Sunlight is a great disinfectant

Who to blame? Who to target in the search for the culprits behind the great banking crisis which has mutated from a calamity in private sector credit and derivatives markets into a broader, damaging economic and social disaster. Playing the blame game is easier armed with the benefit of hindsight. But with each passing day it becomes clear that what we have seen is a multi-tiered case study in market and governing failure. Ordinary citizens — whose pensions and living standards are now threatened and blighted by the folly of financiers blinded by their own hubris and greed — will not easily accept that the current generation of leaders are the people to lead us out of this mess.

There was a collective information failure among debt-happy consumers who truly did not understand or calibrate the risks they were taking in mortgage markets. Blame also spreads through to regulators who basically screwed up, and to politicians who were happy to suck in the torrent of tax revenue from a booming financial sector. But most of all the responsibility lies with the banks. They have lost our trust, and trust once shattered takes an awfully long time to restore.

It wasn’t so many years ago that the A level economics course routinely included a scheduled stop to look at the balance sheet of a commercial bank. We covered assets and liabilities with infinite care; we explained the idea of the credit multiplier and the effect of a loans to deposit ratio as a bulwark against excessive lending and risk-taking. It was pretty boring fare at the time, but it made common sense. And looking back it was important for students to know the basis of how banks created money and the importance of the words capital and risk.

I cannot recall precisely when all of this disappeared from the syllabus but perhaps we are due for a comeback. In fact - bollocks to the specification - I will make sure that students whose first experience of AS economics this year was to make sense of the collapse of Lehman Bros, will know what banking is supposed to be about. It is about collecting money in, lending it out, making sure that the borrower does not go bust and retaining a sufficient cushion of capital to meet defaults.

To London for a talk at the LSE by Gillian Tett the FT journalist whose new book Fool’s Gold has just been published. The Old Theatre was full to hear a lucid and compelling talk ably hosted by that arch-blogger, the Maverecon Willem Buiter, Gillian Tett’s new work is split into three sections - b and it was her take on the impact of innovation that most held my attention.

Over the last twenty years the financial system has been a playground for frenetic innovation. As financial instruments became ever more complex - a domain crowded by a sea of acronyms such as CDOs - the financial system started to resemble an iceberg - in other words, most of what was important was buried deep beneath the surface and to ordinary mortals it was completely impenetrable. The US Federal Reserve’s dominant ideology under Greenspan - which politicians were happy to buy into — was that financial innovation was a good thing, that parcelling up risk through slicing and dicing, actually made the world more stable. This quickly became in Galbraithian terms, the prevailing conventional wisdom and there was a social silence about what was going on.

Senior bankers, politicians, ratings agencies and financial regulators have become semi-detached from the real world. We have witnessed a colossal failure of corporate governance and market regulation and inevitably there will be a backlash and demands for true accountability, transparency and a better sense of proportion about what a financial system is supposed to do. Tett’s argument is that finance became the master of the economic system rather than the servant; and that common sense was lost in a whirlwind of ‘innovative banking’ created by quants who really thought they pushing the frontiers of banking into uncharted territory. What they didn’t realize that was that there was an almost complete failure of information about the likely scale of mortgage defaults in the event of an economic downturn. What appeared to be a rational strategy for dispersing risk and keeping lending off balance sheets became a recipe for a tsunami of toxic debts in the private sector. Lest we forget, that toxicity may well spread to the public sector given the mounting scale of government debt.

Balance and common sense, and credit based on social and economic relationships rather than a set of mathematical equations that only quants with PhDs can comprehend. These are the principles upon which a stronger and more equitable banking system can be built.

Fool’s Gold, Gillian Tett, published by Little Brown

Independent review