Should borrowers and lenders be protected from the consequences of their mistakes? That is the big question that underlies the Mortgage Market Review issued yesterday by the Financial Services Authority. It would normally be a no-brainer; in a free society, borrowers and banks alone should be responsible for their actions.

But we are not operating in normal times or in a normal industry. The banking system virtually collapsed a year ago and had to be rescued by the taxpayer. A central factor was the willingness of some banks, particularly in the UK and the US, to advance mortgages to borrowers with questionable credit worthiness.

The banks appeared to share the popular belief that property prices would rise for ever. If it came to the worst, the banks could repossess their borrowers’ homes, which would have increased in value, and retrieve their money. They could also sell — securitise — the debt, before that market disappeared in the crisis.

While the banking system has been rescued from the consequences of its collective folly and greed, many individuals have paid a heavy price. Shareholders in Northern Rock, Bradford & Bingley and HBOS have taken a loss. Depositors have seen a reduction in income, though their savings have been protected.

Many bank borrowers are now struggling with mortgage arrears, and rising unemployment and future increases in interest rates will push many over the edge. A repossession crisis may have been postponed rather than averted. And outside the South East, where a domestic property slump has been avoided, there is serious negative equity.

There nonetheless appears to be an unmet demand for mortgages, one that is currently being held at bay by large deposit requirements. Some of the more aggressive banks, seeking to expand their market share, are relaxing their offerings in terms of loan-to-value ratios.

Any eagerness to return to former lending practices should be a source of concern. The housing market has not adjusted, at least yet, to realistic levels. Historical trends show a cyclical pattern of boom and bust, lasting roughly 15 to 20 years, going back to the mid-18th century. This time the “bust” hasn’t happened in the residential property market, as it has in commercial property.

The IMF has suggested that the market at its peak was overvalued by 30 per cent. Correction on that scale has happened only in some provincial cities where blocks of newly constructed, unoccupied flats overhang the market. Pundits are divided between those who believe that temporary constriction of supply has put a brake on a long deep fall in prices and those who believe that “this time it is different” and are eager to pile back into the market.

The regulators must operate from a broad national-interest perspective. At present there is a national interest in banks increasing business lending on reasonable terms to solvent small and medium-sized companies because many businesses are being forced to contract production and employment through a lack of credit.

It is less obvious that there is a national interest in pumping up the housing market again. A revival of asset prices helps the balance sheets of banks, but creates bigger obstacles to first-time buyers and those on modest incomes. It also risks creating another artificial bubble that could burst with damaging consequences. A distinction needs to be made between remortgaging, where there is a genuine concern that borrowers in negative equity are not forced to the wall, and new loans.

How should a responsible regulator deal with these conflicting pressures? There is broad consensus about the idea of using bank capital-adequacy rules to temper boom-and-bust cycles, but the rules are not yet in place.

That leaves the regulatory processes on mortgage lending: the subject of the FSA paper. What is needed is to recapture the old- fashioned building society model of lending that was lost in the feeding frenzy after demutualisation: lending with care and treating borrowers with respect. The FSA is right to stress safety with tighter verification procedures for self-certification. Affordability tests will make lenders responsible for properly assessing consumers’ ability to pay. FSA rules will in future cover buy-to-let (or lie-to-bet as it is now known). These are sensible, but modest, consumer protection measures.

But behind the technical details are bigger issues. It is deeply damaging for a wealth-creating culture that housing isn’t just seen as a nest, but a nest egg, a repository for the country’s savings and pensions. It isn’t sensible to run up large personal debts gambling on future house prices. Property speculation is not a productive industry. I suspect a bad attack of amnesia is encouraging the idea that nothing needs to change.

The issue so far ducked is whether banks should be set tough new rules on loan-to-value ratios and multiples of income. There are inevitably many complexities. But it is easy to be blinded by the proliferation of products. Traditional mortgage lending followed rules of thumb that still make sense. The obvious principle is not to lend more than the security available. This should be reinstated.

What the FSA should do is to introduce a traffic-light system: a yellow light, a warning, for high-risk mortgages of 90 per cent or more; and a red light, a ban, for new mortgages of 100 per cent or more, the lending which got us into this mess in the first place. That way there is a clear signal that the wild excesses of the past will not return.

Vince Cable is Liberal Democrat deputy leader and Treasury spokesman

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