While no regulatory changes can ensure there won't ever be another banking crisis, the shape of the industry, post-crash, is becoming clearer.
The financial crisis is a long time a-dying, especially in the UK. In the Far East, it is a distant memory. Even in the US there is a sense of moving on: two Congressional enquiries have produced little new material. But in London, public spending cuts remind us of the debt overhang, and it is politically convenient to blame them on the wicked bankers, rather than on a pre-crisis public spending binge which the Conservatives did not oppose at the time. It will be a while before the Honours Lists are again full of knighthoods 'for services to banking'.
But though the political dust has not yet settled and there is still much unfinished business, we can now begin to assess the overall shape of the regulatory response to the crisis, and the implications for the financial sector. How different will the banking landscape of the next decade be, and what are the implications for the rest of the economy?
Sadly, there is nothing very simple about bank regulation. In part, that is because it comes in three dimensions: global, European and domestic. Globally, the rules are set by the Basel Committee. A decade ago, when I apologised to my wife for another weekend away in Basel, she regarded this as an eccentric but safely obscure way of passing the time. Now, the Committee has been thrust into the limelight. It might be a slight exaggeration to say that its exposure drafts are debated in the wine bars of Canary Wharf, but there is far more awareness today of its work.
The new rules, forged in the white heat of 2008-9, will require banks to hold much larger reserves. There is also a lively debate about whether the biggest banks should be required to hold even more, in order to reflect their systemic significance. Gone are the days when the investment banks could gear themselves up 30 times or more. It was, ultimately, that high leverage that did for Lehman Brothers and triggered the meltdown.
These new rules should be implemented across the world and will be incorporated into a European Directive. The European Commission has been busy in other areas, too. The Icelandic bank collapse revealed a fundamental flaw in the single financial market. A bank authorised in one country of the European Economic Area can do what it likes in all the others without reference to the national regulators. Yet when the Icelanders went bankrupt, their own central bank was far too small to bail them out, so the British and Dutch taxpayers had to pick up the tab.
The logic is that either we have tighter pan-European supervision or we re-introduce local control. Unsurprisingly, Plan A found favour in Brussels, so there is now a new European Banking Authority (based in London, as it happens) and two other new authorities for securities markets (in Paris) and for insurers (in Frankfurt). Although their formal powers are limited for now, we are moving towards pan-European financial regulation and had better get used to the idea.
In the UK, we have to implement the new global rules and to obey the diktats from Brussels. But we still have some discretion over the way we organise regulation and over the structure of our banking system. George Osborne has decided to divide the FSA in two, with a new Prudential Regulatory Authority (PRA), organised as a kind of wholly owned subsidiary of the Bank of England, and a Financial Conduct Authority to pick up all its other responsibilities.
Quite what difference this reorganisation will make to the practice of regulation is not clear. Perhaps more significant is the Independent Banking Commission under Sir John Vickers, tasked with looking at whether we need to break up our megabanks and introduce more competition, especially in the retail market. Its interim report was published in April, and a final set of recommendations is due in the early autumn.
Will all these changes, which regulators around the globe are now busy implementing, ensure that we will never again experience another banking crisis? Can we sleep easy, secure in the knowledge that bankers have learnt their lesson and will behave better in future, lending prudently, husbanding their reserves, being kind to animals and helping old ladies across the road (without an inexplicable charge for the service appearing on their next bank statement)?
Well, the honest answer is 'No'. The regulators have not found a cure for over-optimism. They have not produced an antidote to the business cycle. There will still be ups and downs, and banks will still lend to people who turn out to be in no position to pay them back when the time comes. Some might say that the only thing we can assert with confidence is that it will be a while before a politician repeats Gordon Brown's hubristic claim to have put an end to boom and bust.
So have we done anything at all to guard against a repeat of the crisis and to dampen the animal spirits of the masters of the universe?
There have been a lot of changes in the regulation of banks, to be sure, but most analyses of the causes of the financial instability give a high weighting to weaknesses in monetary policy. Interest rates, especially in the US, were pushed down by Federal Reserve chairman Alan Greenspan in the aftermath of the dotcom bust and were held too low for too long, as credit expanded rapidly and asset prices rocketed. Can we expect central banks, in future, to take the punchbowl away at the right time, before the party gets out of hand? It is hard to be confident that they will. At the moment, the Federal Reserve is still pouring punch to anyone who passes by, and with no charge. Only the European Central Bank has had the courage to respond to signs of resurgent inflation. We must hope that the Fed and the Bank of England will act decisively in the future, and not yield to the inevitable political pressures to keep the good times rolling.
