For non-British readers, I should explain that the British TV advertisements for Hovis bread revolved around an intense misty-eyed nostalgia for the way things were, the supposedly simpler lives of a half-century ago. (In the United States the term “Hovis banking,” coined in the FT this week, might be replaced by “Jimmy Stewart banking,” referring to his role of small-town mortgage lender in the 1946 movie “It’s a Wonderful Life” ) In both countries the calls for banking reform have involved a similar recall of a lost era in which supposedly banks confined themselves to their core businesses and took few risks. Cynics may however wonder to what extent such a return is practicable, and whether its costs to the modern economy might not be impossibly high.

There is no question that a return to Hovis banking would in principle be desirable. As detailed several times in this column, the move from Jimmy Stewart banking to securitization in the housing market added approximately 14 basis points to the annual cost of a mortgage, even during the 2000-06 period when fear of default was largely absent and banks were falling over themselves to issue and invest in securitizations. Similarly, individual investors did fine in the old New York Stock Exchange specialist system, where all trading flowed through the same order funnel, and there were no major transactions conducted off-market. Finally as a former London merchant banker, nothing will convince me that those institutions were not more effective advisors to and financiers of their clients than their behemoth successors, ridden with conflicts of interest as they are.

There are however a number of obstacles to achieving a “back to Hovis banking” outcome. The current behemoths have shown over and over again their willingness to seek new corporate structures or other means to avoid whatever regulations are placed on them. In addition, attempts to persuade Congress to draft appropriate restrictions, or impose appropriate taxes, run into a blizzard of opposition from financial sector lobbyists. Such lobbyists are now further empowered by their successful resistance to meaningful regulation after the 2008 meltdown. If Paul Volcker backed by a large Democrat majority in both Houses of Congress and a President eager to impose “reform” and insouciant about the costs of doing so were unable to make meaningful changes in the industry’s corporate structure, it is unlikely that any such broad-scale reform will succeed in the future.

There is also the problem of principle for free-marketers like myself. A Hovis banking culture, however wholesome, that was achieved by the brute force of regulation would not greatly resemble the relatively free-market structure of fifty years ago. (Americans may object that fifty years ago the Glass-Steagall Act separating commercial from investment banking and the McFadden Act prohibiting interstate branching were in full operation, not to speak of Regulation Q interest rate ceilings. Even in the United States however mainstream investment banking and investment management were less tightly regulated than today, while the housing market was dispersed among a myriad of small banks, none of whom had to make quasi-forced loans as mandated by the 1977 Community Reinvestment Act. In Britain, with the major and damaging exception of controls on foreign exchange movements, the system was then far freer than today.)

There are nevertheless two regulatory changes that have some reasonable chance of being adopted, which would greatly improve the banking system’s operation, without imposing onerous new burdens on its legitimate activities. First a modest “Tobin tax” on transactions, set at 0.01% or 0.02% of the value of each transaction, would raise substantial revenue while slowing the rent-seeking “fast trading” operations that are destabilizing the market. This would not even need to be imposed on a multi-national basis. Since much of the transaction flow information used by the fast trading algorithms requires the trader to be located close to the Stock Exchange, a relocation of the trading computer to the Cayman Islands would give that computer a crucial 16.5 millisecond disadvantage against its New York–based competitors, as the signal flitted the 1,537 miles from New York to Grand Cayman and back.

The second useful regulatory change would impose restrictions on banks’ risk management methodologies. Under Hovis banking, regulators imposed limited restrictions on financial institutions’ capitalization, whether through the bank regulatory system (either formally or, as with the Bank of England, informally) or through the SEC rules on brokers’ minimum capital. When banks’ assets were almost entirely conventional loans or debt and equity securities, these rules were sufficient. However the codification of these rules under the Basel regulatory process has coincided with them becoming increasingly inadequate. The explosion in derivatives markets after 1980, and the rise of securitization techniques through which banks could process loans and keep much of their risk without holding them on the balance sheet has made capital a wholly inadequate measure of banks’ propensity to go belly-up.

There is however an even more serious problem than the banks’ ability to leverage assets, making the same atom of capital support ever larger towers of risk assets, and that is their risk management systems. In this respect the Basel process was highly counterproductive; it ludicrously gave the larger and more dangerous banks an advantage by allowing them to design their own risk management systems, under the theory that they had some magic “sophistication” that would prevent disaster.

Regulating risk management is thus far more important than regulating capital in today’s markets. Capital exists to protect bank creditors and the market against risk, but if risks are inadequately measured, neither bank management nor regulators have the faintest idea about how great those risks are and how much capital is required. The Value at Risk system, blessed by the Basel regulators and almost universally used at least before 2008, is in this respect especially pernicious. It focuses management’s attention on the fluctuation on normal trading days, removing it from those periods in which the market is turbulent and risks are greatest. It also fails to distinguish adequately those instruments which have exceptionally long risk “tails” (such as credit default swaps, in which the potential loss may be 100 or even 500 times the normal daily price fluctuation) or exceptionally fat “tails” (such as collateralized debt obligations on subprime mortgages, in which the underlying risks may be highly and unexpectedly correlated.)

As a minimum, therefore, regulators must demand that banks use a risk management system that accounts adequately for the increased fluctuations likely in turbulent markets. In addition banks must use “litmus” tests to identify cases where traders have designed new instruments like CDS and CDO that “game” existing risk management systems. We discussed possible litmus tests in “Alchemists of Loss.” There may well be others that could be used, but the use and stress testing of such litmus tests is essential in a modern financial system. Accordingly regulators should devote less attention to capital and far more to enforcing minimum risk management standards.

Imposing these two additional constraints would limit financial institution rent seeking and reduce their tendency to unexpected and expensive collapse. But it still would not return us to Hovis banking. The reality is that while global liquidity is so high and the cost of borrowing so low, there is no incentive on financial institutions to behave in a responsible manner. Speculative games are encouraged throughout the system, as is over-leverage, while responsible lending to productive enterprise is discouraged, since it requires more intellectual effort. Only when Ben Bernanke has been replaced by a Paul Volcker clone, and real interest rates have spent several years at eye-wateringly high levels will proper banking prudence again be rewarded better than feckless speculation.

Of course, getting from here to there will be excruciating, as it probably requires most of the overleveraged speculators to go bankrupt. As in 2008, they will resist this necessity, preferring to use their lobbying clout to extract yet another bailout from the unfortunate taxpaying public. This time we must refuse, hopefully having elected leaders with sufficient understanding and backbone to refuse on our behalf. The systemic damage done by the bankruptcy of say Citigroup and Goldman Sachs is substantial, but short-term in nature. It must be endured, in order to avoid the creation of yet another economically destructive cycle of speculation and bubble-blowing.

Having endured the pain of a mass financial sector bankruptcy, and the disruption of a 180 degree reversal of the last 15 years’ monetary policy, we may, with the modest regulatory tweaks discussed above, have arrived at something like Hovis banking by natural means, without having to regulate it into existence. The global economy, and our children’s living standards, will be incomparably the gainer by it.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)