Banks feel pinch of the shoe on the other foot

As Lord Turner, the former UK regulator, once eloquently explained, consumers can easily recognise and return a defective toaster. But identifying an unsuitable pension product or a mis-sold interest rate hedge can take years and, by then, the damage has been done.

Banks and other financial services companies have profited from this opacity for decades.

Policy makers are now trying to rein them in. Sadly for society, the same uncertainty of outcome that has afflicted financial products is casting doubt on the new financial regulation.

When Lehman Brothers collapsed five years ago , sparking the worst financial crisis since the Great Depression, politicians and regulators rushed into action, promising reforms they said would prevent such a catastrophe from happening again.

Banks would be made less risky. Derivatives transactions, seen as a key driver of the crisis, would be forced into central clearing houses and "living wills" would make it easier to shut down large banks and insurers in a crisis.

These changes, the G20 leaders said, would reduce the importance of the "too big to fail" banks and prevent contagion spreading from a failing institution to the broader system.

Thousands of pages of new rules later, most of those promises have been met. Banks have more capital and more liquid assets and new regulations for derivatives are being implemented. Plans to manage failing cross-border banks are taking longer, but the G20 has promised they are on the way.

These rule changes are fundamentally reshaping the financial system. Higher capital charges have prompted banks to sell less profitable businesses and reduce risky trading. Smaller, less regulated competitors are charging through the newly opened door.

Non-bank financial firms, such as hedge funds, now do more than half of the trading in interest rates and foreign exchange. Peer to peer lending and direct loans from investment firms to corporates are becoming more common. Banks no longer dominate the corporate bond market - their inventories have dropped an estimated 40 per cent since 2006, even as the market has grown.

On the plus side, banks are less central and less likely to spread instability. But it is much easier to supervise - and punish - a dozen big players than keep watch over thousands of smaller institutions scattered from Connecticut to Singapore. Critics are also warning that hordes of new participants could exacerbate market swings, making the financial system more rather than less volatile.

Global regulators are concentrating on this issue with a slew of proposals aimed at market practices - reuse of collateral, pay policies and margin requirements among them - rather than specific institutions. Market participants warn that these could gum up the markets and harm the broader economy.

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The financial services industry finds itself in the same awkward position as its customers. Players have been forced to revamp their businesses and are losing market share, but with no guarantee that the rules will work or even stay in place for the long term. The shoe is on the other foot and it is a mighty uncomfortable one at that.

brooke.masters@ft.com

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