The fire next time

Every attempt to make banks more responsible has made them more reckless. Unless the sector is radic

As the financial chaos that began with the collapse of Northern Rock in 2007 enters its second year, the question is: where do we want to be? Are the banks, as the British Chancellor of the Exchequer Alistair Darling has said, to use public capital to restore the relatively free-and-easy commercial conditions of the latter part of 2007? Or should we, as both Gordon Brown and Nicolas Sarkozy have suggested, try to use the 15 November meeting of the 20 chief industrial countries in Washington to establish a new era, like Bretton Woods in novelty if not character? With a new US president, in the person of Barack Obama, due to take office in January, the opportunity is for the taking.

Financial crises are like fireworks: they illuminate the sky even as they go pop. The disruptions of this autumn, the bank rescues, falling securities markets and currency turbulence, have revealed cracks and chips not merely in our financial system but in our general way of looking at the world. The expertise of the economists looks suddenly threadbare. As Robert Skidelsky, John Maynard Keynes's biographer, wrote in the Washington Post last month: "What is in even shorter supply than credit is an economic theory to explain why this financial tsunami occurred, and what its consequences might be. Over the past 30 years, economists have devoted great intellectual energy to proving that such disasters cannot happen."

Any new financial order for the world must tackle the three chief challenges of our age. The first is the privileges enjoyed by people in the banking and securities trade on a scale which would not have shamed the nobility of the ancien régime. The second is the perverse character of modern investment, by which financial surpluses generated by hard-working countries are channelled by the banks not to undeveloped nations that might turn them into prosperous future markets, but to the spoiled and elderly economies of western Europe and the United States, already awash with unproductive capital. The third is our most pressing engagement, which is to prevent further ravages to the natural environment and the general amenity of existence from the reckless combination of the previous two challenges.

The banking crisis that began in earnest with the failure of Lehman Brothers Holdings on 15 September, has lost its novelty as a public spectacle. As people turn back to their ordinary preoccupations, and to the prospect of President-elect Barack Obama, the bankers are lifting themselves up, dusting themselves down and preparing to do what they were doing before, only this time with £400bn of public money. However frightening the events of September and October, they were not frightening enough. As Eric Daniels, the chief executive of Lloyds TSB, put it: he did not expect the government, which has earmarked £17bn for a merged HBOS and Lloyds TSB, to "have an impact on our lending policies or conduct of business". At times our financiers sound like the Bourbon kings, who learned nothing and forgot nothing.

When the Bank of England cut the main rate of interest at which it lends to commercial banks on 6 November, by no less than 1.5 percentage points, the British banks must have thought Christmas had come early. When you can get your funds at an interest rate of 3 per cent and lend at 7 per cent, it is not hard to make money. With these windfall profits, the banks could soon rebuild their capital, repay the public loans and start making themselves lots of money.

The Chancellor and his team had other ideas. At a meeting at the Treasury on 7 November, senior commercial bankers were reminded, with the aid of some pertinent press cuttings, of just how unpopular they are. Now that the public owns Northern Rock and Bradford & Bingley, and is about to part-own Lloyds TSB, HBOS and Royal Bank of Scotland, ministers can no longer be ignored. Even Barclays, which has gone to great effort to avoid taking the UK government's money, raising £5.8bn at higher rates and more unfavourable terms from reluctant investors in Abu Dhabi and Qatar, is faced with the same public distrust and political interference.

Losing your capital is like losing your trousers. It is a real humiliation, and one not to be soon repeated. The British banks will be forced by the government to advertise attractive mortgages and other loans, but they will only make these loans on good security, and it is security that is in short supply. In the market for private housing finance, I imagine we will revert to the conditions of the 1970s, when buyers were expected to provide a quarter or even a half of the purchase price. Northern Rock, which has been longest at this sort of retrenchment exercise, had already reduced its outstanding loans by 10 per cent by the middle of the summer. The Bank of England estimates that, even with the extra share capital underwritten by the government, the largest UK banks would need to reduce their books of loans by around one-sixth to revert to the normal or half-normal level of 2003.

Banks will also try to shrink their establishments, bloated beyond all reason during the boom years or, as in the case of bank branches, maintained out of idleness and sentiment. If Lloyds TSB manages to consummate its union with HBOS, it intends to cut £1.5bn per annum by 2011 in overheads, particularly wages, from the combined business. A rough calculation suggests this could means a reduction of 20,000 staff.

At the heart of banking is a suicidal strategy. Banks take money from the public or each other on call, skim it for their own reward and then lock the rest up in volatile, insecure and illiquid loans that at times they cannot redeem without public aid. Put another way, the assets of the banking system belong to the joint-stock banks, but their liabilities (as we have learned in the past two months) are always and only public liabilities. I guess that is what the Chancellor means when he talks of the "part-nationalisation" of the banking system.

It is a dilemma that goes back to the origin of joint-stock banking at the turn of the 18th century. Whereas private bankers staked their credit, reputations and fortunes on their decisions to lend or not to lend, the shareholders and managers of joint-stock banks carried no such responsibility. That is why, in Britain at least, it was not until the 1870s that joint-stock banks received the protection of limited liability. Until then, their shareholders were liable for losses to the extent not just of their shareholding but of their entire property.

