View From City Road: Investors, prepare for the crash

The next international financial disaster will be far more frightening than the upheavals of the 1980s.

When Latin America collapsed, the bulk of the loans were from a few hundred banks, which had a communal interest in propping up the financial system. Encouraged by governments, they refused to acknowledge default and spent a decade managing themselves out of crisis. Surprisingly few banks actually failed, and the damage to industrial economies was minimised.

A similar story can be told of the leveraged buyout crisis in the US towards the end of the decade, when banks were also the main lenders in the credit binge. Most managed their way out of it safely, helped by low interest rates.

Since then, banks have retreated from domestic and international lending. On the other side of the balance sheet, they have lost their basic raw material - deposits from ordinary customers who in the US have been switching to higher- yielding mutual funds (unit trusts).

In the US, these have mushroomed from dollars 100bn to dollars 1,400bn in 10 years. The driving force behind credit creation is no longer bank lending but securities investment, which is outside the remit of central banks and hard to keep tabs on.

When there is a crisis, it will be a horrible one; millions of individual investors will behave in a far less controlled fashion than a few hundred bank lenders.

Banks cause damage mainly by refusing to lend new money, and they cannot, on the whole, ask for their existing loans to be repaid overnight. Mutual fund investors, on the other hand, can easily inflict serious damage on markets and investment if they become scared. They can sell and put their money back into the banks. Such a sell-off would produce enormous flows of funds that would destabilise bond and equity markets and seriously damage the real economy.

Dr Henry Kaufman, that famous pessimist, highlighted the risks of mutual funds this week in a speech to a conference in New York. He thinks instability will be made still worse by the new fashion for what he calls 'high-octane' portfolio managers with a short-term focus and no loyalty to any market. This embraces many traditional mutual fund investment managers as well as the George Soroses of the world - the unregulated and unsupervised hedge fund operators.

Dr Kaufman wants banking, securities and insurance regulators in the US to develop common standards and he suggests a new international body to police national regulators, to see they are up to scratch. Sensible, yes, but too late and too long-winded to prevent mutual funds making the next crash worse than the last. Investors, fasten your seat belts.