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The Government should be resolute in resisting the claims of shareholders for compensation. That applies particularly to the hedge funds that piled into Northern Rock stock in the autumn hoping for quick speculative returns. They gambled and they lost. Regrettably, however, we cannot draw distinctions among the different classes of shareholder, however much we might wish to protect the interests of small, loyal Northern Rock investors or former employees and suppliers who may have held stock for some years. No more taxpayers’ money should be expended on bailing
out Northern Rock shareholders, beyond that which will be determined by arbitration.
Hon. Members in all parts of the House in the months to come will doubtlessly be inundated by pleading on behalf of well orchestrated, high profile shareholder groups, as they battle, perhaps even in the courts, for compensation. The temptation to make common cause with such groups should be resisted. We now need to give the new chief executive, Ron Sandler, the breathing space to make plans for the future that are economically viable, rather than simply politically expedient. The likeliest and wisest way to proceed involves the parcelling and sale of parts of the Northern Rock business, as market conditions allow in the months and, potentially, years ahead.
There is no easy fix. Politicians need to appreciate that if taxpayers are to stand a realistic chance of recapturing their guarantees and loans in full, we almost certainly face a long haul.
5.22 pm
Mr. Adrian Bailey (West Bromwich, West) (Lab/Co-op): I, too, congratulate the Treasury Committee on its work—as I am not a member of the Committee, perhaps I am better placed to do so. It produced a comprehensive report on a detailed and arcane subject, which was not made easier by the fact that the issues were unfolding as it did its work. The nature of the Committee’s conclusions does it great credit.
Before coming to the substance of my remarks, I should like to declare an interest. I am chair of the all-party group on building societies and financial mutuals and make my comments as a committed supporter of the building society and mutual sector. However, although I am predisposed towards the sector, I recognise that companies in the financial services market are extremely important and that they complement the building society sector. It is in the interests of the consumer that the public have confidence in both sectors.
In 2005 and 2006, the all-party group conducted an investigation into the consequences of demutualisation for building societies, in a report called “Windfalls or Shortfalls?” The purpose of our investigation was to find out exactly what benefits, if any, had arisen from demutualising and who had enjoyed them. I will not go into the full range of our conclusions, except to say that the advantages that building societies enjoyed in not having to pay dividends to their shareholders was passed on to the consumer, hence building societies tend to dominate in the best value tables.
Interestingly, the one company that stood alone and bucked the situation was Northern Rock. In its evidence to the Committee—it did not give verbal evidence, but it sent a letter—its deputy chief executive, David Baker, said:
“Since 2000 we have been able to tap into Residential Mortgage Backed Securitisation markets to fund a growing proportion of our lending.”
He gave a figure of about 37 per cent. by 2004. He continued:
“These funds have been raised increasingly abroad in Europe, USA and more recently in the Far East. Our wholesale funding had followed a similar trend and about 75 per cent. of all our new funding is now raised abroad.”
He went on to say, most conclusively:
“We do not believe this would have been possible had we been a mutual building society.”
In view of the consequences of the model outlined by David Baker, I am sure that investors in building societies throughout the country will be profoundly relieved by that statement, and I emphasise it because it is of particular importance that there are regulatory obstacles to building societies funding a proportion of their lending through the wholesale market. That has provided a protection and security to building societies that has not been so evident in the banking sector.
Mr. Mark Hoban (Fareham) (Con): Does the hon. Gentleman not remember a Bill that received Royal Assent last year at the behest of building societies to increase the proportion of funding that they could get from wholesale markets?
Mr. Bailey: I well remember the Bill; indeed, it was proposed by an Opposition Member, and I supported it in the Chamber. The Bill allowed greater flexibility to be exercised, but it also introduced an FSA regulatory process for wholesale lending to building societies, and it was never envisaged that that would reach the 75 per cent. proportion that was evident in Northern Rock. Whereas the situation is more relaxed for building societies than it was before that legislation, regulatory restrictions still apply to the amount that building societies can borrow from the wholesale market.
Northern Rock—its staff almost boasted of this—had “an extreme business model”, to use the FSA’s phrase. As I have said, it was disproportionately wholesale-funded. There was an absence of suitable insurance, and there was no plan B—no stand-by facility, whereby alternatives could be found if the existing sources of funding dried up. Ultimately, the blame for that must lie with the directors—the chairman, the chief executive and the non-executive directors—because they alone had devised that model, and in doing so they knew that they could aggressively seek new mortgages. The hon. Member for Twickenham (Dr. Cable) outlined some of the mortgages that they boasted of securing. Again, they boasted about them in the evidence that they gave to the building societies group. The fact is that they were using a model to borrow money to lend aggressively in mortgage packages that were somewhat doubtful and the sources of which were very vulnerable.
I mention that in particular because we have all been subject to shareholder pressure to get Government compensation. Indeed, one of the issues that must be examined is that of the Bank of England’s moral certainty and the belief that it should provide liquidity to underwrite bad business practices—or not. It seems to me that the fundamental stance of the shareholders is basically that it should, but the Bank of England took a hard-line position and it did not. My right hon. Friend the Member for Norwich, South (Mr. Clarke) supported that, as the issue of moral hazard is obviously crucial in the robustness of the banks’ business models.
