Leading article: The screaming need for regulatory reform

The unreconstructed global banking sector still poses a real threat

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One year ago, the American investment bank Lehman Brothers went bankrupt. In the process it almost destroyed the global financial system. Twelve months on, some confidence has returned to financial markets. Several banks are reporting profits. But anyone who believes that the international financial system today is any safer than the one that plunged the world into chaos last September is deluded. If anything, the world's large banks pose an even greater danger to our economies than they did last autumn.

The number of banks has fallen. But those that remain now enjoy the implicit backing of national governments. Where once bankers speculated with the savings of ordinary depositors, they now do so with the money of taxpayers. Just as dangerously, there has been no real reckoning for those bankers who behaved so recklessly in the boom years. Aside from a handful of high-profile resignations, the managements of these institutions remain largely unchanged. This screams moral hazard. What precisely do these executives have to do to earn the sack?

There is certainly plenty of evidence that they are up to their old reckless ways. Obscene remuneration contracts are returning as banks compete for the "talent" able to generate fat profits from short-term speculation. Make no mistake: the seeds of the next banking crisis are already being sown.

So the need for regulatory reform is screamingly urgent. The question is: will those reforms materialise? There is much in President Obama's legislative proposals outlined to Congress yesterday (and also in the regulatory principles of the international Financial Stability Board) which is welcome. Banks should indeed be forced to hold more capital to absorb losses. And it is common sense that any financial institution large enough to pose a systemic risk should be closely scrutinised by the authorities. Bringing the sprawling derivative markets on to transparent exchanges is also vital for stability.

Sadly, the White House, like our own Government, lacks the appetite to go further. Our preference would be for banks deemed too big or interconnected to fail to be broken up and investment banking re-separated from retail banking. There is also scope for authorities, working together across borders, to be prescriptive over safe levels of employee remuneration. The existence of banking empires and a bloated bonus culture both significantly increase the overall level of risk in the financial system. Yet the best must not be made the enemy of the good. The reforms on the table are infinitely better than the status quo.

Some ask whether the goal of regulation should be to limit the contagion from future banking crashes or to prevent them happening in the first place. The sensible answer to that is: both. Of course, it is impossible for any regime to eliminate the possibility of a financial crash entirely. Instability is inherent in any free market economy. But it is a fallacy to conclude that all regulatory effort is therefore pointless. One of the key features of the era which ended with Lehman's demise was the obeisance of the authorities – especially in the US and the UK – to the idea that financial markets are essentially self-regulating.

It is not enough for governments now to acknowledge that this ideology was dangerous and wrong. They need to put in place the regulatory framework that will consign such complacency to the dustbin of history forever.

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