Britain's banks are still a danger to the real economy When the authorities intervene in banking, their aim is to protect the economy from the banks rather than the banks from the economy. This turn of phrase, borrowed from Sir Mervyn King, the outgoing Bank of England governor, should be the yardstick for progress. On the morning after the annual Mansion House speeches by the BoE governor and the chancellor, the question is whether George Osborne is correct to say that the UK has reached a turning point from "rescue to recovery"? Is the economy now protected from banks? Judging by the amount of activity, you might think that the authorities have moved to a new phase. First came the personnel changes with the defenestration of Stephen Hester, the Royal Bank of Scotland chief executive, and the announcement of the impending departure of Paul Tucker, the BoE deputy governor. Next was a choreographed publication of a weighty tome on financial sector ethics from the Parliamentary Commission on Banking Standards and launch of an Office of Fair Trading investigation into competition in banking for small and medium-sized companies. Last night Mr Osborne gave the green light to an initial institutional sale of part of the government's holding in Lloyds Banking Group and pledged to review the idea of extracting some of the worst assets from RBS into a bad bank. And today the Prudential Regulation Authority will set out how Britain's eight largest banks and building societies plan to address any deficiencies in capital. Quite a week. But after all that, is the economy now protected from the banks? The simple answer is No. The move from rescue to recovery is a question of degree and there is quite some way still to go. Sir Mervyn talked about "the work of a generation." Much progress has nevertheless been made since 2007. The crisis at Co-operative Bank demonstrates that parts of the new regulatory mechanisms are working in the way ultimately intended. The Financial Policy Committee of the BoE identified capital shortfalls across the banking sector and passed its findings to the PRA. That new arm of the BoE stood its ground and insisted the Co-op plug a £1.5bn hole in its capital buffers. With the authorities demanding action and no taxpayer money on the table, the wider Co-op group has been forced to inject money from other parts of the business and extract a significant, but still to be determined, contribution from bondholders. There was no knock-on distress to other banks" funding costs or lending. This was banking recovery in action, a regulatory intervention much preferable to the resolution of a dying bank or a taxpayer bailout. But what is true for the Co-op or for other small financial entities still would not apply to the big boys. If RBS, Lloyds, Barclays, HSBC, Nationwide or Santander UK got into difficulties, the authorities could not stand back. Nor will we know, ultimately, how healthy Britain's banks are until monetary policy returns to something approaching normality. The eventual return to interest rates near 4 or 5 per cent contains many hidden dangers for banks if their customers cannot cope with higher borrowing costs. Before a new world of normality can be achieved, action is still needed on many fronts to make banks and bankers a more normal part of the British economy. Four "Cs" are especially relevant in removing the special tag from banking and bankers. As the parliamentary commission makes clear, the first is the conduct of the industry. Perverse incentives with enormous rewards for success and insufficient sanction for failure must be addressed, especially when the distinction between both depends so much on luck. Deferred bonuses, clawbacks and the mere hint of criminal penalties will help, but can be successful only if banks and bankers embrace a new culture. Success is far from guaranteed. Competition in commercial banking is the second missing feature of the landscape. The OFT's announcement of a review of small business lending is an encouraging sign the authorities will think more radically than forcing RBS and Lloyds to sell a few branches. Third comes the more difficult area of capital. While banks are far better capitalised than in 2007 and in the long run the BoE is right to argue that higher capital levels do not impede lending, the transition is difficult and gives banks the incentive to reduce lending in the process of becoming safer. Finally, there is the new ringmaster, Mark Carney, whose job as BoE governor will be to balance the necessary stability of the banking sector with the equal requirement of growth and economic stability. With Sir Mervyn's words about generations ringing in his ears, he knows the process of banking reform is only at the end of the beginning. The UK economy remains far from immune from its banks. When Mr Carney leaves the BoE in five years, if he can plausibly claim Britain is at the beginning of the end of banking reform, he will have justified his appointment.