It is unfashionable to say so, but Alistair Darling’s response to the financial crisis was broadly right — at least after his Pauline conversion in mid-October to the necessity of offering unlimited government guarantees to all British banks. The financial system has been stabilised. The economy and the housing markets are showing signs of recovery. Northern Rock has repaid most of its government borrowings well ahead of schedule and there has been no necessity to nationalise fully other leading banks. And despite all the lurid headlines about trillions of pounds of public money flowing to greedy bankers, the cash cost to taxpayers of all the guarantees offered to financial institutions has so far been precisely nil.

In view of this record, the Treasury White Paper on reforming financial regulation deserved a more respectful hearing than it got in Parliament yesterday or indeed the pre-emptive dismissal from the Bank last month.

To cut through the thicket of this debate, which may be technical but is absolutely crucial to the economic prosperity and political stability of Britain, I would suggest five broad principles, each with some policy implications, which the White Paper recognises, but doesn’t spell out.

First, despite the populist outcry against the banks, large and profitable financial institutions are indispensable in any market economy. This is especially true in Britain, which internationally enjoys a comparative advantage in this crucial sector. Finance is a key activity in any capitalist economy for three main reasons:

— financial institutions gather the small deposits of risk-averse savers who may need their money at a moment’s notice, and transform them into large, risky physical investments that will take months, years or even decades to pay back

— financial institutions allocate resources among the myriad competing ideas presented by businesses and entrepreneurs

— the world is undergoing a time of unprecedented globalisation, with money flowing internationally on a previously unimaginable scale. This means enormous growth in the size, complexity and profitability of financial institutions. Britain is uniquely well placed to benefit. The policy prescription that follows from this principle is that Britain, more than any other leading economy, has an interest in encouraging global financial innovation, since this would be beneficial to its economy, even if it were a net cost for the the world.

The second principle is in tension with the first, but in no way contradicts it. It is that financial markets are imperfect and often make catastrophic mistakes. Financial institutions are driven by herd instincts. Waves of euphoria and despondency among bankers invariably aggravate economic cycles and sometimes mis-allocate capital on a monumental scale. Sometimes herd instinct is the surest and safest means of allocating capital, since markets take many years to adjust to new technologies or business ideas. But when those waves of emotion become purely self-fulfilling, government regulation must bring them under control.

The implication is that bank rules must change with the economic environment — tightened when the economy is booming and loosened in slumps. Banks must be forced to save their boom-time profits, rather than pay them out to shareholders and employees, so as to offset inevitable losses when the economy slows.

The third principle, which follows from the first two, is that banks are not just ordinary businesses and cannot operate by the same rules. Much of the damage in the financial crisis was caused by forcing banks to use mark to market accounting rules, which deluded them into paying out illusory paper profits in the boom and then vastly exaggerated their potential losses in the slump, causing panic among their depositors.

The policy prescription is obvious. Banks and their supervisors must be given much greater leeway than other businesses in reporting their financial position. Accountants have passionately opposed such discretion, arguing that all companies must provide shareholders with the most transparent and timely information possible. But if there is a contest between shareholder transparency and financial stability, stability must win every time.

The fourth principle also follows from the first two. Because banking is so vital to the economy, but also inherently unstable, all banks must enjoy some government guarantees. This does not mean they should rely on the Government to bail them out, but it does mean no bank can ever be allowed to fail in a disorderly way.

Mervyn King and Vince Cable have claimed that a bank that is too big to fail is simply too big. But this is plain wrong. As the Treasury White Paper points out, even quite small bank failures will have catastrophic results in a modern globalised economy, as the world learnt from the Lehman Brothers disaster and Mr King himself should have learnt from the messy effort to rescue Northern Rock.

Once it is accepted that all banks at all times require an ultimate back-stop of government guarantees, this leads to several conclusions.

All banks must be regulated and operate with more capital to cover potential losses. But they must also be forced to keep a large portion of their money invested in cash and government bonds, which they can liquidate immediately. This liquidity regulation is even more important than capital regulation and has been neglected in the British debate.

Another key issue is the character of government guarantees. An important lesson of the past two years is that ambiguity in the scale of government guarantees is counter-productive. In future, governments will have to acknowledge that all bank deposits and secured loans are guaranteed without limit, but that all other money invested in the banks could be subject to 100 per cent loss.

The issue of supervision leads to the fifth broad issue in this debate: never again must regulators rely on credit ratings, the banks’ internal risk models or the management’s assumptions about economic variables such as house prices. Instead, regulators must impose their own risk models and standardised economic assumptions on the banks, as the US Government did in its successful stress tests. Pay structures are also a legitimate subject for regulation, as argued by Lord Turner of the Financial Services Authority.

These five principles might not quell populist outrage or prevent economic cycles, but they could ensure that future financial crises were avoided without killing the golden geese on which so much of Britain’s prosperity depends.

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