As for the banks themselves, they will certainly have to keep larger reserves in future. In theory, this will have two effects. They can lend less for a given quantity of capital, and that lending will be somewhat more expensive. The consequence should be a slower rate of credit growth and fewer marginally viable loans extended. The banks will also be able to absorb more losses themselves, using their own capital, without having to dip their hands into the public purse for support. But success in banking will still depend on sound credit judgement. In the recent crisis there was a striking divergence in performance between RBS and HBOS, on the one hand, and Lloyds and Barclays, on the other. So no rules will guarantee prudent banking. Good governance and competent management are both crucial.
I doubt whether bank boards will quickly go back to hiring a retailer, like Andy Hornby, to oversee a bank balance sheet. They will also, or should also, be wary of allowing one individual, such as RBS's Fred Goodwin, to hold sway without effective checks and balances.
The media also have a role to play. In the go-go years, Fred the Shred was a hero of the City pages. If the government had made him Lord Fred of Shred the applause would have been loud and long. In 2002, Goodwin was Forbes magazine's global businessman of the year. Hornby, too, was a golden boy who could do no wrong - shaking up the stuffy old bankers with a bracing dose of retail pizzazz. The venerable New York Times published a blush-making hagiographic profile of Jimmy Cayne, the bridge-playing boss of Bear Stearns, who doubled and redoubled his bets until the bank collapsed in a heap. More scepticism on the part of the Fourth Estate will be in order in the future.
There are, though, those who argue that more capital will not do the trick, and that there remains a fundamental flaw in the market - that some banks are simply too big to fail, and therefore have an incentive to take excessive risks. If those risks come off, they are rewarded handsomely. If they fail, the government bails them out. So it is a case of 'heads they win, tails we lose'. I doubt if bankers think about their decisions in quite this way. Did Goodwin deliberately plan to make big bucks for five years, then end his career as a social pariah? But some banks clearly did use incentive mechanisms for their traders which encouraged them to bet the farm in the hope of short-term bonuses.
It isn't easy to find a structural solution to this problem. Many patent remedies have been proposed, from 'narrow banking', which would limit public guarantees to banks offering super-safe retail deposits backed by government bonds, through a ban on investment and commercial banking in the same group as a retail bank, to the Americans' Volcker rule, which outlaws proprietary trading by banks with insured deposits. Vickers recommends, instead, separately capitalised retail bank subsidiaries, with higher capital backing for all those activities of a bank that benefit from an implicit government guarantee. I expect the British government to favour that solution, especially when other European countries have no appetite for breaking up their universal banks like Deutsche or Societe Generale.
So the best guess must be that the future of British banking will look a little like the past, except that banks will be more constrained in how much leverage they can take on, and will need to pay particular attention to the security of their retail operations. Vickers is also likely to recommend a more rigorous approach to competition, which may require Lloyds, at least, to divest a large number of branches.
Will all this be enough to make bankers popular, able to walk freely down London streets, without fear of rotten tomatoes? I doubt it, unless there is also a change in the way they are paid. Much printers' ink has been spilled on the iniquities of bankers' bonuses, but we are still short of a fully persuasive explanation of why pay in the financial sector has run so far ahead of earnings in the whole economy for the past 20 years. Lack of competition may be part of the answer, as may technological change, which increases the amount of business a successful trader can do, and a version of the 'winner takes all' phenomenon that has allowed major banks in London and New York to gain market share.
In fact, there are signs that relative pay is falling. Top traders in investment banks earned maybe $40m four years ago: now they pull in a mere $15m. But there are curmudgeons out there who still think that is more than they are worth. There's no pleasing some people.
Until some greater reality penetrates the pay structures of our major banks, they will continue to lose the PR war, and will deserve to do so. If banks wish to regain the public's respect, that's a problem still to be solved. Pointing to their higher Basel-dictated tier-one ratios will not win the argument in the public bar, or get their CEOs back on the Birthday Honours list.
- Howard Davies was the first chairman of the Financial Services Authority and is a non-executive director of Morgan Stanley.