In the wake of the greatest financial crisis since the 1930s, President Obama's Administration is preparing sweeping changes to banking regulation. Not so Alistair Darling. Even though UK financial regulators presided over the first run on a British bank (Northern Rock) for more than a century, the Chancellor insists that the regulatory system was not to blame for the credit crunch. Rather, the culprits were to be found in bank boardrooms.

“Too many people did not understand the risks to which they were being exposed,” said Mr Darling yesterday. This sounds like special pleading by an embattled Government looking for someone else to unload on. But Mr Darling is essentially right. While there is much blame to go round in the collapse of the Western financial system, the problem is not one of regulation.

As far as I know, literally no commentator predicted this crisis. There were some who rightly foresaw disaster from the growth of derivatives and the amassing of debt, but even they generally expected the spark for this to be the behaviour of hedge funds. Hedge funds are unregulated investment vehicles for very wealthy private clients. They typically borrow to invest, and they engage in short-selling (that is, they sell stock they do not own, in the hope that the price will fall and that they can buy it back at a lower price). A decade ago, a failed US hedge fund with the awesomely inapt name Long-Term Capital Management almost brought down the financial system owing to the massive amounts it had borrowed.

But today's financial crisis was not brought about by unregulated hedge funds. Against all expectations, the weak point proved to be the most heavily regulated part of it: the commercial banks. I was for some years part of the senior management of an investment bank, and if there was one mantra that I would repeat it was this: the business of finance is above all about managing risk.

Risk management is a vital function in an efficient economy. Derivative instruments allow businesses to protect themselves against adverse movements in foreign exchange rates, for example. But the commercial banks took on risks that they did not understand and that eventually overwhelmed them.

The UK bank that has become synonymous with irresponsible lending, Northern Rock, imagined that it had hit upon a clever means of making profits. It was in reality a fantastically risky business model. An institution with its roots in the friendly societies of the North East turned itself into a financial engineering shop. It borrowed money short term in the wholesale market and lent it long term, as mortgage finance, to its customers. It raised about 70 per cent of its funds this way. When the US housing market collapsed, causing a cascade of bad debts through the banking system, the wholesale lending market seized up. Northern Rock could not borrow money except at punitive rates.

That was an extreme case. But the banks collectively failed. They imagined that new financial instruments made lending less risky. Because loans could be packaged up, sliced and sold on, they imagined that they could diversify away their risk. In fact, this process of creating marketable securities out of consumer loans - “securitisation” - acted more like a contagion. Banks began to hoard money for fear of not getting it back. Viable businesses that depended on access to stable lines of credit found they could no longer pay their suppliers.

Grossly irresponsible banking thus brought down the real economy into a bitter recession. The crisis is often thought of as the result of collapse in the US housing market and especially its sub-prime mortgage segment. That is not true: the US (and UK) housing collapse is a symptom, not a cause. The essential failure was the banks' and nobody else's. They exploited a massive credit bubble, engineered by central banks that kept interest rates below market clearing levels, while underestimating the risks they were taking on. That is the explanation for the banks' massive exposure to asset-backed securities where the collateral was US sub-prime mortgage loans.

How could this disaster have come about? Regulators clearly failed to perceive the risks to the wider financial system. The tripartite structure of regulation (with responsibility divided among the Treasury, the Bank of England and the new Financial Services Authority) that Gordon Brown introduced as Chancellor was inadequate. Banking supervision ought to be returned to the Bank of England. On the international level, the rules of capital adequacy (the minimum capital that banks must hold) need to be overhauled. They need to be made “pro-cyclical”, meaning that banks should be required to build up reserves when business is booming, so that they have enough when the economy falls into recession.

There is a strong case too for separating commercial banking from investment banking. That separation was legally mandated in the US in the 1930s under the so-called Glass-Steagall Act, and was repealed only under President Clinton. Its rationale has suddenly become topical again. Commercial banking is a utility-like function, on which the whole economy depends. It ought not to be endangered by “bets” made by the proprietary trading arms of an associated investment bank.

But again and again, when considering this mother of all crises, you come back to the failures of strategy by the banks themselves, which are outside the scope of regulation. Those who were in the boardrooms had no clear understanding of the risks they were running. In the case of Royal Bank of Scotland, the board failed to exercise a restraining influence on such madcap schemes as the purchase for 70 billion euros of ABN Amro.

“Greedy bankers” is not an adequate explanation of the crisis; but “incompetent and ignorant bankers” comes very close to it.

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