Financial Services Bill

My Lords, if the previous speaker will allow me, I will not follow his interesting proposal. I would rather start from what the Minister made clear was the principal object of this Bill, which is to ensure so far as is humanly possible that a banking meltdown such as we recently experienced, at immense and continuing cost to the public finances, the taxpayer and the economy as a whole, does not occur again. The present Prime Minister cannot escape his substantial share of responsibility for the disaster, not least by his precipitate abolition as Chancellor of the greatly improved system of bank supervision that I introduced in the Banking Act 1987 and its replacement by the fundamentally flawed tripartite system. Indeed, the dysfunctional nature of his regime is all too eloquently exposed by the changes being proposed in the Bill. Some of my best friends are bankers, although I cannot compete with the Minister in that regard, but the popular view that the root cause of the crisis was the greed and folly of all too many bankers is justified. The success of the market economy derives from the fact that greed and folly are in general kept in check by the disciplines of the marketplace. In banking, the disciplines of the marketplace in the last resort are all too often absent. That is the heart of the problem. It has long been recognised—at least since the 19th century, with Bagehot and all that—that the particularly grave consequences of banking failure mean that the authorities have to stand ready to help failed banks. The quid pro quo is that banks are obliged to submit to a form of regulation that is neither necessary nor desirable in the case of other industries. What kind of regulatory framework do we now need to put in place? That is really what we are discussing today more than anything else, although I acknowledge that there are some other issues. Clearly, we need to ensure that the banking system is adequately capitalised at all times. But it is neither practicable nor sensible to try to put in place for the banks as they are now a sophisticated regulatory system that is both flexible enough to deal with all the many complex forms of modern banking and robust enough to provide the safeguards that we need. If we try, the system either will be inadequate or will stultify the financial sector with overregulation—probably both. We need a fundamental structural reform of the banking industry—a reform that will maximise the extent to which we can rely on the disciplines of the marketplace and minimise and simplify the burden that regulation has to bear. A year ago, I wrote an article in the Financial Times advocating a return to something along the lines of the American Glass-Steagall Act of 1933. The purpose of that would be to enforce a separation between narrow, commercial, deposit-taking utility banking on the one hand and high-risk investment banking on the other. It is quite simply unacceptable that taxpayer-guaranteed retail deposits should be used to finance high-risk investment banking activities and that the taxpayer should be required to bail out banks whose solvency is threatened when those activities come unstuck. Any such separation is, needless to say, anathema to those who currently run broad or universal banks. Maybe they have intimidated the Minister. Incidentally, being a free-standing investment bank did not seem to prevent Goldman Sachs, for example, from achieving no small success in its field. Be that as it may, the universal bank lobby raises four objections, all of which need to be considered. The first is that corporate clients require their commercial banks to offer them the full range of financial services and that to restrict their activities in any way would drastically reduce the financing options available to business and industry. This is palpably absurd. While many corporates may well desire and need a wide range of financing options, they have no need to get them all from the same institution; probably many of them would prefer not to have to do so. The second objection is that the crisis was caused not—it is said—by the banks engaging in high-risk, high-reward proprietary or principal trading, but by old-fashioned imprudent lending, largely against house purchase, as with the subprime market in the United States. The truth of the matter is that both activities made major contributions to the meltdown but, whereas the second can be addressed by straightforward capital-adequacy-based regulation and sensible supervision, the first cannot. The third alleged objection to a new Glass-Steagall is that, even if such a separation were made, the collapse of a "pure" investment bank can still be a systemic threat—look at Lehman, they say. However, the case for compulsory separation is that it very substantially reduces the threat of systemic risk in a way that nothing else can. Moreover, had the core commercial banking system been thoroughly sound, the collapse of Lehman, although a shock, would not have posed any systemic threat. In any event, I am not arguing that investment banking should be completely free of all prudential regulation, although such regulation would need to be light touch, both for practical reasons and to allow the sector’s creativity to flourish adequately—something that is most unlikely to happen in the current climate without a new Glass-Steagall. Only one serious objection has been raised to the reform that I am suggesting, which is that in the complex modern financial world it is impossible to draw a line between those activities that a narrow bank is permitted to undertake and those that it is not. In particular, it is said that prohibiting narrow banks from engaging in principal trading, or proprietary trading, would be unenforceable because such trading is indistinguishable from a bank’s normal treasury operations, when it is merely acting as an agent, notably in hedging its risks. But however difficult it may be to draw a line, it is perfectly possible. Moreover, it is generally agreed, even by the Government, that a new and improved system of prudential supervision and regulation will in any case need to insist on different capital adequacy and other requirements