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10 Mar 2008 : Column 27

The Treasury Committee therefore disagrees with the Government about where the powers should reside. We believe that the new powers should reside not with the FSA but with the person who takes up the new post of head of financial stability and deputy governor of the Bank of England, and I shall outline the reasons for that. There is a need for creative tension and grit in the system. I remind hon. Members that the deputy governor in charge of financial stability was on holiday in France for a week in August when the financial turbulence occurred. That does not say much for application.

Secondly, when asked, “Did you do your job?” every one of the tripartite authority members who came before our Committee replied, “Handsomely.” But if they all did their job so handsomely, how did we end up in the biggest financial mess since 1880-odd? That is the question that perplexed the Committee. When we asked the Governor of the Bank of England who was in charge, he said, “Well, can you define ‘in charge’?” That indicated a real lack of leadership. If we do not get some grit into the system, we could find ourselves in the same situation again.

Some people will say that that would include overlap. Perhaps there will be overlap; but I would suggest that the tension created could be more beneficial than detrimental. Giving the FSA too much power emphasises the conflicts, but there is already a conflict. The FSA is in charge of prudential regulation, yet it is meant to support consumer interests. That is a conflict of interest. Added to that is the fact that the FSA has a role as regulator, yet also needs to find a private sector solution and oversee the special resolution regime. That is a bit like a surgeon who tells the people he is about to operate on that he has a part-time job as an undertaker, saying, “If the operation doesn’t go well, we’ll look after you well after that.” Let us look into those conflicts of interest and see whether we can get them sorted out.

John Thurso (Caithness, Sutherland and Easter Ross) (LD): Does the right hon. Gentleman agree that one of the main lacunae, which he has just identified, was the lack of practice, among the three members of the tripartite authority, of working together on what we identified in the report as war-gaming? Does he agree that if that had taken place, some of the grit that he would like to see might have been identified?

John McFall: I agree with the hon. Gentleman entirely. Again, he is a member of the Committee and contributed greatly to the report. There were no war games taking place. Back in 1997, when the system was established, perhaps it was suggested that it would work because there were four individuals involved: the Governor of the Bank, Eddie George—Lord George—and his deputy, Howard Davies, and the permanent secretary at the Treasury, Terry Burns, and his deputy, Steve Robson. They all knew one other, and might have thought, “If anything goes wrong in the system, we’ll be able to sort it out, because Eddie knows Terry, who knows whoever else.” However, when the players change, the system must be robust, but it was not robust, so war games are an essential element in ensuring that it becomes so.

Mr. John Redwood (Wokingham) (Con): When the right hon. Gentleman’s Committee looked into the matter, did it come to any conclusion about what fair
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figures should go into the estimates for the actual costs incurred so far, for the contingent guarantees and for the cash costs of the advances, as it would help this debate very much if we had some figures?

John McFall: That certainly would help the debate, but the Treasury Committee does not have inside information. All of us on the Committee have realised that if we overstretch ourselves, we can make fools of ourselves. We have not overstretched ourselves; therefore our report has been well received. I do not want to get into crystal ball gazing; what I am asking is for the Ministers on the Front Bench to fill in the blanks and to fill them in soon. Then we can have a decent debate on the issue.

To get back to my point about the overlap, some might say, “This is going against the efficiency in regulation over recent times,” but perhaps there is a push back from that. I remember being most impressed during my visit to Washington by the role of the Federal Reserve. There is overlap in regulation there, and we would not want to replicate that in this country. However, once the Federal Reserve has its eyes on something, people perk up and start to listen. One of the tragedies of the situation is that both the FSA and the Bank of England sent out messages to the financial community with their financial stability reports about possible problems in liquidity, but nobody took them on, because there was no mechanism for feedback. In our latter report on financial stability and transparency, the Committee said that those warnings needed to heeded at board level and that a message needed to go back to the FSA or the Bank from the board level saying, “We have looked at the situation.” So I hope that that step is taken rather quickly.

On the efficiency in the market, perhaps we have been overwhelmed by the benign economic conditions and there has been too much complacency in financial institutions to prepare for the bad times, as well as the good times, and the war games and other aspects relate to that. The Government have also said that the Bank of England will have a statutory responsibility, and the Government reforms call for the Bank to have that for reasons of financial stability. I suggest to the Government that that is all well and good, but what instruments are at their disposal to meet that statutory responsibility?