All attempts to regulate the banks have made this prudential problem, as it is known, worse. The Bank of England, which like so many institutions has suddenly become obsessed with history during the crisis in the same way that other people "get" religion, published in its latest Financial Stability Report a chart showing the effect of regulation on the caution of American bankers. In the 1840s, American banks held on average one dollar in their own funds to two dollars of loans and other assets such as government bonds. That meant that half their money was not earning anything, but also that half their loans could go bad without causing loss to depositors.

With the Civil War and the passing of the National Bank Act in 1864, that proportion fell to 25 per cent. In 1913, the Federal Reserve was founded and the proportion fell to 18 per cent. Since then, the bankers have managed to get various classes of asset exempted, and the proportion has fallen to under 10 per cent. Each attempt to make the banks more safe has made them more reckless. According to the Financial Stability Report, before the crisis of this autumn the chief UK banks had £200bn of their own capital to support £6trn worth of lending, a proportion of one in 30. As the Bank notes in a sort of wonder at the majesty of financial phenomena: "Recent events have illustrated that banks can now incur losses much faster than they can recapitalise themselves in stressed market conditions."

By choking off lending, the banks have set in train a decline in general trading activity that looks to be worse than those of 1991, 1982 and, possibly, 1974. My suspicion is that the semi-orderly contraction in bank lending envisaged by the Bank of England will drop us off in roughly the same place as if the likes of HBOS and Royal Bank of Scotland had been bankrupted. That, of course, can never be tested. Yet the result of the government rescue is to entrench a sort of banking nobility, endogamous and permanent, without responsibility and not subject to ordinary commercial law. It reinforces the vacuous and illiterate City culture of pecuniary display, cost-free philanthropy and nuisance travel. And it perpetuates banking practices whose eventual disintegration, ten or 15 years in the future, will make this crisis look routine.

So what is to be done with the banks? My own modest proposal, which has not many adherents, is to take away from joint-stock banks the privilege of limited liability which they abuse every moment of the day. That would certainly separate the sheep from the goats but would, perhaps, reduce the equity capital available to the banking system a little too sharply.

More realistically, now is the time for government authorities to begin slowly to peel back some of the other privileges, such as deposit insurance, that under the guise of protecting the public, merely protect the banker. What this means is that you and I will think for a moment before entrusting our money to a bank. We might ask for a balance sheet at the counter, the work of a few moments. We don't know how to read a balance sheet. The clerk will show us. The public, turned into infants by bank regulation, become adults again. Banks will be obliged by a discriminating public to carry more of their own capital. At Bradford & Bingley, the pretty woman in a green bowler becomes a plain man in a black one.

The second challenge, which arises from the imbalance of savings between west and east, is one that Keynes would have recognised even if, in his time, it was the US that had the money. The tendency of the west to borrow and spend and the east to save and lend is the shadow or phantom behind the banking crisis. China, Japan and the oil-exporting countries earned such colossal surpluses from their exports that they could find no other home for them than the indebted households and governments of the rich countries. In the case of the two Chinas, Japan, Russia and India, these hoarded surpluses exceed the entire resources of the International Monetary Fund, the institution set up at Bretton Woods to assist distressed countries needing access to foreign currency for their trade.

Meanwhile, the turmoil in the banking system has meant that entire countries - Iceland, Hungary, Pakistan and most of the poorer nations - can without warning lose all access to foreign currency to buy food for their populations. The answer is to increase the resources of the fund or some successor while recognising that the world has changed out of all recognition from 1944. The US is now a debtor, not a creditor, and the rich new powers of Asia need representation according to their wealth.

That leads to the final challenge of limiting the damage to the natural environment from the rapid expansion of trade and population in recent years. Even before the banks fell to bits, energy and grain markets, movements of people and climate patterns were frantically signalling that something was going awry with the worldwide commercial system.

At one level, the decline in business activity will be a blessing. Certain perverse projects, such as the expansion of the London airports, will not pay for themselves in the new world of tightened belts and shut wallets and must be delayed or even, God willing, abandoned. It is one of the bizarre features of our civilisation that money will do for its own preservation what we, for our own welfare, will not.

Here the conjunction of a new US administration and a disgraced business and financial Establishment is interesting, to put it mildly. If the investment, for example, necessary to limit or reduce carbon-dioxide emissions appeared to sceptics both uncertain and costly, the $3trn cost of cleaning up the current financial mess puts it into perspective. If some latter-day New Dealer is looking for counter-cyclical investment both to keep people in work and to raise public morale, the environment is by far the most promising field of activity. For example, the Detroit carmakers have jogged along for more than 80 years on a rich and combustive mixture of cheap gasoline and easy credit.

That era is now over, which is why the US motor industry is by almost every prudent measure utterly bust. There is no purpose in Barack Obama summoning from the tomb the corpse of Henry Ford. Any rescue operation in Detroit must take account of the new world of tighter credit and environmental standards and more costly motor spirit.

To concentrate merely on regulating the financial sector might buy stability for a year or two, but the weaknesses in energy and food supply and the degradation of the environment will not go away. The rainbow over the downtown skyscrapers will have but one meaning: no more water. The fire next time.

James Buchan is the author of "Frozen Desire: an Inquiry into the Meaning of Money" (1997). His latest novel, "The Gate of Air", is published by the MacLehose Press (14.99)