Banking (No. 2) Bill [HL]

My Lords, before I turn to the main body of my remarks on the Bill, I will comment on the position stated so forcefully by the noble Lord, Lord Bilimoria, who I regret is not in his place, and echoed by other noble Lords. That position is that returning regulatory powers to the Bank of England would, in some sense, create a more robust regulatory system. Noble Lords who take this view should recognise that, in the decade prior to the Bank of England Act 1998, the Bank of England had a lamentable regulatory record. Johnson Matthey, BCCI and Barings were all significant failures by the Bank of England. Indeed, the Bank of England’s Board of Banking Supervision commented with respect to Barings that the Bank of England did not understand the market that it was supposed to be regulating. I shall return to the Bank of England later in my remarks. This Bill is one of the most important measures to come before us in this parliamentary Session. Everyone knows that the success of financial services is a vital component of this country’s economic future. The Bill seeks to create a new framework for the operation and protection of those services, at least as far as banking is concerned. Yet, while being important in itself, the Bill is surely, as many noble Lords have said, but a first step in the series of measures that are needed to transform the operation and regulation of financial services in this country and, indeed, internationally, as the Prime Minister noted following the G20 meeting in Washington in mid-November. Because this is but a partial measure—a first step—it is vital that the measures in the Bill are crafted from a coherent and consistent analysis that will carry over to the later legislation that will complete the pressing task of financial markets reform. This first step must not be a false step, jeopardising what follows. In these difficult times, it is particularly important that the Bill should embody a thorough understanding of the lessons that should have been learnt from the bitter experiences of the past two years or so. To identify those lessons, there is no better place to start than Mr Alan Greenspan’s evidence before the US House of Representatives on 23 October. He stated: "““Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief””." He went on to say: "““This modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year””." Mr Greenspan was honest, almost painfully so, about the intellectual and practical failure of the policy stance that he had adopted for 10 years as chairman of the Federal Reserve board. But the actual content of his mea culpa is in fact wrong and betrays a serious lack of understanding of what has happened. The issue is not whether banks would manage their risks efficiently, but whether they could do so. Greenspan has failed to take on board the fact that the financial risks taken by firms have significant externalities; that is, they impose costs and risks on society as a whole far greater than the costs and risks experienced by the originating firms. Just as it is impossible for a single energy user to manage the risks of climate change—that depends on the operation of the system as a whole—so it is impossible for an individual bank to manage the totality of risks to which it is exposed. That, too, depends on the operation of the system as a whole. It is this systemic risk that has been so brutally revealed in the disappearance of liquidity from financial markets. Systemic risk is an ever present characteristic of financial markets; it is embedded in their DNA. It is, therefore, totally wrong to attribute what has happened to black swans or similar highly improbable events. Systemic risks are ubiquitous in markets of white swans. They are totally normal and have reappeared regularly, albeit in different guises, for the past 300 years. Financial regulation should focus on systemic risk, not that of individual firms. That is the first lesson that Mr Greenspan and we should by now have learnt. Regulation is essential because, in the presence of systemic risk, free, competitive markets are inefficient and prone to crisis. The classic example of systemic risk is the bank run, which was well described by my noble friend Lord Peston. The failure of bank A, due to imprudent loans, provokes a run on bank B, even though bank B is solvent. However, because its lending is longer than its deposits, it is illiquid, and the run forces it to collapse. The second lesson that should have been learnt from recent events is that this classic example of systemic failure is hopelessly out of date. In the past 30 years, the structure of financial markets has changed fundamentally; it has shifted from a bank-based to a market-based system. Financial intermediation has moved from banks into markets—into long chains of securitised counterparty transactions—and financial crises are now manifest in financial markets in general rather than in banking markets in particular. Hence, crises no longer take the form of bank runs; instead, market gridlock is the source of systemic risk. Despite popular belief, the failure of Northern Rock was certainly not the result of a bank run. Northern Rock was brought down by gridlock in the commercial paper market long before the queues formed outside its branches. I shall sum up the lessons that we ought to have learnt. First, systemic risks are endemic to the financial system as a whole and cannot be managed by individual firms. Secondly, systemic risks stem today from gridlock in financial markets, not from bank runs, and gridlock may originate anywhere in complex chains of counterparty transactions throughout the financial system. Thirdly, therefore, detailed knowledge of the operation and structure of firms and markets is essential to the effective regulation of systemic risk. The question that we face is whether these lessons are embodied in the Bill or whether it has failed to reflect the lessons of recent events. One cannot this evening test all elements of the Bill, but I shall consider three parts of it. First, on the target of the special resolution regime, the