rock, and the Federal Reserve's rescue of Bear Stearns, that governments have no choice but to support banks when they are in danger of going under. Even relatively small financial institutions are "too big to fail". But this support comes with a price tag. Taxpayers are being forced to bear some of the costs of the bad lending made by banks. A system in which the banks earn huge profits from dodgy lending and the public picks up the bill when things go wrong is – or should be – politically unsustainable.

Another compelling reason for reform lies in the impact on the real economy. Banks are the beating heart of our economic system. When they stop pumping money around the system, limbs are prone to start falling off. Industry and retailers need capital to operate. We cannot tolerate a system in which the banks can suddenly shut off the supply of funds to the economy – particularly in a downturn of the sort we are experiencing at present.

So what should be done? The fatalists have half a point. Regulation by national or international bodies can never be perfect. Each banking crisis tends to be different from its predecessor in some way, which makes pre-empting trouble difficult. But what links these periodic crises is a general collapse in lending standards and a mass mispricing of risk. Financial institutions and their employees have a tendency to succumb to a state of financial euphoria in which they assume asset prices will carry on rising forever. For some, a downturn had never been part of their experience. In such circumstances, judgement became sloppy. Greed takes over.

What the international finance system needs is a regulatory framework that checks what John Maynard Keynes termed the "animal spirits" of lenders and large investors. We need a debate about how this framework ought to be constructed. Any reform needs to curb excesses, without damaging the flow of credit to businesses and sound borrowers. It will be anything but simple. But we cannot allow our economies to be periodically jeopardised by the excesses of the financiers. One year on from the start of the credit crunch, it should be clear that we cannot simply shrug our shoulders and wait for history to repeat itself. That would be the height of irresponsibility.

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