BANKING: Banking expert David Lascelles believes that while financial innovation has been sullied in the current credit crisis, it will always find ways around regulation, writes SIMON CARSWELL

LIFE AS a financial whizz kid, devising new credit instruments to sell on to investors might be over now that the global banking crisis has damned the investment banking model forever. However, one experienced banking commentator believes financial innovation will find life again, possibly amid the chaos.

David Lascelles is a director of the Centre for the Study of Financial Innovation, a city of London think-tank, and a former banking editor and New York correspondent with the Financial Timeswhere he worked for 20 years.

One of the most engaging speakers at the Irish Banking Federation (IBF) national conference in Dublin last month, Lascelles told the gathering of bankers that although regulators might believe that financial innovation is the root cause of the global financial crisis and may try to police innovation out of existence, innovation could in fact respond to the crisis by creating products to ease the turmoil.

He says that European regulators in Brussels want to curb securitisation, risk transfer techniques and leverage by forcing banks to keep a portion of the risk on their books. Innovation will be taken out of the bankers as a result of the global financial crisis, he says, and the new rules of banking are still being set as we are between the credit crunch and recession.

"The trouble with trying to curb innovation is that you merely end up encouraging more of it. The instinctive response from investment bankers is always to see rules as a challenge and try to find a way around them," he said.

He believes that new innovative products could be created as soon as regulators try to "put a cap on innovation". These could include liquidity default swaps or insurance - similar to the credit default swaps that protect investors against defaulting bank debt - and liquidity auctions which could help thaw the frozen credit markets that have starved banks around the world of vital reserves of funding.

He believes that bankers could also devise new ways of strengthening the capital of a bank and creating new markets to tap ways of accessing capital, or develop products that enhance the quality of credit to give a bank a higher rating.

Lascelles says there will be a drive to simplify banking and for regulators to scrutinise banks' strategies, approve new products, assess the entry of banks into new markets and examine merger proposals.

He says that complexity undoubtedly played a part in the crisis with lots of people ashamed to admit that they didn't understand the financial instruments that had been created.

"The stock market may decide the safest banks are the simplest banks and put a premium on banks with simple models," he says.

Lascelles says that the Irish Government, to its credit, was one of the first that "woke up to what was going on" in the international credit markets. "Their behaviour was quite impressive - a co-ordinated bailout, central bank intervention and a big political show of support."

The terms and conditions of the €440 billion Irish bank guarantee scheme has laid down a mandate to the Irish banks availing of the State insurance policy to simplify their banking models and return to the core basics of banking.

In return for the insurance cover, the Minister for Finance Brian Lenihan will take an active role in how the banks are run - who they lend to, how much they lend, which institutions they merge with, which markets they expand into and how much their senior executives are paid. "The post-crisis values will favour plain banking and banks will have to take that into account in their business plans. With less opportunity to innovate, there will be fewer sources of profit. Life will become less interesting," says Lascelles.

Another speaker at the IBF conference, Angela Knight, chief executive of the British Bankers' Association (BBA), says that it can be predicted with a fair degree of certainty that the crisis will spell the end of the independent investment banking franchise "for the time being as we know it".

"It was once assumed that the competitive advantage of that model lay in its ability to leverage off their business, typically gearing it more than the commercial banks through activities such as prime brokerage.

"This will no longer be possible as funding elsewhere in the financial system is unlikely to be available in such quantities," she says.

Lascelles says the "excitements and rewards" of recent decades have drawn many of the world's most talented, ambitious and energetic people into banking, and now wonders what kind of people will be attracted to the new and more constrained and heavily regulated world of banking.

"One of the greatest challenges in banks will be to resist the temptation to go for higher yields by trying something new," he says.

Lascelles believes a single, common approach to regulation such as the creation of a global regulator would not work as "a diversity of control systems" helps to prevent crises emerging. "Let's hope they do not make the same mistakes at the same times and break down together," he says.

"If this crisis has shown anything," says Knight, "it has shown that globalisation of markets means that a problem in one country can infect around the world. It means that there is no such thing as a local or regional solution for an international industry but someone has to lead."

Lascelles says that better regulation "lies in networks in today's highly connected world" and that these sophisticated networks are quite easy. He believes the impact of state intervention in the banks will take years, perhaps decades, to unwind, to recover government aid and to set public finances and rules on state aid and monopolies back in order.

"So long as all these remain unresolved the behaviour of the banks will remain very political," he says. He questions whether these are lasting changes or temporary adjustments to a stressful situation. He answers it by saying he believes that many enforced changes, including shotgun marriages between banks and even the joining of investment and commercial banks, may prove unsustainable or unworkable.

Lascelles says that innovation is "hard to curb" and that it will "almost certainly break out again before too long". The new banking structure with its regulations and constraints could prove "insufficiently profitable to sustain itself" and might require "freeing up".

"We might actually end up craving more innovation once more," he says.

Lascelles says that innovation will always find a way and that you cannot really regulate against it. He says that in many ways what has caused the financial crisis was that capital rules were not flexible enough.

"For the foreseeable future, banking will be a very different place - inhibited, constrained, a public whipping boy in the minds of a generation. It could even become boring."

He says that innovation has been sullied in the current crisis and that political types found it very easy to identify and blame innovation as the main cause of the problem for the credit crunch. "Undoubtedly, innovation is a good thing," says Lascelles.

"It was abused and it went too far. But you will find it very difficult to stop it."