main purpose of the Bill is, of course, to create a special resolution regime for banks and, to a certain extent, building societies and credit unions. A bank is defined in Clause 2 as, "““a UK institution which has permission ... to carry on the regulated activity of accepting deposits””." The creation of special resolution regimes is well established in the US and is long overdue in the UK. The Government are to be applauded for bringing them forward. However, in the light of our second fundamental lesson of recent events—that systemic risks stem from gridlock in financial markets—the clause defining the targets of the regime is unreasonably restrictive. It means, as the Government have just now recognised, that the special resolution regimes could not have been applied to Lehman Brothers, yet the collapse of that firm is probably the most serious financial policy failure of the post-war era. What should we learn from the Lehman failure? Systemic failure may not originate in banks; instead, it may originate anywhere in the complex structures of financial counterparties, whether they are investment banks, special purpose vehicles, hedge funds, or elsewhere. Confining the special resolution regime to banks is long out of date. I look forward to hearing the Government’s amendments in Committee, which should rescue the Bill from this archaic anomaly. Secondly, let us look at Clauses 33 to 48 on the transfer of securities. It is important to note that the impact of these clauses is contrary to the Government’s objectives as set out in the G20 communiqué of 15 November, to which Her Majesty’s Government subscribed. The G20 communiqué placed considerable emphasis on the need to develop efficient clearing mechanisms for financial instruments. However, the passage into law of Clauses 33 to 48 would seriously compromise the attainment of that objective. Indeed, it would seriously compromise netting in general. The reason for this is that the Bill grants sweeping powers of contractual override. This will mean that lawyers will not be able to issue ““clean”” legal opinions for netting exposures. This will in turn require parties to recharacterise their short-term lending transactions on a gross basis, rather than a net basis, hence increasing regulatory capital charges and market risks. Essentially, the broad stabilisation powers would drive up the costs for British banks engaging in netting, yet the Government have committed themselves to increased netting, not less. This contradiction is an unintended consequence of the Bill and I will be proposing ameliorating amendments in Committee. Thirdly, on the roles of the FSA and the Bank of England, my final test of the Bill’s provisions against the lessons of recent events concerns two proposals at each end of the Bill. These are Clause 7, the trigger clause where it is proposed that a stabilisation power, "““may be exercised in respect of a bank only if the FSA is satisfied that the following conditions are met””," and Clause 228, proposing the establishment of the Financial Stability Committee of the Bank of England. As I have argued, a fundamental characteristic of financial markets today is that systemic risk resides in the structure of markets and firms. In the current division of regulatory responsibility, the Bank of England has the main responsibility for managing systemic risk but has no direct knowledge of firms. That knowledge of markets and institutions, if it resides anywhere, resides in the Financial Services Authority. Hence it is indeed appropriate that the FSA should have its finger on the trigger. The Bank of England does not have the detailed supervisory knowledge of not just banks but the structure of financial institutions as a whole to perform this role. There is a problem, however. The FSA has no direct responsibility for systemic risk; that responsibility rests with the Bank of England. The FSA knows about firms and markets and the Bank of England has the responsibility for managing systemic risk. This dangerous dichotomy, already too evident in recent events, could be overcome by making the new Financial Stability Committee, to be established by Clause 228, a combined committee of the Bank and the FSA, jointly and severally responsible for financial stability. This would have the dual advantage of informing the Bank’s stability analysis about the actual operations of firms in disintermediated markets and ensuring that systemic risk became a basic tenet of the FSA’s operational philosophy. In other words, the Financial Stability Committee could be an operational bridge between the FSA and the Bank of England—the bridge that has been so conspicuously lacking in recent months. If a joint committee is to be an effective bridge, however, not just between the Bank and the FSA but between markets and systemic risk, it must be composed of and advised by the informed, the sceptical and the contrary. The last thing that we need is another committee of City grandees who are richly incentivised to spot the bursting of the bubble and notably fail to do so. In view of the remarks that he made in his maiden speech, I think that the noble Lord, Lord Smith of Kelvin, would agree with me. A contrary Financial Stability Committee should have behind it a well resourced research department. Experience of the past year has shown that it was only the lowly research teams that spotted well in advance the danger of sub-prime mortgages; they were ignored, but it is about time that they had a voice at the high table. A joint Bank/FSA Financial Stability Committee would be the perfect mouthpiece. I will be proposing amendments in Committee that would establish the Financial Stability Committee as a joint committee of the FSA and the Bank of England and would ensure that its membership extended far wider than the narrow extent currently envisaged in the Bill. This is a good Bill, but it could be an even better Bill. Some of the lessons of the so-called credit crunch have emerged only in the past few months, after the Bill was drafted. We have the opportunity and the responsibility to bring it right up to date.