The present crisis is not an act of God, unpredictable to and unpredicted by ordinary mortals.  It was not caused by loose monetary policy in the United States.  Nor was the crisis the result of the American and European love affair with housing, or the proclivity of English-speaking consumers for excess credit.   The crisis was caused by sub-prime mortgage lending in the United States only in the same sense that the First World was caused by Princip’s assassination of the Archduke Franz Ferdinand.

       Just as there were many contributing factors to the outbreak of the First World War, there were many contributing factors to the outbreak of the credit crunch.  But the cause of the crisis was unsuccessful speculation by large banks in wholesale money markets.      

We attached a casino – proprietary trading activity by banks – to a utility – the payment system and the management of the deposits and lending that are essential to the day-to-day functioning of the non-financial economy.  The losses in the casino have threatened to bring the utility to a halt. If we are to emerge with any confidence, we need to put in place measures which will prevent these events happening again. The way I have framed the problem points directly to the solution – permanent separation of the utility and the casino.

       Financial services regulation is generally reviewed in isolation.  From experience of other businesses we have learnt that regulation works best when it is carefully targeted on specific market failures.  Structural regulation is generally to be preferred to behavioural regulation –  regulation of the scope of business activity is more effective than regulation of the conduct of business activity.  By removing the opportunities for misconduct rather than monitoring the conduct itself, regulators can minimise the unintended consequences of their actions, avoid the pitfalls of superficial conformity but substantive disregard of regulatory principles, and focus their energies on the evils that made regulation necessary in the first place.

We have comprehensively failed to apply these lessons to financial services.  We claim to impose general prudential supervision of these businesses.  That activity fails every test of good regulatory practice.  Such supervision encourages institutions to treat prudential regulation as constraints to escape rather than a guide to good practice, and leads us to control many things without controlling things that most concern us.  In practice, financial services regulation is mostly concerned with what is derisively called ‘box-ticking’ – ensuring compliance with detailed administrative rules.  And, given the political power of large financial institutions – the most effective industry lobby in western economies today – and any realistic view of the skills likely to be available to regulatory agencies, it cannot be otherwise.

       We are at the end of a failed experiment in structural deregulation.  Until the 1970s both Britain and the United States had specialised financial institutions: the result of a mixture of convention and regulatory restriction.  These conventional and regulatory restraints were successively relaxed, allowing the emergence of the large, diversified conglomerates we see today.

These large, diversified financial conglomerates are, in the popular phrase, ‘too big to fail’.  They are also  riddled with conflict of interest.  There is a basic conflict of interest between the purchasers of securities and the issuers of securities. A more recent conflict – central to the current crisis – is the result of deposit insurance.  The deposits of the retail bank, effectively underwritten by the taxpayer, can be used as collateral for the trading activities of the investment bank.

       In addition to these conflicts, there are conflicts of interest within investment banking itself.  The modern investment bank – including the investment banking activities of commercial banks – gives financial advice to large corporations, offers asset management services, engages in market making, issues securities, and undertakes proprietary trading on its own behalf.  The customers of every one of these activities have interests which conflict directly with the interests of the customers of every other.

       The claim made was that market forces bolstered by internal and external regulation through Chinese walls, would mitigate these conflicts, and allow conglomerates to reap the informational advantages of conglomeration without the associated disadvantages.  This claim has proved false.  Worse, the tensions between functions were aggravated by clashes of organisational culture.  It is hard to imagine two more diverse business styles than the individualistic opportunistic aggression required in proprietary trading and the routine bureaucratic processing of millions of daily transactions needed for retail banking.  In practice, these financial conglomerates, characterised by incompatible baronies and unfathomable interactions between products, were unmanageable and, effectively, unmanaged.  That management failure is the central explanation of why we are where we are today.

       We need to restore narrow banking – to ensure that the casino cannot again jeopardise the utility.  That means ring-fencing the payments system, routine deposit taking and lending to consumers and to small and medium sized businesses.  There are several measures that might help towards this objective and a combination is probably appropriate.  I suspect such an outcome will now be best achieved by taking the failed banks into direct public ownership for a period.  Measures to re-establish narrow banking will necessarily involve the divestiture or closure of the investment banking activities of retail banks.  Such restrictions will provide an opportunity to reintroduce measures of structural separation between fundamentally incompatible wholesale financial activities.

       The causes of the crisis, and the remedial measures now required, are embedded in the structure of the modern financial services industry.  Addressing these structural issues, which will require high political courage, is a prerequisite of policies to prevent a similar crisis.