We need to fill in the individual responsibilities of the authorities, so that they stick to their mandates and so that, with the special resolution regime, we do not get into situations such as the one that we got into with Northern Rock. All that needs to be filled in, because future Treasury Committees could face problems in the financial markets and ask future Governors of the Bank of England why they did not fulfil their duty to protect financial stability, and I do not want them to be told, “Well, it’s because Parliament did not give us adequate powers to achieve it, and the FSA did not listen to us when we asked for action.” That is what the recommendations of our Committee are about.

This unanimous report has been well received, and it has cross-party support. The Treasury Committee was the first to the line when the crisis blew up. We have engaged the public in providing a detailed understanding of what went on, and I should like to find from today’s
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debate that that detailed understanding is translated into a detailed prescription, so that we never again have a run on a bank, as we had with Northern Rock.

4.6 pm

Mr. Michael Fallon (Sevenoaks) (Con): I will not follow the Chairman of the Treasury Committee, the right hon. Member for West Dunbartonshire (John McFall), in a detailed analysis of what went wrong after the events at Northern Rock, although I want to add my tribute to the way that he led the inquiry and drove us forward to produce a report that has been warmly received, not just on both sides of the House but more widely in the City and beyond.

The debate today is timely. We are in a financial banking crisis, and I do not think that we are near the end of it. We see a loss of confidence in commercial banking, the freezing of the bond markets and, perhaps still to come, the probable unravelling of the carry trade. I start from the position that there is probably no financial crisis that the Government or politicians cannot, if they try, make worse. We should be extremely wary of every temptation to try, not least because not all but some previous regulations certainly contributed to our present discontents.

Basel I drove the search for yield off balance sheets. The Sarbanes-Oxley Act drove the search for yield across the Atlantic, fired up the City and all our financial services sectors and perhaps made every British building society consider itself the next Morgan Stanley. Some aspects of Basel II may well be unhelpful in binding the extremely conflicted credit rating agencies into the regulatory structure. The answer may not necessarily be instant, knee-jerk regulation.

It is just worth looking at the Government’s consultation paper. It comprises 29 proposals for new legislation, 11 different rule changes for the Financial Services Authority to consult on and a further 23 significant operational changes to the ways in which banks operate—plus a whole load of other stuff, dealing with Scottish and Irish banknotes or the composition of the Court of the Bank of England, which may not directly help us to unfreeze the bond markets but seems simply to have been stuck in there.

Of course, we have to deal with the failure of Northern Rock. Why did it fail? Who failed? The answer is that they all failed: senior management made mistakes and the non-executive directors failed to check them; the regulator failed to supervise the firm and the tripartite committee failed to keep it out of trouble; and the Chancellor at several key points failed to act promptly and decisively. Even so, I am wary of wholesale legislative reform.

The first general point—and our Chairman, the right hon. Member for West Dunbartonshire made it—is that regulators must do their job. The FSA did not do its job, as the report makes clear. Of 3,000 staff, only three were directly employed in looking at Northern Rock—the only significant UK bank without a London office. The ARROW—Advanced, Risk-Responsive Operating FrameWork—process, under which Northern Rock was supervised, was conducted once every three years; and the chairman and chief executive lacked any formal banking qualification. We should recall that this was one of the fastest growing UK banks.

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Like the Chairman of the Treasury Committee, I do not necessarily think that we ought to be impressed by the need for tidiness. When we asked the tripartite committee how its members did their job, we found that, as the right hon. Gentleman said, they all liaised and consulted and all did their little bits. Some degree of regulatory overlap would be useful and, so far as the larger banks are concerned, I would like the Bank of England to be given some overlapping power, like the Federal Reserve, to go anywhere, see anybody and ask any questions.

Secondly, there are obvious gaps that need to be filled—for example, the special resolution procedure, where risk is systemic, and an easily understood compensation scheme for depositors. Those should have been put in place years ago; indeed, the Governor wanted them put in place years ago, and it is for the Government of the day to explain why they were not.

Thirdly, it is clear to me at the end of this inquiry that the Bank of England should be at the centre of all this. Of course I accept that the Chancellor has to authorise in the last resort the expenditure or commitment of public funds, but I believe that he should do so on the Bank’s advice and that the role of the Bank should be paramount. It is the Bank that should have overall supervision of liquidity; it is the Bank that keeps day-to-day watch on the money markets; it is the Bank that should have working knowledge of the bigger banks’ operations. That is why I would like to see the Bank of England with its authority restored as a properly independent central bank, not simply the interest rate-setting arm of the Treasury. In the end, it is the Governor—not the Chancellor and not the chairman of the FSA—who should be the ultimate guardian of our financial system. That is why our report proposes new ways to strengthen the Bank’s role.

