Banks have a battle ahead to restore their financial standing

Early in the new millennium, as they surveyed the wreckage of the global technology boom and the burst stock market bubble that it had produced, the world's leading financiers marvelled at the resilience of the 21st-century financial system.

Despite heavy losses in telecommunications and the collapse of large companies such as Enron and Parmalat in other sectors, no big financial institution had run into serious difficulty. This, bankers and regulators argued, was because banks had embraced techniques such as securitisation and the use of derivatives to pass on risks that they would previously have held in their entirety.

This approach, dubbed the "originate and distribute" model, was widely hailed as having transformed the banking industry into a less risky - and more profitable - business.

Today, those claims have been shown to be hollow boasts. The crisis in the US mortgage industry, far from being smoothly absorbed by the global financial system, has proved contagious, prompting a paralysis among professional investors and a crisis of confidence in the banking system.

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"The crisis has shown that regulators have been asleep at the wheel, not just in terms of what they have allowed to be included in capital but also what they have allowed to be excluded from the balance sheet," says Simon Samuels, European banking analyst at Citigroup.

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Issuance of mortgage-backed securities has dropped sharply, while demand for more complex instruments such as collateralised debt obligations - packages of loans that have been sliced to create new securities - has dried up completely. Many bankers think it will be months, if not years, before they can start issuing these securities again.

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In short, this means that banks will be forced to fund more of their future loans from their own balance sheet resources. The shift has prompted some leading bankers to declare the prevailing business model obsolete.

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The next 12 months will be crucial in determining whether the banking industry comes back to earth with a painful bump or whether it can engineer a smoother landing. Either way, it will be a long time before any banker dares to claim that his industry is less risky than it was before.

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