Banking (No. 2) Bill [HL]

My Lords, the debate today has been on a higher level than much of the public comment in the press and news bulletins. I am glad to be able to take part in a debate which is beginning to identify some of the underlying difficulties that have arisen in these exceptional circumstances. I have no current interests to declare but I have been involved with banks or banking throughout most of my working life. I worked in a merchant bank in the 1960s and 1970s. In the 1980s I was the Minister responsible for the then Banking Bill and the then Building Societies Bill. In the 1990s I became director of an international bank and chairman of its audit committee. I was also for a time on the boards of the Securities and Investment Board and of the FSA. I say this because I have been trying to look at the picture from many different angles. There is one thing that comes back to haunt me and which I cannot understand. This is what I would like to talk about this evening. I am amazed and appalled by the events in the financial markets, and banking in particular, which have occurred in the last year or two, especially in recent months. The question which does not seem to get much coverage is: how did it all come about? Connected to this is the question: how are we going to prevent it happening again? We read comments to the effect that no one foresaw what was coming and that there was no advance warning. That is not entirely true, however. There were big imbalances and tensions building up in the world economy, the difference between China’s surplus and the US deficit, overheated investment markets and housing in many countries, and overgeared instruments for leveraged buyouts. These were all signs of excess and they put some people on notice. About two years before the Northern Rock affair exploded, the Governor of the Bank of England issued a statement that the market was mispricing risk. That was a crucial observation by one of the key players; it came from a source who knew what he was talking about. It seems, however, to have had little impact. It does not seem to have affected the way in which the FSA looked at individual institutions; it does not seem to have changed broad banking policy in any way. It all went on gloriously as before, as if there were no icebergs in the ocean. Inevitably the crisis has led to suggestions that we need more regulation. We may do but we also need better regulation and we need much better supervision. Supervision is ultimately the ingredient that has failed and which set off this whole process. Regulation is a matter of setting rules and the nature of regulation may well change as result of current events. Supervision is the oversight of the actual business of institutions and therefore where in this case and others the damage will have begun. How could the crisis have developed on such a scale, with nobody realising what was happening until the last moment? It has involved many banks in many countries and the puzzle is what caused everyone in key positions in or in relation to those institutions to have a complete mental block at the same time on the nature of these instruments. This must be the worst collective failure on a colossal scale in economic history. Too many of the important players seem to have suspended their critical faculties. Within banks there are managers, traders and dealers at the coalface; there are risk departments and control systems; there is a head of risk who reports to the board and to the audit committee; there is an internal audit structure and beefed-up forms of audit committee, which not only look at figures and data but carry out stress testing. They think they are on top of things. Of course, it was the banks’ fault in that they bought piles of what transpired to be toxic financial waste, but others should also have noticed. The first to have done so should have been the external auditors, but those who perhaps above all should have noticed were the rating agencies, which seem to be covered with a lack of glory in this whole story. The supervisors are critical in this. Sub-prime mortgages are a high-risk asset, no matter what wrappings you put round them. You can call them an SIV, a CDO or any other acronym, but basically they consist of dodgy risk, and those who entered into them on such a substantial scale seem not to have focused on that at all. How can such a crisis be stopped from happening again? I think that supervision will have to be thought through from first principles. It is important, and I am glad, that the FSA is beginning to undertake this but I hope that it looks at the issue in a way that reveals why the institutions affected took on and built up such huge positions in instruments and types of business that they did not properly understand. Of course, we will get new proposals on regulation. In some respects that may be a very good thing, but it will also probably be influenced by overseas interests, because co-ordination in an international market is very important. The right personnel must be employed, and the people who carry out an extended and, one hopes, more penetrating process of supervision must become a source of key information about the nature of the assets on the balance sheets of deposit-taking institutions. There is no getting away from that. What about the future? We are in the middle of a storm at the moment but we have to think beyond that. When we get beyond it, I hope that the regulatory function, which is separate from the supervisory function—although they overlap—will apply in a form that enables the supervisors, in their turn, to make a proper and well informed judgment about the nature of the institution over which they have supervisory responsibility.