Beyond that, there is plenty for the FSA to be getting on with to raise its game: greater emphasis on liquidity management, more transparency and much more rigorous stress testing, as has already been suggested. We may need to look much harder at the whole issue of external validation. It would be fair to say that the Select Committee was unimpressed with the role of the credit rating agencies, which seemed to us hopelessly conflicted. One credit rating agency had taken over £3 million in fees from Northern Rock alone.

We also looked hard at the role of the auditors. I do not understand how auditors can give a full, fair and firm opinion but exclude any treatment of the off-balance-sheet vehicles. I find it troubling that Northern Rock’s auditor earned nearly three times as much in non-audit fees—in consultancy fees—for arranging the securitisation of Northern Rock’s off-balance-sheet vehicles, as it did for the audit, which of course excluded them. I find that troubling.

I conclude by raising two wider but related issues. The first is what we mean by financial stability and the systemic risk to it, and the second is the extent to which we can still regard banks as market institutions rather than public utilities. When I posed the first question on Second Reading of the emergency legislation a few weeks ago, I did not get an answer. I think that we need one, however, so let me put it a different way. In the 1970s, the Soviet Union had financial stability and Hong Kong probably did not, but I know which market we would probably all prefer to invest in. Financial
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stability is something we all say we are in favour of. In Juvenal’s great phrase, “Laudatur et alget”—it is praised, but cold-shouldered. We say we want it, but we certainly are not content with it. We do not expect our bank to deliver it. We do not expect our pension fund to deliver simply stability. We do not expect our investment manager to deliver stability. We expect them, on the contrary, to search continually for better yield in this era of low inflation—to achieve higher than average rates of return, even as inflation disappears globally.

Indeed, if something then goes wrong with that search for yield, we do not restrain ourselves from trying to establish, as we heard from the Liberal Democrats, an attempt to prove regulatory failure. If we do not get the yield we expect—if something goes wrong and our investment seems to sink—our constituents will try to secure regulatory failure and then demand a form of compensation. That is why we have to be extremely careful about the concept of financial stability and how we define systemic risk to it, otherwise, there is no bank, no building society and no investment that can be allowed to fail if enough of our voters are committed to it. At the end of all this, I would prefer a definition of exactly which financial institutions are systemically important. I would like that defined, perhaps by the Bank of England in its financial stability report, but certainly by an authority independent of Government, not by shifting political calculations and emergency meetings of Ministers, so that it is clear to everybody which financial institutions cannot be allowed to fail and which ones still can.

The second related question is, what are banks today? Was Northern Rock, for example, really a bank? It had remarkably few depositors. It seemed to me much more of a finance house—a rather poor Tyneside imitation of Morgan Stanley—borrowing money from around the world and betting on future movements of interest rates. To what extent are all our banks and building societies really market institutions? Are they instead public utilities, still dependent on implicit public subsidies when they fail?

John Thurso: I am following the hon. Gentleman’s argument closely. Does he agree that the critical factor is the depositors? If the depositors and the need to protect them are taken out of the equation, we arrive at something that one could probably allow to fail.

Mr. Fallon: That is certainly one way of defining it. Very big UK banks may be in the system which, for other clearing and operational reasons, one would not want to see fail. However, I think the hon. Gentleman agrees that we must have a clearer definition of what systemic risk actually is.

Mr. Andrew Love (Edmonton) (Lab/Co-op): Is not the problem with defining which banks can and cannot fail that we are giving an implicit Government guarantee and therefore creating an unlevel playing field which those that do not have that guarantee will complain about?

Mr. Fallon: They certainly will, but one starts from a position that includes the very large, major UK banks and works outward from there. I do not envisage the
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risk to be very large. What needs to be clear is that the House would be prepared to see the vast majority of banks and almost all building societies fail provided, of course, that the depositors were properly protected; otherwise, we will not have a market financial system at all.

Let us not forget that banks have been extremely profitable in recent years. Some of the British banks are world-class players. They have been extremely profitable for UK plc and for their shareholders, but they have also been profitable—very profitable—for their senior managers. That profitability, and some of the vast salaries involved, may now need to be priced a little more realistically. I should like the capital and liquidity requirements laid down for those banks to be readdressed. The House must never again be put in the position of suddenly having to commit more than £100 billion of public money.

