Financial Services Bill

My Lords, before participating in this debate, I should draw attention to my interests as a director of Standard Life and as a board member of the Office of Fair Trading, which is referred to in this legislation. As other noble Lords have said, financial services are extremely important and, although the sector has had its problems, we should not denigrate the important role that it has played and, one hopes, will play in creating wealth for the UK in international markets. As the noble Lord, Lord Myners, correctly said, the objective of this Bill should be to help financial services to work better. Against that test, I am in the camp that views the Bill as something of a mixed bag: there are certainly some good things but there are many things that require further consideration. However, before we go further, we should note that the Bill is silent on perhaps the most important issue, which is what role national regulators will be left to play, whether located in the FSA or the Bank of England, under the evolving EU plans for pan-European regulatory supervision. The draft directive on hedge funds is a case in point. As we debate the powers in the Bill, it would be helpful to understand better what powers the Government believe the UK will have in future to set our own policies for the financial services industry or to represent our distinctive UK view in international forums. To return to the Bill as it stands, I fully support the aim to strengthen what is called "macro-economic prudential regulation" in the UK. Whatever institutional arrangements are put in place, it must be right to ensure that consideration is given to the stability of the financial system as a whole, as well as to the soundness of individual institutions. It is, with hindsight, an amazing case of myopia that ballooning levels of government and private debt prior to 2008 rang so few alarm bells, and that the multiplier effect of credit expansion outside the conventional banking system, supported on a very small base of capital, was not seen as a dangerous source of instability. It is hoped that this generation has relearnt those lessons, but going forward it is important that some institution is tasked with the responsibility of monitoring these macro-economic developments and that it has the tools to curb credit expansion and reinforce capital levels as required. That institution must be sufficiently independent of the Government of the day and independent of considerations to do with fiscal convenience and electoral cycles. Alongside that macro-prudential supervision, we then continue to need effective supervision of individual organisations to ensure that the risks they run do not put the wider financial system at risk. I use the word "supervision" rather than "regulation" deliberately because I think that, if the FSA has a fault, it is that historically it has seen its job too much as applying and enforcing regulations in a detailed tick-box approach, instead of applying mature supervision based on understanding and making judgments about the situation of individual firms. That is one thing that was lost in the removal of the old supervisory system. Having said that, there is one area where I think we need to question whether the Bill currently goes far enough in prescriptive regulation, and that is on the constraints around the activities and balance sheets of deposit-taking retail banks. In this area, I go part of the way with my noble friend Lord Lawson and the noble Lord, Lord Barnett. There is no getting around the fact that retail deposits are special because they form a core part of the nation’s money supply. Because, in the interests of the wider economy, people need to have confidence in money as a form of payment, it is inevitable that Governments stand behind the value of money deposits in regulated retail banks and that they stand behind those banks. We have seen only too recently the level of panic and disruption that can occur if people start to lose confidence that their money on deposit is safe. However, that government guarantee essentially means that the large retail deposit base of many retail banks is a subsidised, low-cost source of funds for those institutions. If and when those deposits are used to fund high-risk activities or assets, even on the margin, the risk and reward are asymmetric—the bank and its employees get the upsides but the Government, as guarantor, get the downside exposure. This inevitably encourages higher levels of risk-taking than would occur, for example, in a partnership where the principals took all the upside but also all the downside risk. The current regulatory approach seeks to redress this asymmetry by imposing higher capital requirements on riskier activities, effectively raising their cost of funds. To this the current Bill adds the requirements of creating recovery and resolution plans, which aim to set out how an institution facing financial difficulty in one area of activity could limit the damage so as to prevent the whole organisation becoming insolvent. All these are sensible steps. However, I still believe there is a case for going further and requiring retail banks, where their deposits are guaranteed, to ring-fence those deposits and capital so that they are applied to prescribed assets and activities with appropriate matching risk characteristics. Unless there is that clear segregation —some kind of firewall, as it has been described—I find it difficult to see how one can avoid extreme risk events in the rest of an institution ultimately falling back on the funds and capital represented by guaranteed retail deposits. The fact that that backstop funding is available from the Government is inevitably reflected in the capacity of the institution to take on risks and counterparties that would not be available on equivalent terms without the government guarantee. As this Bill goes through, the House should look at whether there are practical ways of achieving this ring-fencing of retail deposits and their capital backing. As the noble Lord, Lord Lawson, pointed out, it is this objective which lies behind the recent Volcker proposals in the US and the much earlier Glass-Steagall legislation. Where I differ from my noble friend Lord Lawson is that I do not think it is necessary or desirable to go as far as Glass-Steagall, which prohibited investment