How do we prevent a repeat of the “sub-prime” fiasco?

How do we prevent a repeat of the “sub-prime” fiasco? What regulatory changes are needed to reduce the chances of another systemic melt-down – and the crushing blow that deals to the broader economy?

What’s incredible about this crisis is that it was largely self-imposed. It’s the direct result of our hubris and greed – in particular, the Western world’s determination to pump-up a series of debt-fuelled asset price bubbles, and the failure of regulators and politicians to prevent that, despite the lessons from history.

The irony is that we live in a golden age of global commerce. In recent decades, Asia’s resurgence, the collapse of the Soviet Union, improved communications and, above all, the spread of liberal economic ideas, have generated an awe-inspiring leap forward. By mid-2007, when “sub-prime” burst from the shadows, the volume of physical world trade was three-times higher than in 1991.

International trade generates wealth, helps cut poverty and, lest we forget, makes different parts of the world less likely to go to war with one other. It binds humanity together - and ever more cross-border commerce is vital to support a fast-growing global population.

But the sub-prime crisis, and the related economic fall-out, means all that’s now under threat. Over the last 18 months, as the credit-crunch noose has tightened, global trade volumes have been throttled, falling 20pc. Across the world, as unemployment rises, protectionism now looms.

So, here we are, having benefited for decades from growing trade, unprecedented international co-operation and technological advance. But now the Western world’s financial sector has created “sub-prime” – with the damage spreading from Wall Street to Main Street as firms can’t access credit and investment and jobs are vaporised.

But the damage is truly global, given that the credit crunch is now causing countries to impose ever more trade barriers as myopic politicians panic and pander to domestic vested interests.

The Doha “trade round”, if completed, would rip-down barriers to international commerce, locking-in another decade of burgeoning world trade. On the brink of success when “sub-prime” hit, the negotiations are now grid-locked – further from success than they’ve ever been since launching in 2001.

This financial crisis, and the strain it’s placing on domestic economies, has sparked such a protectionist backlash that we now face the out-right failure of a multi-lateral trade deal for the first time since the 1930s – with all the lost wealth and escalating international tension that would bring.

So, the question of how we fix the Western world’s financial system is important. It goes way beyond the scandal of the huge bonuses still being dished-out by banks dependent on taxpayer finance – however galling that may be. It matters far more than domestic politics, too – however grotesque the spectacle of Gordon Brown clinging to power as the rest of us scream for a general election.

For, in my view, the UK has a unique role to play. Along with the US, this country is the epicentre of “sub-prime”. A lot of the regulatory failure, and the financial culture which caused it, emanated from here. That’s why, for better or worse, what we do to address the issues raised by “sub-prime” is being widely watched. Yet our regulatory response has been risible.

Over many years, the UK’s banking sector increased its leverage and took insane risks, while finding ways of making those risks less transparent. Despite the havoc this behaviour caused, the main reason credit remains scarce and our economy on its knees is that UK banks still haven’t “fessed-up” their losses.

The failure of our politicians to make this happen, their cowardice in not insisting bail-out cash was conditional on forensic external audits and a bank purge, has been a cardinal error. Similarly, despite the UK’s welter of financial expertise, we’ve also failed dismally to develop a coherent regulatory model.

For many years, this column has criticised Labour’s “tripartite structure”. Splitting responsibilities between the Bank of England, the Treasury and Brown’s Financial Services Authority, was always going to mean issues fell between the floorboards. In fact, Brown made the regulatory system ineffective on purpose – so he could unleash, and bask in the glory of, a debt-fuelled boom.

So I applaud the Tories’ recent proposal to return banking supervision to the Bank of England - where it belongs. But I despair at HM Opposition’s determination to now “scrap” the FSA altogether. This decision has been driven by a desire for a “political top-line”, rather than shrewd analysis. The FSA has many faults, but getting rid of it would be a costly, spiteful mistake.

The FSA’s current regulatory remit goes way the banks. It should continue overseeing insurers, pension funds and so on. This kind of sub-sectoral regulation is beyond the Bank’s expertise. The FSA should also build on its work protecting the interests of retail customers.

The most important thing, though, is that the FSA becomes a subsidiary of the Bank, releasing it from the Treasury’s whip hand. The previous split didn’t work not because the FSA existed per se, but because its senior staff knew their masters were sitting in Whitehall.

That meant, by definition, the FSA turned a blind eye when banks pursued expansionary policies it knew the Treasury wanted. This lax, politically-motivated approach to bank regulation flew in the face of the Bank’s mandate to maintain low inflation and “financial stability”. No wonder there was turf war and a lack of information-sharing with Threadneedle Street.

So maintain the FSA but make it an offshoot of the Bank of England. That’s the best way to better regulate the UK’s entire financial system – and help prevent future systemic crises. Don’t just scrap the FSA root-and-branch to prove how “hard” you are. That’s policy vandalism.

If the FSA has been an area where the Tories’ policy response has been too heavy-handed, in an even more important area they’ve been far too timid.

“It isn’t sensible,” Mervyn King recently stated, “to allow large banks to combine high street retail banking with risky investment banking strategies, and then provide an implicit state guarantee”.

The Bank Governor’s words echoed around the world. He was calling for a return of “Glass-Steagall” and, in doing so, was taking on the big “universal banks” of Wall Street and the City.

Named after the two Senators who introduced it, Glass-Steagall was the centrepiece of America's regulatory response to the 1929 Wall Street crash. It built a firewall between commercial banks (that take deposits) and investment banks (which pursue higher-risk investments, having raised finance elsewhere).

For more than 60 years Glass-Steagall kept such institutions separate. Why? To stop bonus-fuelled investment bankers getting their hands on taxpayer-backed deposits, “levering-up” by borrowing against those deposits, then using them to gamble recklessly. If such bets work, the banks win big. If not, taxpayers foot the bill.

That's what has happened since Wall Street convinced Bill Clinton's government to repeal Glass-Steagall in the late 1990s. The same “fusing” of commercial and investment banking then happened in the City too. No other single act did more to cause this crisis.

If readers think such technical issues are remote, remember that it’s because these universal banks become so big, and were able to take crazy risks with ordinary households’ deposits, that “sub-prime” sparked a fiscal crisis too. The UK has now spent a £1,200bn bailing out its banks – precisely because they’re “too big to fail” and ordinary voters’ cash has been at stake.

This column has long-called for a new Glass-Steagall. Credible people now agree. Mervyn King has been joined by Vince Cable, Nigel Lawson and Paul Volcker.

Last week, the Treasury Select Committee produced a report on the new regulatory landscape. While the annex was full of testimony from expert witnesses on the separation of investment and commercial banking, the words “Glass-Steagall” didn’t appear in the report.

The Tories say they “see the arguments” for the re-introduction of this crucial regulatory divide. They accept that since it was removed, the Anglo-Saxon economies have lurched from crisis to crisis. But they “don’t want to introduce it unilaterally”.

Were the Tories to take this step, the world would notice. Taking London’s cue, other countries would follow. By leading the charge towards a new global Glass-Steagall, an incoming Tory government could do much to restore London’s name as a centre of regulatory excellence.

But it won’t happen. Today’s politicians are far more interested in securing banks' campaign donations than they are in preventing future systemic collapse.

Liam Halligan is Chief Economist at Prosperity Capital Management