Scrutineer: Why we should have let RBS and HBOS fail

TAXPAYER rescue of Royal Bank of Scotland and HBOS may prove to have been the worst solution: "zombie" banks, a prolongation of the crisis and a recession deeper and longer than would otherwise have been the case.

The 200 billion that the IMF estimates to be the cost of the UK bank "rescues" would have been better spent on massive tax cuts. This would have spared us the worst of the recession and secured recovery earlier and more robust than the years of sturm and drang that now lie ahead. This constraint on growth will cause the failure of many thousands of businesses that might otherwise have had a reasonable prospect of survival.

So argues Andrew Lilico, a leading specialist in financial sector regulation, in a provocative paper, What Killed Capitalism (*) published today. He argues the emergency responses have made a devastating crisis worse and we should stop trying to save failed banks.

Nationalisation of most of the UK's banking sector marks the end of 300 years of private capitalism – "a disaster of the first order". Bailing out failed banks, he says, has let bondholders off the hook and marked a catastrophic abandonment of the principle of "caveat emptor".

So what killed capitalism? Lilico cites five main factors: genuinely valuable innovation, over-confidence in regulatory banging; the use of novel products to bypass regulatory requirements; extreme moral hazard in respect of housing and over dependence on annual inflation targets which did not contain any measure reflecting the rise in housing costs. What did not cause the credit crunch was greed or bonuses.

Nationalisation of a huge swathe of the banking sector – and indeed the lion's share of the banking system in Scotland – only validated the poor decisions that led to the crisis. "The banks took on too much bond-based debt at the expense of equity on the premise that debt was low risk. By sparing bondholders, the government has made this judgment right … this rewards the behaviour that led to the failure of these institutions."

Instead, says Lilico, the correct policy should have focused on employing market mechanisms so as to punish the bondholders and force the required restructuring. "Formulaic" prudential capital requirements made it worse once the crisis was here and should have been suspended.

The Bank of England should have been made the prudential supervisor and placed failing institutions into a special administration regime. Retail depositors should have been made into preferred creditors, ranking above secured creditors and the real economy supported with tax cuts.

"How much less bad would things have been if, instead of spending 200bn on the financial sector, the government had made 200bn of tax cuts?"

The hidden cost of the bail-outs is loss of growth. Private capitalist economies, because they promote innovation, grow on average rather fast. A state capitalist economy must grow more slowly. He describes the government's insistence that the sustainable growth rate of 2.75 per cent had been unaffected by the credit crisis as "preposterous". A more plausible figure would be 2.2 per cent.

If that seems insignificant, an economy growing at 2.2 per cent over the next two decades would be about 10 per cent smaller. That's less job creation, less investment, less tax revenues – and a large swathe of investment and long-term deals entered into in 2005 and 2006 predicated on that higher growth will now go bad, inducing an additional GDP loss of between 5 and 6 per cent.

Of particular interest in helping to prevent a return to the crazed lending in the mortgage market is a broad recommendation for the return of the principle of "caveat emptor". One of the changes Lilico advocates is for a clearer definition of the role of genuine independent financial advisers (rewarded by fees) and salesmen, paid by commission. A disturbingly large number of mortgages advanced in recent years have turned out to be poorly or inadequately researched and documented where not fraudulent – the tell-tale signs of a system driven by the thirst for commission income.

His analysis of what caused the crisis – and what should now be done – is a major break from the fragile consensus. What makes this clearly written and compelling analysis particularly resonant is his warning of an impaired recovery as new government agencies struggle to establish and assert oversight and control over the banking system.

Only now is the Treasury embarking on the recruitment of dozens of risk specialists who will take control over the 600bn of toxic assets acquired from the banks under the Asset Protection Scheme. These problematic portfolios will take years to unwind. This is not the end, or the beginning of the end, but a new and worrisome beginning.

• (*)What killed Capitalism, Andrew Lilico, Centre for Policy Studies, wwwcps.org.uk