banking and retail banking activities being undertaken in the same institution. I am inclined to believe it should be possible to hold both a retail bank and what, for shorthand, I will call an investment bank as separate subsidiaries under the same group holding, enabling the holding company to combine the offerings as they see fit in developing integrated services for major corporate customers if those customers see fit to buy them. That requires clear regulations that limit the ability to move funds from the retail bank to the investment bank so that recourse to the retail bank’s capital is blocked. This may sound difficult, but it is not dissimilar in principle to the rules around corporate pension funds or to policyholder-owned with-profit funds in life companies where the bankruptcy of the ultimate holding company does not allow shareholders to have access to those protected funds. I am not convinced by the argument that, operated in this way, it would be impossible to draw the dividing lines. Equally I am not sure that the Volcker proposals have got it quite right in focusing on proprietary trading. We should be clear that the risks that retail deposits should be shielded from are not just speculative position-taking, but also—and perhaps more importantly—balance-sheet investments in high-risk securities. As we now all understand, much of the crisis for many financial institutions was caused not by their own proprietary trading but rather by their willingness to invest in complex secondary and tertiary securities, where the underlying borrower risk had been masked and the risk exacerbated by complex and poorly understood derivative positions. In principle, therefore, the retail bank might be limited to investing its guaranteed deposits in primary loans—by which I mean loans to known customers where the bank had made its own risk assessment—together with government securities and transient exposures held to support customer transactions. All other activities could be funded in a separate legal entity where the suppliers of funds—whether depositors, shareholders or other counterparties—knew the risk that their capital was exposed to and understood that they would not be protected by a bail-out of the retail bank. I have dwelt on this issue at length because it is complicated and because I would suggest it needs to be a major part of our ongoing consideration of this Bill. It may be that the Government can convince us that the provisions in this Bill are adequate, but if there is a time to get this right, that time is now. While I am on the subject of omissions, let me briefly flag one other related area which I think is a missed opportunity. Under current accepted accounting conventions, banks are not allowed to make provisions against specific loans when they put them on the books. They can only make provisions when there is a recognised risk of default. It is assumed that all loans will turn out to be good loans, despite the historic evidence of average default rates. As a consequence, the impact of loan losses on bank capital levels serves to exaggerate the economic cycle. Capital is not held when things are going well but capital is rapidly destroyed in a downturn. I have never understood why the same principles that apply to prudent insurance risks—in other words, recognising and providing for expected outturns at the start of a contract—do not apply to lending risks. It may be that the Government feel they are not powerful enough to take on international accounting standards, but I would be interested to know whether the Government have considered this issue or whether it has just been ignored. There is much else in the Bill I could speak to, but in the interests of time let me quickly pick out a couple of other points. First, there is what I feel is a rather strange set of provisions relating to remuneration reports. I should make clear that I have no problem with the regulator—or supervisor, as I prefer to call them—taking an interest in the structure of remuneration and wanting adequate reporting to ensure that remuneration did not incentivise excessive risk-taking, but I confess I do not understand what is special about financial services that requires additional reporting about the absolute levels of remuneration compared to any other sector. Why is it useful and appropriate to require more information about the levels of non-director remuneration in financial institutions than in other sectors with highly paid talent—for example, broadcasting, sports, advertising agencies, or even lawyers? We may or may not think individuals in any or all of these occupations are overpaid, but we need more justification from the Government before we legislate for this level of intrusion into the activities of private companies as to why they want to single out one sector for special treatment. The noble and learned Lord, Lord Goldsmith, referred to the groundbreaking clauses around class-action suits. Like him, I have some concerns about the lack of clarity about how they will be applied. Again, I stress that these are personal views. Clearly, there is a difficult balance to be drawn between procedures which help customers get proper redress on the one hand and the risk of creating a costly industry in class-action suits where lawyers are the main beneficiaries on the other. The decision on whether and under what circumstances to allow the opt-out way of proceeding rather than claimants having to opt in is clearly crucial to this balance. While it may be sensible for the courts to have discretion in deciding this, I am not sure that we should legislate to give them a free hand without greater clarity about the criteria and filters which the Rules Committee may subsequently develop. I hope that when we address this part of the Bill the Government can set out on the record what kind of guidance they expect to be applied or, even better—as the noble and learned Lord, Lord Goldsmith, asked for—let us see the draft regulations as they might be developed. I have not had time to address the many other issues covered by this Bill but these will all no doubt be part of the debate to come. Let me end where I started by welcoming the objectives of this Bill while believing that there is a great deal of work still to do before we can be satisfied that this collection of measures is best fitted to the task.