Financial Services Bill

My Lords, it is now a year and a half since the collapse of Lehman Brothers and since that fateful weekend when the UK banking system teetered on the edge of collapse—a collapse only prevented by the decisive action taken by this Government with a bank rescue plan that was, in due course, copied around the world. The rescue was, as we now know, a remarkable success. Indeed, it has been almost too successful in that many bankers, with their notoriously short attention span, have already consigned the crisis, and their role in it, to history. Fortunately, the Government and the regulatory authorities have taken a very different view. Every major financial centre has undertaken a wide-ranging review of the structure of the regulatory system. In Britain, the new thinking was launched by the Turner review in March last year, followed later by the Treasury White Paper, in July, and by several valuable Bank of England studies. The de Larosière committee set out proposals for EU reform last February. The US Treasury published its own White Paper nine months ago, and in December the Basel Committee on Banking Supervision published its own comprehensive proposals. These studies display a remarkable degree of unanimity. All acknowledge serious shortcomings in regulatory analysis prior to the crisis. Those shortcomings derived from the philosophy of banking regulation embodied in Basel II, the conventional wisdom in the decade before 2007. That conventional wisdom decreed that greater transparency, more disclosure and more effective risk management by individual firms would manage risk effectively. The result was a regulatory system that was highly market sensitive and strongly pro-cyclical—in other words a regulatory system that encouraged herding, fed panics and, by ignoring the system-wide costs of risk-taking by individual firms, weakened the defences of the financial system as a whole in the face of extreme events. All in all, the Basel II philosophy resulted in a regulatory infrastructure that made the downturn much worse than it might have been. To give them credit, the authorities everywhere have rapidly reset their regulatory compasses. They now argue for a new approach that, in professional jargon, is known as macro-prudential regulation, which was referred to earlier in the debate. Broadly, that means that the activities of firms should be regulated according to the impact they have on the stability of the system as a whole—the macroeconomy. What sorts of measures flow from this approach? They include, first, that regulators should take particular notice of the interconnections in the financial system, tracing as best they can the pathways through which financial contagion can spread. This requires a detailed knowledge of markets that in this country is found only in the FSA, but that detailed knowledge must be projected on to a system-wide template. Secondly, it requires that any institution which poses systemic risks—be it a bank, a prime broker, an insurance company or a hedge fund—should be strictly regulated. Thirdly, systemically relevant institutions should undertake pro-cyclical provisioning. That means accumulating capital in good times to provide a buffer against downturns. Fourthly, "leverage collars" should be enforced, relating the ability of the banks to expand their balance sheets to macroeconomic conditions—note, macroeconomic conditions, not the circumstances of the individual firm. Fifthly, measures must be taken to ensure that firms can fail without endangering the stability of the system. As if this was not enough, all this must be implemented on an international scale because systemic risk is a characteristic of global markets. This is a truly radical agenda. Let us suppose, for example, that pro-cyclical provisioning became the norm. The economy is booming; tax revenues are rolling in, sustaining a healthy fiscal balance; house prices are rising; borrowing is easy; everyone is happy, and a general election is approaching. Then the regulator sharply slows down the economy by severely restricting bank lending. Just imagine the furore. But that is the sort of approach that macro-prudential regulation will demand. Lying behind this radical approach is the sort of radical thinking that everyone involved in financial policy should be confronting. As an aside, that is why it is disappointing to encounter yet again the intellectual vacuum that characterises the contributions of the Official Opposition. From the Opposition Front Bench we heard nothing that remotely amounted to a vision of how the content of financial regulation might be reformed. Instead, as nature abhors a vacuum, all that the Opposition propose is a shuffling of institutions that will condemn the FSA and the Bank of England to at least 18 months of bureaucratic restructuring, when they should be getting on with the job of complex regulatory reform. Those of us who were involved with the pre-FSA regulatory system, and who worked on the transition to the FSA, witnessed the degree to which these bureaucratic upheavals paralyse effective regulation for an unexpectedly long time. How does the Bill measure up to the new approach that all serious students of regulation propose? I must confess that I searched in vain for the new vision. I would be grateful if, when he sums up, my noble friend will indicate where the essence of the new macro-prudential approach is to be found in the Bill. If there is to be pro-cyclical provisioning, which measures in the Bill will help to implement those procedures? How does the Bill face up to the Bank of England's concerns that this provisioning should be based on clear but simple rules rather than discretion? Which authorities are to be accountable for devising and implementing such rules? Does the legal apparatus introduced in the Bill permit the introduction of macroeconomically defined leverage collars? If so, how are such measures to be related to the overall stance of macroeconomic policy? The essential problem with the Bill is that, in Churchill’s