There are lessons from Northern Rock. There are lessons for the regulator that failed in its duty, for the tripartite arrangement that could not deal with the consequences, and for the Government who fatally dithered; but, ultimately, there are lessons for us all.

4.20 pm

Frank Dobson (Holborn and St. Pancras) (Lab): It is important for us not to confine our thoughts about the future regulation of the British banking industry to an attempt to ensure that a crisis such as that at Northern Rock does not recur. There are more fundamental problems affecting the industry, along with its opposite numbers in Wall street and other financial centres.

It has been notable in recent times that the representatives of the British banking industry, whether appearing on television or radio or contributing to articles in newspapers—backed up by their supporters’ club consisting of most of the financial commentators—have been making very gloomy predictions about the economy, about profits, about jobs, about growth, and about the likely impact on taxation in this country. They say that it is all being caused by the credit crunch, but scarcely ever go on to acknowledge that they themselves are solely responsible for the credit crunch— the banking crisis that we face. Their usual targets when things go wrong are public sector pay, trade union militancy, alleged failures in public services, the national minimum wage, which they say will cripple the British economy, and part-time workers seeking security of employment, who will apparently ruin the economy. However, not even the failure of Northern Rock will damage the British economy in anything like the way the banks are damaging it.

The credit crunch—the financial crisis, the banking crisis, the international banking crisis—was caused because United States financial institutions lost fortunes on what, after things all went wrong, they started to call “sub-prime mortgages”, or, in plain English, “lending money to people who could not pay it back”, which has generally been frowned on by bankers in the past. Having lost their money, the banks packaged up the loans in new financial instruments with the wondrous title “collateralised debt obligations” and sold them on to a collection of mugs hitherto known as “international bankers”.

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CDOs are rather like pre-prepared and pre-packaged supermarket salads, with different assets all chopped up and mingled together, but these packages contained very few genuine assets. The remaining elements were worthless, or rather worse than worthless: they were liabilities. A CDO was a bit like a pre-packaged Caesar salad in which there is one anchovy and all the rest is lettuce, apart from the fact that the package containing the salad is transparent. There was nothing transparent about the CDOs; however, they were sold on as top-quality and bought by idiots as top-quality, and the credit rating agencies invariably gave them triple-A ratings. They were risk-free. The banks bought them out of recklessness or stupidity, or perhaps they were deceived, but what is more likely is that they suffered from the worst form of deception—self-deception—and it is they who have got us into this mess.

Mr. Kevan Jones: On top of that, does my right hon. Friend agree that it is scandalous that most of the people who were arranging the various financial packages also took huge commissions?

Frank Dobson: They took huge commissions and in the case of some of the American banks when they lost, let us say, $15 billion or $20 billion the chief executive was asked to leave but was given $20 million to help him on his way, so there was in fact no punishment within the system, but there was a reward for grotesque failure.

Mr. George Mudie (Leeds, East) (Lab): My right hon. Friend assigns motives to the banks, but he has missed out one of them: greed. Does he not agree that the basis on which they bought these securities was that someone would be prepared to pay them more than they paid, so it was about simple greed? They were not interested in what was in the security. Instead, they were interested in only one thing: can I sell it on—or, in other words, can I pass the parcel and make a lot of money before the music stops?

Frank Dobson: I entirely agree, and I think the hon. Member for Sevenoaks (Mr. Fallon) made the same point in slightly different terms. It is clear that people were behaving like a collection of greedy lemmings. The problem with that is that it is not only they who go over the cliff; does everybody else. If I may mix my metaphors, the lemmings who go over the cliff have a $20 million parachute, but the rest of us go crashing down to the bottom without the benefit of anything to cushion us.

I do not accept the point the hon. Member for Sevenoaks made in comparing Northern Rock unfavourably with Morgan Stanley, however. Has Morgan Stanley done a good job in this situation, as it has lost $9 billion on sub-prime mortgages? By many standards, the people running Morgan Stanley were just as stupid, ignorant and greedy as those running Northern Rock.

Another problem is that no one knows what the real exposure is of any of the American banks that committed the original stupidity or the people who then stupidly bought up the liabilities thinking—apparently—that they were assets. Consequently, banks are now frightened to lend to, or borrow from, each other because they fear default as they do not know the extent of one another’s exposure.

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