Casino banks are not the problem - small ones are

Only a few months ago, the Co-op was meant to be the saviour of the British banking industry. Soberly managed, ethically responsible, rooted in local communities, it stood for everything that we'd like the banks to be in stark contrast to the wide boys in the City, with their frantic trading and massive bonuses, who caused the financial crash.

The Treasury was anxious to off-load a chunk of Lloyds-HBOS branches to the Co-op and create a genuine new force in the finance industry. And now? It turns out that the Co-operative Bank was as useless as the rest of them. Its credit rating has been slashed, and it may yet need a bail-out. There's a lesson in this: it's not the casino banks that are risky, it's the safe, dull ones.

Only a few months ago, politicians and pundits were queuing up to heap praise on the Co-op. Vince Cable, a man who can be as reliably counted on to be wrong on just about every economic issue as Gordon Brown once was, singled out co-ops and mutuals as the way forward for the financial sector. Ed Miliband praised it as a model for the rest of the industry. Even the chancellor, George Osborne, sung its praises.

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The Treasury backed it as a genuine new force in the British banking industry. The Lloyds branches that have to be sold as part of its merger with HBOS were meant to be transferred to the Co-op's ownership. Few other institutions were so favoured by the political establishment.

True, there is much to like about the Co-op model. Small scale, local, serving its communities, and rewarding customers as much as its staff, it looked to be the perfect antidote to the gamblers and spivs in the City. It didn't pay huge bonuses. It didn't take wild, speculative risks using financial instruments that no one could understand. It looked to most outsiders like a far more appealing model and also one that was much less likely to require bailing out at the expense of the taxpayer.

The trouble is, it hasn't worked out like that. In fact, the Co-operative Bank looks to be in a heap of trouble. It had to pull out of the Lloyds deal after it turned out that it did not have the capital to support the takeover. Last week, Moody's slashed its rating on the bank, the boss had to step down from his post, and the bank even had to take to Twitter to try and reassure customers there was no threat to their money.

As the figures emerge, it turns out that the Co-op is massively exposed to property loans, partly as a result of its takeover of the Britannia building society. Now it has to see if it can raise more capital. If it can't, the government may yet have to step in with a bail-out.

Within that sorry story, there is an uncomfortable truth about the British banking industry that politicians and regulators are not facing up to. What looks like old-fashioned, safe banking is the most dangerous activity of all.

Take a look at where the problems have come from. The biggest disaster in Britain was the Royal Bank of Scotland. It lost a fortune not on exotic derivatives or proprietary trading, but on British companies and on a crazy expansion into overseas markets at precisely the moment those markets were collapsing.

RBS had an investment bank, but a relatively small one. Likewise, HBOS lost its shirt in the property market and had to be rescued by Lloyds which then had to be bailed out by the government. Northern Rock had to be rescued because it had lent too enthusiastically in an over-heated property market, especially in buy-to-let. So did many of the other smaller mortgage lenders.

By contrast, the banks with the greatest exposure to the capital markets escaped largely unscathed. HSBC didn't need bailing out. Neither did Barclays, which, through Barclays Capital, is Britain's most successful and aggressive investment bank. These outfits may have manipulated the Libor interest rate, but that hasn't in the end cost the taxpayer anything indeed, through massive fines, the public has done rather well out of it.

Now the Co-op debacle has highlighted two big flaws with the way banking regulation has been handled since the crash of 2008.

First, 'too big to fail' banks have rightly been criticised. But there is no point in replacing them with 'too small to have a clue what they are doing' banks. Smaller banks rooted in their communities may have their virtues, but their management can be just as inept as their bigger competitors and perhaps more so.

Second, we should remember that the casino banking everyone attacks is in fact relatively safe. It is in old-fashioned banking that huge losses are made. The problems in Britain have been in the property market, where valuations became hugely over-stretched. The banks that lent to developers have come unstuck.

There may be big problems ahead in retail and consumer lending a lot more loans could go sour as the high street declines, and the mountain of debt that households have taken on becomes unaffordable. But the traders and wheeler-dealers of the City are not exposed to those markets and don't suffer those kind of losses.

No one will be trumpeting the virtues of co-operative banking for a long time to come. The industry is ripe for reform. But small, not very smart, mutual banks are not the solution.