Similarly, the Financial Services Authority has attracted criticism because although it recognised that the business model was extreme and inappropriate, it did not challenge Northern Rock either to change it or to provide an alternative source of funding, should things go wrong. Those areas of concern must be taken
up in any Government inquiry in order to understand what regulation, if any, is appropriate to change that approach. Ultimately, when it comes to compensation and the role of the shareholder, it must be that the balance of culpability for this fiasco has to lie with the directors and the company. The public cannot be expected to underwrite either through the Bank of England or as taxpayers the business decisions of a board of directors.
What should be done? With a spectacular failure such as this one, there is a danger of issuing emergency regulations that are just window dressing and provide no substitute for dealing directly with the actual problem. The hon. Member for Cities of London and Westminster (Mr. Field) might not have said that the whole thing was political, but he did emphasise the role of political decisions. However, neither his answer to my intervention nor the intervention of the hon. Member for Ludlow (Mr. Dunne) provided a very convincing basis for making that allegation. In respect of the comments of the hon. Member for Cities of London and Westminster about the local football team, I should make it clear, speaking as a resident of West Bromwich, that I am a Cheltenham Town supporter—and my team was considerably less successful on Saturday!
We need to ask whether the existing regulatory framework is sufficient and whether the problem was simply the result of its not being properly applied. I think that there is considerable evidence to demonstrate that most of the regulatory framework was actually in place and, had it been properly applied, it might have prevented the problem. Comments were made earlier about the small number of FSA staff who were charged with dealing with Northern Rock. I note that it states in this morning’s The Times that five FSA members have resigned. It seems that there is a problem with staff turnover. How far that contributed to the lack of adequate monitoring and supervision of Northern Rock, I am not in a position to say, but it is obviously an issue that must be addressed. There is little point in implementing a whole set of new regulations if those fundamental problems are not dealt with at the same time.
The second question is about the Bank of England and the balance of responsibility on the moral hazard. The refusal to provide the necessary liquidity in the market is said to have contributed to the problems, but the Bank’s overall responsibility for the preservation of the robustness of the banking system has also been emphasised. I believe that there is a debate to be had about that.
Mr. Mudie: Will my hon. Friend comment on the Bank of England’s behaviour in finding what every hon. Member in the Chamber thinks was the best solution—a market solution? Is there evidence of the Governor or any staff member of the Bank of England speaking to either of the two private sector firms that showed an interest in August, before the September collapse? Why is the FSA hit by such savage criticism when that sort of behaviour goes unnoticed and unquestioned?
Mr. Bailey:
My hon. Friend asks an interesting question. My understanding, bearing in mind that I was not on the Treasury Committee, is that there was conflicting evidence on that and that the Committee could not
come to a hard conclusion. If the Committee, having asked people the questions, could not come to a hard conclusion, I hope that he will forgive me if I duck the issue. I do not know the answer to his question, but the subject is perhaps worthy of further investigation.
The Committee went on to propose a range of other potential regulations or policies that would help to prevent such an event from happening in the future. They include deposit protection, pre-funding and insolvency procedures. Those need to be examined closely and the industry needs to be consulted. I am a little concerned, however, that much of the source of inspiration for those—the hon. Member for Hammersmith and Fulham (Mr. Hands) raised this issue—is the American model.
I was given to understand that about 10,000 financial institutions carry out banking functions in America, many of which are much smaller than institutions in this country. As a result, insolvencies are much more common and a process for dealing with those has been developed. It could well be that good, hard lessons can be learned from the procedures implemented there, but I would be a little wary of assuming that we can necessarily graft on to our own body of regulation regulations that are derived from a totally different financial services market, which has a far greater number of players and many more smaller players. I mention that as a cautionary note.
I underline and support comments about a communications strategy. They were well made. In today’s communications world, with 24-hour coverage, intense speculation about the smallest announcement, moves or sub-text within a balance sheet means that a coherent position has to be taken by the tripartite authorities when a problem is obviously arising. That is one of the problems that arose between 10 and 17 September last year. As a result of not getting a coherent message, media speculation was rife. That reinforced the natural sense of concern and worry of the depositors in Northern Rock and was a contributing factor to the queues that lined up outside that bank. There may well be a need for new regulation. However, that regulation must be proportionate and focused on the institutions where it is relevant.
To return to my comments on building societies, I would not wish a body of regulation designed to deal with possible problems from a Northern Rock-style financial model to be imposed on building societies, which are based on a totally different model. The danger is that a new regulatory framework could be introduced that might be relevant to current circumstances but could prove a big problem for perfectly sound, well-run companies that have delivered value for money for, in some cases, hundreds of years
In what will be a tighter and an illiquid mortgage market, we shall need to find whatever means we can of assisting the first-time buyer. If we introduced a set of regulations that might involve making the liquidity position of a range of financial institutions considerably more difficult than it is already, we could be working against our wider social objectives. There is a balance to be struck. I hope that the Government’s consultation exercise will be deep and probing, and that the outcomes will reflect that balance. I hope that they will secure
changes in regulation that are proportionate to the problem highlighted by Northern Rock without in any way damaging the wider financial services sector, particularly the building societies sector.
