Suppose that at some time in 2006 – or, more usefully, earlier – the Financial Services Authority had written to the banks it supervises about the explosion of structured credit products.  They might have said that the practice endangered their balance sheets and endangered financial stability more generally.  Suppose the FSA had gone on to insist that banks substantially reduce the exposure to these markets.  With hindsight, this judgment would have been entirely justified.    

Yet would these banks have accepted this opinion?  Or would there have been the political and press reaction that has greeted other means to tax or rein back City activities?

If the FSA had insisted that their view be put to the board of each bank, would the discussion around the table have reflected gratitude that unnoticed risks had been brought to their attention?  Or would there have been outrage at bureaucratic interference in the affairs of well managed private businesses?   

If the regulator had imposed more demanding capital requirements on the most aggressive originators, would these companies have meekly complied?   Or would they have claimed distortion of competition and threatened judicial review, and organised quiet, or not so quiet, meetings with government ministers?  If higher solvency margins had been in place at Northern Rock or Bear Sterns, would it have made any difference to the fate of these institutions when their liquidity dried up?

The notion that future banking crises can be averted by better regulation demonstrates unrealistic expectations of what regulation might achieve.  Banking supervision asks public agencies to second guess the decisions of executives who earn millions in bonuses and business strategies which yield billions in profit.  If Hank Paulson, US Treasury Secretary, were doing the job of day to day regulation personally then he might – just about – have the respect and competence to get away with it.  But the work is done by relatively junior administrators who lack the authority to intimidate the bankers and who have little confidence that their controversial decisions will win political support. 

Perhaps there was once a golden age when the authority and wisdom of central bankers was so great that such regulation was possible and effective, although the recurrence of bank crises suggests otherwise. Today the financial services industry is the most powerful political lobby in the country, and public trust and respect for regulation are low.  All regulators feel buffeted by threats of legal action and there is no easier way to win applause from business audiences than by denouncing red tape.

But in financial services, the demand today is for more regulation.  That call should be resisted.  The state cannot ensure the stability of the financial system, and a serious attempt to do so would involve intervention on an unacceptable scale.  But to acknowledge responsibility for financial stability is to assume a costly liability for failure to achieve it.  That is what has happened.

Since financial stability is unattainable,  the more important objective is to insulate the real economy from the consequences of financial instability.  Government should protect small depositors, and ensure that the payment system for households and businesses continues to function.  There should be the same powers to take control of essential services in the event of corporate failure that exist for other public utilities.  The deposit protection scheme should have preferential creditor status, to restrict the use of retail deposits as collateral for speculative activities.

Banking supervision should then be limited to the weeding out of unfit persons.  Capital requirements, liquidity provisions, and risk assessments should be matters for the business judgment of financial institutions themselves.  We cannot prevent booms and busts in credit markets, but today’s regulation of risk and capital, more reflective of what has occurred than what might,  does more to aggravate these cycles than prevent them.    Regulation in a market economy is targeted on specific market failures, not a charter for general scrutiny of the business strategies of private business.  Banking should be no exception.