We must restore the kind of culture on which Scotland's banking built its name

I will be supporting an amendment about the need to consider the “regulation, culture, and practice of banking”. Culture underpins practice. Regulation seeks to affect both.

Economists still refer to Charles Mackay’s classic book Extraordinary Popular Delusions and the Madness of Crowds, nearly 200 years after it was first published. Delusions begin when an asset suddenly becomes fashionable, and people want to own it. That demand pushes the asset’s price up, tempting more people into buying the asset because its price is increasing. Delusion turns into mania when there is a near-universal belief that it’s possible to buy the asset now, and then sell it tomorrow at a profit. Eventually, the bubble bursts.

A modern-day chronicler of these sudden outbreaks of folly would need to explain how bankers can turn delusion into mania. Seeing the increasing demand for the asset, banks increase their lending, often designing their loans so that they will only be profitable so long as asset prices continue to rise.

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The money which banks make available pushes the asset’s price up, creating more demand for loans. But as soon as the price falls, borrowers struggle to repay their loans. Banks find they are exposed to substantial losses. Some will simply fail.

This is the classic route to a banking crisis. Banks amplify an asset price boom, then blow up the economy. It’s a tendency which infects the culture of banking. Regulation is needed as society’s best defence against reckless banking manias.

A little over 20 years ago, Royal Bank of Scotland and Bank of Scotland, at the time considered to be Britain’s most successful banks, fought each other to take over National Westminster. The Royal Bank won. The expanded group went on an acquisition spree over the next eight years, paying over the odds to acquire access to new markets. For a few months in 2008, by some measures, it was the world’s largest bank. This mania ended in spectacular costly failure.

Bank of Scotland, after failing to take over NatWest, feared it would become the victim of a hostile takeover. It quickly agreed merger terms with Halifax. Run from Yorkshire, the new group tried to expand its market share, succeeding in acquiring new business, but on terms which quickly led to crippling losses. Mania destroyed Britain’s best run bank.

People have written books about what went wrong with the Scottish banks. As well as losses on lending on property after the boom years of the early 2000s, the banks’ profits came from trading in complex derivatives, whose valuation was always uncertain. As the crisis unfolded and it became increasingly obvious that many bank assets had become worthless, both banks had to rely more and more on short-term funding, which could easily be withdrawn.

Essentially, they collapsed when other banks stopped believing they were generating enough income to survive for another day on their own.

BORROWING a question which Sir John Kay posed some years ago, I have been wondering how best to ensure that the self-proclaimed masters of the universe might instead truly be servants of the people.

The obvious answer might seem to be for Scotland to look at what the UK has done since the financial crisis, and to mirror that – with strengthened prudential regulation to ensure the solvency and liquidity of individual firms, a financial policy committee charged with maintaining the stability of the entire system, and a new conduct regulator, which would drive banks, and other financial intermediaries, to act in the interests of consumers.

That was essentially the recommendation of the SNP’s Sustainable Growth Commission, which wanted to ensure financial services could continue to be marketed across the whole UK.

If banks are truly to be servants of the people, their culture should be based on caution, prudent management and a focus on profitability. In the run-up to the crisis, new financial innovations and globalisation allowed giant banks to expand their activities worldwide, with huge flows of money going into the financing of the US housing market. It seemed very exciting and for a while very profitable. It was a failure of culture, practice and regulation.

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The obsession with size led to the “too big to fail” problem, with governments in many countries covering the huge losses of giant banks. The directors of these banks behaved reprehensibly, almost knowing that society would somehow absorb the fallout. For years, almost on a “double or quits” basis, they had been able to place, “heads we win, tails you lose” bets.

Scotland’s international reputation for prudence in banking and finance, earned over 250 years, was blown in a decade.

Bankers deluded themselves that they could cast aside their traditional methods, fuelling their mania through lavish, self-congratulatory bonuses.

The internal cultures of banks became toxic. The cultural failure extended beyond banks. Regulators, especially in the UK and US, stepped back, encouraged by governments to trust the banks, and impose “light-touch” regulation. The whole system was rotten.

Scotland, once again independent, with its own banking system and regulator, must re-establish its historic culture of prudence, based on proper regulation and oversight. This is vital work. Now is the time to start it.