5.41 pm
Mr. Peter Lilley (Hitchin and Harpenden) (Con): I pay tribute to the hon. Member for West Bromwich, West (Mr. Bailey). He made a powerful point, to which the Government would do well to listen, about the dangers of producing a system of regulation that might have prevented the problem we have just experienced, but would create new problems for very different sorts of building societies. I also pay tribute to the Treasury Committee and its Chairman, the right hon. Member for West Dunbartonshire (John McFall), for the valuable report that provides the substance for today’s debate. It is slightly surprising, however, that it is the only substance for the debate.
Last time we debated Northern Rock we rushed through legislation, having been told that it was essential to set aside the normal process of parliamentary scrutiny so that steps could be taken rapidly by the new management at Northern Rock which would bring about a new situation. We expected those steps to be taken rapidly, and we expected some illumination to follow, although we were not given it at the time of the nationalisation debate. We expected to know more about the competition rules and regulations, and the approach that we would have to adopt. None of that has happened. We could have had proper parliamentary scrutiny at the time, but we were denied it, not because of the needs of the business but because of the desire of the Government to escape the embarrassment of prolonged debate.
I do not intend to pursue that point, however. Instead, I want to examine some of the factors underlying the problem of Northern Rock and the problems of the banking system, both nationally and internationally. Let me begin by mentioning a mistake which is so basic that no one in the Chamber has made or would make it, but which was commonly made by many commentators at the time when Northern Rock’s problems were exposed. They said “The problem is that Northern Rock has been borrowing short and lending long.” Well, of course it had: that is what banks do. If it had not borrowed short and lent long, it would not have been a bank.
It is intrinsic to the nature of fractional reserve banking that banks borrow short and lend long. Banks tell depositors that they can have their money back on demand or at very short notice, but in practice only a fraction of the people who deposit money at any one moment want it back, so the banks need keep only a fraction of the money liquid and in reserve. In normal circumstances, they will be able to invest long-term in less liquid assets. That is the nature of fractional reserve banking, but it is also why fractional reserve banking systems, although stable in normal circumstances, are potentially and intrinsically unstable.
If everybody decides they want to remove their money—as they have the right to do, and as the banks have promised them they can—they cannot do so because the banks only have a fraction of the money on reserve. We can draw an analogy with bridges: if people walk over a bridge in the usual random fashion
it might carry 1,000 people, but if all those people march over it in step, it will collapse. The banking system can operate if some people are putting money in and others are taking money out, but if they all decide to take money out, it collapses, as we discovered when people formed queues outside Northern Rock branches.
It follows that there are only two possible approaches. One is the extreme but rigorous intellectual one proposed by people such as Murray Rothbard, which I do not think has many supporters in this House—apart, possibly, from the right hon. Member for Holborn and St. Pancras (Frank Dobson)—which asserts that fractional reserve banking is intrinsically fraudulent and that it should not be allowed or sustained. As a result, banks would find that they had to keep 100 per cent. of their assets in liquid reserves and would cease to be fractional reserve banks. I would not propose that view, but if we do not accept it, we must instead have a lender of last resort who is prepared to step in and prevent a bank from failing if there is the remotest chance of that bank failure spreading to other banks and causing people to want to withdraw their money simultaneously—to march in step rather than put money in and take it out in the usual random fashion—and that must be accompanied by deposit insurance. I think that the Bank of England might momentarily have forgotten that intrinsically it has to operate as a lender of last resort, and have thought instead that moral hazard overrode that position so it had to let Northern Rock go belly up. That cannot be allowed to happen; the lender of last resort is so important that it must at times override the concerns about moral hazard to protect depositors and to prevent the contagion of other banks—but not, of course, to protect the shareholders. There is no obligation on the Government or central bank to prop up the value of shares; people have put their equity at risk, and they know that they can lose it—and, as we are aware, there are, of course, equity risks in other areas.
Although we must accept this fundamental nature of the banking system, while we are looking afresh at our banking and mortgage finance systems, we might also look at the experience of other countries. The right hon. Member for Holborn and St. Pancras mentioned a point that I have previously made: the Spaniards have demonstrated that if banks are required to consolidate all their loans and operations, which we elsewhere have allowed them to take off balance sheet, they are less likely to go down the road that has led to the sub-prime crisis in most other countries. We might also look at what happens in Switzerland, Hungary and some other countries where mortgage loans are generally required to match more closely the term of deposits and bonds. That may result in slightly more expensive mortgages over their life, if short-term interest rates are on average a bit lower than long-term interest rates, but it produces a more stable system. There is a case for examining more closely what happens in countries that require that and which do not seem to have had these problems. They also do not seem to have had as much housing market inflation as our system has had.
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