Investment banks defied the business cycle: reaping profits and bonuses at record levels until the leverage caught up with them. Then they were forced to go hat-in-hand to governments for bailouts putting the burden on the shoulders of taxpayers.

At the occasion of 25th Sustainability Executive Roundtable we interviewed Thomas Huertas, Director of the Banking Sector at the Financial Services Authority in the UK. He is a firm believer that better regulation will avoid a repetition of recent financial meltdown.

“Prior to the crisis there was a view by many central bankers that we had reached a point where the business cycle had been "conquered;" we had something called "the great moderation," and we could look at a very stable economy. Well, we know now that's not the case. The economy is a very turbulent place, reverses may occur.”

And though today central banks’ prime lending rates are at historic lows, consumer lending rates are correspondingly too high. “From a regulatory standpoint, we want to be sure that banks are careful with regard to credit, that they make loans at rates that correspond to the risk of the borrower. We don't advocate banks simply go out and lend to stimulate the economy - that's the easy part. The hard part is getting the money back."

Correcting the shortcomings

The collapse of Northern Rock in the UK exposed two glaring shortcomings in the regulatory framework: a seriously low deposit insurance level (just the first £2,000 of deposit were fully insured) coupled with an inability to pay out the insured deposits rapidly, and the lack of a resolution scheme for banks. “Banks were subject to bankruptcy under the normal corporate bankruptcy proceedings,” says Huertas, “and that turned out to be very inappropriate… we have corrected both of those shortcomings.”

Banks should be allowed to fail

“We have to find a way where banks can be made ‘safe to fail’ and we're working on that through things such as an introduction of living wills to measures such as a "bail in" approach. This “bail in” approach would convert forms of investors' capital such as preferred stock or subordinated debt and possible long-term debt into equity capital if the bank runs out of the ability to finance itself in the private markets.” (See Finance Professor Theo Vermaelen’s comments on COERC’s in Knowledge this month)

Huertas believes banks should be able to fail in the same way that non-financial corporations fail - a bankruptcy procedure that allows a bank’s capital to be restructured, while it continues its operations, continues to serve customers, above all depositors…at no cost to the taxpayer.

“If we can’t solve [this problem], it has in my opinion, wide sweeping implications for the type of banks and banking structure that we will have. It’s simply just not acceptable for a banking system to have a situation where the profits are private and the losses are socialized.”

Note: The new Conservative-led coalition UK government has decided to dismantle the Financial Services Authority, turning its watchdog powers over to the Bank of England and its Governor, Mervyn King.