London looks like a bubble searching for a pin

I remember in early 2007, there was a rash of articles in the papers arguing that "London should secede" from the rest of the UK.

The capital was a global city, a euro-Singapore, with its own economic micro-climate. The rest of Britain was a parasitic appendage, feeding off the tax revenues of the City and its offshoots.

Then the crash came. And that sort of talk receded for a while.

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Yet with the Olympics right ahead of us, and the property market still buoyant, the idea that 'London is different' has made a big comeback.

This is dangerous thinking. The Libor scandal has rightly breathed new life into the drive to make the financial sector more accountable. Change is absolutely necessary we have no doubt about that.

The problem is, with politics being what it is, we won't get healthy change. We'll just get a swathe of new rules that'll batter the industry without making long-term improvements to our financial stability.

Here's why and what it'll mean for you...

What's wrong with our financial system?

Regulation doesn't always work the way you think it should. Drachten, a town in Holland, pioneered an approach to road safety that involved getting rid of pretty much all street furniture. So there are no road signs, no traffic lights no safety measures.

The result? There have been no fatal accidents and traffic flow has doubled. It may seem counter-intuitive. But as Dylan Grice of Socit Gnrale points out in his latest piece, removing the various signals forces people to concentrate. They have to keep their wits about them, rather than relying on external signals.

In short, the "illusion of safety" makes us take more risks. Remove this illusion, and we make better decisions.

As far as Grice is concerned, the same goes for financial markets. The illusion of a safety net primarily in the form of a central bank to bail everyone out is one reason why individuals and banks take risks that they shouldn't.

He has a very good point. The trouble is, to have a genuinely capitalist system, where actions are matched to consequences, you'd have to unwind everything from central banks downwards. And that's just not going to happen.

Why not? Because, as Grice also points out, people hate these "free" traffic zones. It doesn't matter that the statistics show they work, people just don't feel comfortable. Pointing out that it's this lack of comfort that makes the zones work, doesn't help either.

So while you might be able to push through some experimental traffic zones, the chances of removing all the safety barriers from our financial system are slim to non-existent.

Two simple changes to make to regulation

However, that's not to say we couldn't make the current system work better. I'd start with two simple changes that could be pushed through a lot more rapidly than splitting the banks.

First, reduce the level of protection offered by the Financial Services Compensation Scheme (FSCS). Rather than covering 100% of savings up to £85,000, I'd reduce it to 90%.

Don't get me wrong. I think depositor insurance is vital. If regulators and 'sophisticated' investors find it hard to understand banks' balance sheets, you shouldn't expect ordinary people to need a degree in forensic accountancy before they can open a current account.

But keeping the threat of a potential loss alive in the minds of savers would make them that bit more cautious. It would remind them that when you put your savings in a bank, you are actually extending it a loan.

In turn, that would force savings institutions to focus on persuading potential customers of their solvency, rather than just offering the most headline-grabbing interest rate.

So that's one easy step that would make everyone in the market that little bit more safety-focused.

However, there's another elephant in the room that no one in power seems to want to acknowledge. It's our old friend, the property market.

Credit bubbles can inflate anywhere. Emerging markets, railways, exciting new technologies: speculative capital piles in, and when it blows up, lots of people lose their shirts. Sometimes as with the Long-Term Capital Management hedge fund the biggest victims even end up being bailed out.

But if you really want to trash an economy, get yourself a property bubble. It's the one way that the average individual can gear themselves up to the gills, taking a punt on everything from the future direction of interest rates to government policy, all with no real understanding that this is what they're actually doing.

And when the bubble bursts, you won't be left with lots of useful, but cheap, infrastructure like a worldwide net of fibre-optic cables say, or a fully rolled-out rail network. Instead you'll have a load of cruddy, badly-built flats in places no one wants to live, fit only for demolition.

What's the answer? As with every other financial product, there's plenty of nit-picking regulation around the mortgage market. But all those things get ignored or bypassed during bubbles. What you really need is for someone at the top who doesn't make their money by selling mortgages or houses to knock some steam out of the market when it gets too hot.

So the simple answer is to add a line to the Bank of England's mandate that says: "Don't allow property bubbles to form". Then develop explicit targets from there.

You'll get all manner of academics whining that it's impossible to spot bubbles. But anyone who still says that after the past two decades should be removed from any position of financial authority. Jeremy Grantham of US fund manager GMO has pretty conclusively demonstrated that it's possible.

Yes, but what does all this mean for investors?

So that's what I'd do. Any other suggestions you have are most welcome just stick a note in the comments below.

Of course, we're not in charge. And the problem is, the path of least political resistance is to pile on badly thought-out new rules on the one hand, while continuing to try to prop up the property market on the other.

You might argue that this means you should buy the banks while they're beaten down. They'll always come back. But I can't agree. What's more likely to happen is that we'll end up with a shrunken financial sector that's just as prone to blowing up, but which generates less money.

It's possible that London might even lose its crown as the world's top financial centre. Certainly the number of articles in the press crowing about London's unique status, smacks of the sort of hubris you get before a crash.

So I'd avoid the banking sector there's a lot more upheaval to come in that area. It'll have an impact on the rest of Britain's economy too. For more on that, and for ideas on where you should be putting your money instead, read this week's MoneyWeek magazine cover story on the downfall of the banks. (If you're not already a subscriber, subscribe to MoneyWeek magazine.)

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