to reflect the different degrees of risk in different activities, so lines will have to be drawn anyway. That is a practical point of the first importance. A key question is whether the separation that I am advocating needs to be complete institutional separation or whether it can be achieved by the less brutal means of a ring-fence or a firewall within a single institution, with retail depositors being given absolute priority in the event of a failure. While the latter may appear at first sight a judicious compromise, it is in fact seriously inadequate. There are a number of reasons why that is so. First, the characteristic of such ring-fences is that they are not watertight under extreme pressure. The ring-fence option rests much more weight than is prudent on the assumption of sophisticated and effective supervision and regulation. In practice, it is likely, if not certain, either that the regulators will be outsmarted by the hugely better paid and more motivated practitioners or that they will be excessively heavy-handed to try to prevent this, and maybe both. As the sage Paul Volcker, whom I remember well as the distinguished chairman of the American Federal Reserve during my time as Chancellor, and who is now an adviser to President Obama, recently observed: ""I am not so naïve as to think that, even with the best efforts of boards and management, so-called Chinese walls can remain impermeable against the pressure to seek maximum profit and personal remuneration"." If the investment banking activities come unstuck, this will inevitably weaken and possibly bankrupt the group as a whole. Moreover, we have only to look at the United States to see the practical reality. Citibank, for example, has always been a wholly separate, and thus theoretically ring-fenced, corporate entity within Citigroup, but that did not save it. It is of course true that, even with complete separation, narrow commercial banks might still have normal banking exposures to investment banks and other financial companies, although in practice these customarily access the capital markets directly. Normal banking prudence is much more likely to limit the scale and nature of such exposures than is the case with a conflict of interest that arises when the institution and its shareholders have a substantial equity interest in investment banking. Only a structural reform of the kind that I have been advocating can make financial regulation both effective and realistic, allowing investment banks the freedom to pursue their own often high-risk creativity and innovation without endangering the entire financial system and the economy as a whole. Protection of the economy—and, indeed, of the taxpayer, who has had to bear an unacceptably heavy burden in bailing out the financial sector—could be secured by ensuring, by regulatory requirements and supervision, that the commercial or utility banking sector is always thoroughly healthy. The discipline of the high-risk investment banking sector, which would be forbidden to take retail deposits, would thus be left largely to market forces, with only relatively light, simple and thus realistic regulation, so avoiding the highly damaging increase in moral hazard that the current "too big to fail" doctrine has brought with it. The essential point is that broad or universal banking, for a number of reasons, greatly increases systemic vulnerability, so there is a strong public interest in preventing it. This is the conclusion that is now being reached by President Obama in the United States, on the advice of Paul Volcker, whom I quoted a moment ago. Whether the American Congress will allow him to implement it remains to be seen, but it is most encouraging that, in a letter in yesterday’s Wall Street Journal, it has been strongly supported by no fewer than five former US Treasury Secretaries from both parties. Meanwhile, that is also the conclusion that has been reached by Mervyn King, the Governor of the Bank of England, as his eloquent testimony on a number of occasions, including to both the Economic Affairs Committee of this House and the Treasury Committee in another place, has made clear. Indeed, in his most recent appearance before the latter committee, the Governor went further and addressed the argument that, however desirable a structural separation of the kind that I have been discussing may be, it is not something that the UK could do on its own without grave damage to the competitive position of the City of London. I know that my honourable friend George Osborne, while largely accepting the case for structural separation, has been concerned about this. With a financial sector that is five times as big in the UK as it is in the United States, relative to the size of the economy as a whole, the Governor pointed out that, in fact, the boot is on the other foot. He told the Treasury Committee: ""The only way we can really sustain a large financial centre in London … is if we can make sure that it doesn’t impose a prospective burden on taxpayers"." Only in this way can we fully restore global confidence in the British economy, with all that that implies. The point is this: there are some who argue that having a banking and financial services sector as large as ours, in relation to the economy as a whole, makes us uniquely vulnerable—a sort of Iceland writ large—and that it should be a deliberate object of government policy to reduce it. I reject that. The City of London has historically been a great source of strength to this country and should continue to be so in the highly competitive globalised world of the future. However, it will be source of strength, rather than a source of weakness, only if it is made much more robust by the essential structural change that I have outlined. I began by remarking that the overriding object of this Bill is to ensure so far as is humanly possible that a banking meltdown such as we have recently experienced does not occur again. The structural reform that I have been advocating is not a sufficient condition for this, but it is, without doubt, a necessary condition. The Government’s failure to recognise this is the greatest single error in the regulatory regime that they are now seeking to put in place.