In the still percolating LIBOR case, some U.S. and U.K. regulators say they didn’t mount the barricades when Barclays told them that the rate might be fixed because that didn’t amount to a prudential problem. Sure, it might not have threatened the banks doing the fixing, but one would think that any bank that cooked some books might be boiling a few others. And, even if the fixing banks kept their hands clean, misrepresentation of key market factors is malfeasance. It surely is when a store adds a zero to a credit-card receipt – that costs the customer even if it arguably increases the merchant’s safety and soundness. So, why do regulators look the other way – at least for a few years – if processes critical to hundreds of trillions aren’t honest?

This is, of course, the question before the regulatory house. In testimony this week, FRB Chairman Bernanke told Congress that the Board did the best it could because it reported possible LIBOR fiddles to the U.K. regulators. These regulators duly passed the reports along to a trade association and, then, went back to the understandably preoccupying business of resolving the 2008 financial crisis. One understands why, in the midst of all that mayhem, LIBOR might not have been seen to matter all that much. But, since then, it has made a difference and, thus, might well have warranted supervisory attention beyond the FRB referral of its worries to the CFTC. The Board made the referral to alert the CFTC to possible market-fraud concerns, but did nothing about the prudential ramifications of the case, apparently standing aside because it didn’t think there were any. In the four years since that referral, rates were not only likely set too low to make them look better than they are, but also too high from time to time to give traders the illicit edge they enjoyed with LIBOR in the crisis run-up. Parties other than banks were, thus, very much at risk while regulators stood aside.

This case reminds me of one some years ago, when heroic supervisors at the OCC first spotted the looming mortgage crisis. As early as 2002, a senior policy analyst in the Office went public with her concerns because private worries about increasingly dodgy mortgage underwriting weren’t getting any respect. These worries eventually led to a proposed guidance on non-traditional mortgages – not a rule, mind you, because the agencies discounted the value of anything so binding even as they thought a bit of chit-chat on the books might be nice. So, out went a proposed guidance with many non-binding, but tough underwriting criteria. And, just about the time the guidance went out, the calls for deletions from it came in.

One key one was to delete from the guidance a provision that held originating banks liable for ensuring that loans they securitized met the same underwriting criteria applicable to those they held in portfolio. What’s a “non-traditional” mortgage? It was then as now one that departed from the known universe of prudent underwriting – that is, loans without documentation, those allowing negative amortization and the like. Sometimes, these mortgages can be sound because sometimes borrowers do in fact have long-term ability to pay even these speculative obligations. But sometimes is not a lot of the time. So, one might have thought regulators would have required banks to hold themselves accountable for all the loans they booked, not just those they kept.

But, one would have been wrong. The non-traditional mortgage guidance languished on the books for several years. It finally went to print in late 2006 when the Senate Banking Committee couldn’t believe its eyes, called the regulators up and, then, the other agencies corralled OTS and got it to concede to a final standard. OTS didn’t, though, go down without a fight. In the final guidance – still not a rule, mind you – the initial proposal that securitized loans had to be as sound as those in a bank’s portfolio was nowhere to be seen.

The thinking seems to be that banks can sell rotgut as long as they don’t drink it. But, as any number of neighbors to cheesy liquor stores know all too well, pushers are often users and users don’t end up on Park Place. So it was with bankers and all too much of this is due to regulators who looked the other way as long as no one they knew got hurt.

What is prudential regulation about? It has to be about long-term prudent operation that takes into account not just day-to-day capital adequacy and the like, but also legal, reputational, compliance and strategic risk. Each of these is in the regulators’ rulebook and seemingly among the criteria on which banks are to be judged. But, bank regulators before the crisis looked the other way if banks only injured bystanders. Now, they are building ever more voluminous rulebooks of ever more complex supervisory standards that will make it even easier to miss the fundamental point: banks can’t be banks without trust and trust can’t be had without truly prudent practice, which takes market, consumer and client well-being fully into account, not just the next quarter’s profit.