The best journalism, it is said, is the first draft of history. Too Big to Fail by Andrew Ross Sorkin is certainly worthy of that designation. As a bit player in the dramatic events that Mr Sorkin describes (I am an independent director of Morgan Stanley in my spare time), I can confirm that he accurately captures the atmosphere of chaos and uncertainty that reigned in New York in the autumn of 2008.
It was a time when the tectonic plates of the financial system seemed to be shifting beneath us. Institutions that had been seen as Rocks of Gibraltar were revealed to be smoking volcanoes, at risk of imminent dissolution into lava and ash. Even Goldman Sachs continued to exist only thanks to the kind attentions of the United States Federal Reserve. On the other side of the Atlantic, the British government found itself to be the proud owner of over 80 per cent of Royal Bank of Scotland, which, according to some measures, had for a while been the world's largest bank.
The experience was a lesson for banks, regulators, central banks, and treasuries, which, not surprisingly, were unprepared to handle a comprehensive crisis. Their tools and powers were lacking.
The overriding conclusion that emerges from any analysis of these unhappy events is that nothing will ever be the same again: the relationship between the state and the markets needs to be rethought. A new "social contract" between finance and the people, through their governments, is required.
That is easy to say, but governments, individually and collectively, are still struggling to redefine the terms of that contract. Progress has been painfully slow, partly because officials have been fire-fighting, and partly because urgent domestic political imperatives compete with the desire to establish new, globally applicable mechanisms that would provide a stable underpinning for the international financial system and prevent regulatory arbitrage and the de-globalisation of finance.
As a result, we are seeing different national regulatory approaches emerge. In the US, the key driver of the biggest institutions' decision-making is the Fed's stress tests, which essentially assumed that everything that could go wrong would go wrong. In Switzerland, the leverage ratio is now central. Elsewhere, various versions of the Basel 1 and Basel 2 accords on international banking standards are in operation, sometimes with ad hoc supplements.
A new global Financial Stability Board is trying to make sense of all this, and also to work out a new "macro-prudential mechanism" reflecting system-wide risks. But it has no formal authority to mandate a common approach to capital (the G-20 should give it one).
There is not much more progress to report on the too-big-to-fail problem itself. What should be done about the mammoths of the financial jungle - some of which were conjured into being by governments themselves in the heat of the crisis? Mr Sorkin's book reminds us that, only 18 months ago, the US administration saw one answer in the creation of bigger and bigger banks, on the shaky argument that lashing two sinking ships together would somehow make them both seaworthy. The British government did the same, acting as midwife to the Lloyds-Halifax Bank of Scotland combine, now widely seen to have been a major error.
It is no secret that there are deep divisions among public authorities on this question. In the red corner, so to speak, we find former Fed chairman Paul Volcker and current Bank of England Governor Mervyn King, not natural revolutionaries. They would like to carve up the megabanks and especially to separate retail banking from securities trading, or what is often now called "casino banking". (In fact, the analogy is unfair to casino owners, who have a much stronger record in risk management than do most investment banks.)
In the blue corner sit US Treasury Secretary Tim Geithner and his British counterpart, Alistair Darling, who argue that a revival of the Glass-Steagall Act, which divided investment banking from commercial banking, is not appropriate for today's markets. They believe that regulators can ring-fence capital supporting different business lines, to prevent contagion risk, and perhaps impose a surcharge on large "systemic" firms, to reflect the price of their implicit support from the central bank and government. Depending on size, this might constrain the ambitions of institutions that have plainly been "too big to manage", as well as "too big to fail", which is the most fearsome combination.
Where do I stand in this lively debate? I believe that more diversity in banking, and more competition, is highly desirable. There is far too much concentration following the crisis, certainly in the United Kingdom and other parts of Europe. Neelie Kroes, the retiring EU Competition Commissioner, was surely right to demand some divestiture of branches from the biggest groups, though arguably she did not go far enough. It is encouraging, too, that private equity funds look interested in creating and funding new entrants. We need new capital, and new approaches to management, in the banking system.
But I am nervous about the idea that regulators are best placed to determine the future shape of markets. If the authorities are seen to have brought new institutions into being by fiat, might they not be obligated to support them, come what may? Over time, the aim must surely be to minimize the proportion of the financial sector that is subject to some form of state guarantee. A regulator-designed banking system would make that aim more difficult to achieve.
The author, former chairman of Britain's Financial Services Authority and a former Deputy Governor of the Bank of England, is currently director of the London School of Economics. His most recent book is Global Financial Regulation.
© Project Syndicate, 2009, www.project-syndicate.org.