famous phrase, it is a pudding without a theme. However, it contains some very tasty plums. Among the plums are the establishment of the Council for Financial Stability and the addition of the financial stability objective to the list of objectives of the FSA. Having spent a considerable amount of time and effort in the debates on the Banking Bill trying to persuade my noble friend that there should be such a council and that the FSA’s responsibility for stability should be recognised, and having been rebuffed on the former and severely lectured to the effect that the latter was totally unnecessary, I cannot but welcome these measures— ""joy shall be in heaven over one sinner that repenteth"." Even in the absence of an overall macro-prudential vision, there are a number of other plums that provide useful sustenance. The requirement that the FSA promotes international regulation and supervision is one such welcome measure, though I must confess that I thought it did that already. Will my noble friend explain how in practice its activities will change? What will the FSA do now that it did not do before? The measures on short selling address an obvious systemic problem and are welcome, but I worry that they deal with the symptom and not the disease. The disease is the general problem of herding, notably the simultaneous deleveraging that the Basel II standardisation of risk modelling so actively encourages. Herding is a product of the homogenisation of the marketplace, a homogenisation greatly enhanced by the liberalisation of financial markets and the conglomeration of financial institutions that has been one of liberalisation's consequences. Without direct measures to address the phenomenon of herding, the temporary suspension of short selling is a sticking plaster on a gaping wound. The requirement that institutions develop recovery and resolution plans is also a welcome addition to the armoury of measures designed to reduce systemic risk—in this case tackling, at least in part, the problem of "too big to fail". I have one concern with the provisions as drafted. The recovery and resolution plan drawn up by an individual institution will necessarily be based on the risk parameters as observed by the institution itself. It will not be possible for the institution to take into account the systemic costs of its recovery plan, or indeed of its resolution procedures. The need for the authority to take explicit note of systemic issues when assessing recovery and resolution plans should be in the Bill, and I intend to bring forward amendments to that effect. I am sure that the provisions with respect to remuneration will be a major focus of public attention. I confess to being agnostic on this matter. Clearly, if remuneration practices actively encourage greed and excessive, even immoral, risk-taking, and hence increase systemic risk, they should be constrained or eliminated. However, given the market and regulatory structures existing in the run-up to the crisis, even if all bankers had been models of moral rectitude, the result would not have been much different. There is one measure that is not in the Bill that I believe would significantly improve the quality of regulation in the UK. When I joined the board of the old Securities and Futures Authority in 1997—I had the pleasure of serving with the noble Lord, Lord Hodgson—I harboured considerable suspicion about the role of practitioners in self-regulatory organisations. Would they not simply look after their own? During my time at the authority, observing the performance of practitioners at first hand, I changed my mind completely. Far from looking after their own, the practitioners were typically tougher than the staff. Practitioners who were given responsibility for regulatory decisions "went native" as regulators. Their commitment was to "the industry". They were concerned with the maintenance of integrity and fair market dealing that would be to the ultimate benefit of the financial services industry as a whole. I was also impressed by the very high level of expertise that the practitioners brought to guiding the work of the staff of the SFA. These were people who worked in the markets on a daily basis and were at the leading edge of their various disciplines. I am very sad to say that the Financial Services and Markets Act was a notably anti-practitioner measure. Practitioners were corralled into advisory bodies, well away from statutory decision-making responsibilities. From my time on the FSA's Regulatory Decisions Committee, I can testify that this was a major error. The quality of enforcement work I saw at the FSA was considerably inferior to that performed at the old SFA. If we are to improve the expertise that is brought to bear on UK financial regulation, we need to find new ways of involving practitioners directly in the regulatory process. I will be considering whether the Bill can be amended to achieve that goal. One final comment: it is commonly argued that regulatory reform can take place only on an international scale, and that all national measures should be suspended or postponed until full-scale international agreement is reached. This is a wonderful device for kicking reform into the long grass. It is also nonsense. Most of the important regulatory innovations in the past 40 years were launched unilaterally or by one or two countries. The first Basel capital accord was a bilateral deal between the UK and the USA when the noble Lord, Lord Lawson, was Chancellor of the Exchequer. Moreover, the structure and content of the UK regulatory system has never been the same as that in the US, to no obvious detriment. We must push ahead as fast as we can. The multilateral system will fall into place in due course. Eighteen months or so on from Lehman Brothers, it is disappointing that a comprehensive reform package is not before us. What is in this Bill is worth while, but it is less than a halfway house. There is much more to be done before the regulatory system catches up with the last crisis, let alone prepares for the next one.