UK banking needs more than hard self-regulation

‘Hockney-esque’ is how the City minister, Lord Myners last week described today’s government effort to reboot Britain’s banking system.

It’s a high-brow reference to the fact that today’s government proposals will be a mix of white and green paper. Many of the more radical decisions will be delayed for more consultation. Some angry taxpayers could argue that toilet paper is more appropriate.

What other industry would definitely cost the public tens of billions of pounds, and plausibly hundreds of billions of pounds in bailouts, yet have its role in the economy defended in the document meant to rein in their excesses?

At the very time that teachers and nurses are likely to face pay freezes, at least partly to help pay off the debt incurred by this bailout, the banking fraternity have begun to argue they really are worth the boom time bonuses.

Treasury insiders are adamant that this paper will herald a complete change of theology and philosophy. The FSA will be empowered for intrusive regulation. It will set its own regulatory perimeters.

So if a bank gets round heavy-duty regulation (so-called regulatory arbitrage) by launching bizzarely named off-balance sheet funds, the FSA can chase them. If banks inisist on rewarding traders and salesman on the basis of short term share price or short term bonuses, the FSA can punish them. And if banks grow beyond their station, the FSA would be able to get involved.

So what would the FSA’s weapon be? Banning banks acting in these ‘bad’ ways? No. Jailing miscreants? No. Breaking banks up? No. The weapon of choice will be raising the levels of capital that banks have to set aside for each of these “risky” activities. This should limit their ability to lend and their profitability.

But actually I think it’s even more subtle than that. The Treasury hope is that the mere threat of such action from the FSA would encourage a bank’s board to rein the excesses of their executives in the good times. A dynamic that almost completely failed over the past decade. You could call it “hard self-regulation”. I imagine many people will be unconvinced, particularly given the lack of details.

I would anticipate some action on derivatives, but Britain may not go as far as Europe in demanding that all of the famous bets on bond insurance (so-called credit default swaps).

This crisis was at its heart about complexity. The response is not going to be simple.