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Westminster Hall

Tuesday 4 November 2008

[Mr. Joe Benton in the Chair]

International Banking Regulations

Motion made, and Question proposed, That the sitting be now adjourned.—[Mr. Dave Watts.]

9.30 am

Mr. James Plaskitt (Warwick and Leamington) (Lab): It is a pleasure to serve under your chairmanship, Mr. Benton. I am grateful to Mr. Speaker for giving me this opportunity to discuss Government policy on international banking regulations, not only because of the experiences that we have all just been through but because we look forward to the meeting of the G20 in Washington DC on 15 November. This is a timely opportunity to hold what I hope will be a constructive discussion about the issues that are on the table for that meeting of world leaders and all the work that will follow, and I hope to hear something about what the Government’s approach will be.

There is no doubting the scale of the challenge before the G20 as its members plan the meeting. Clearly, it is huge. There is even talk of a new Bretton Woods. If one thinks about the context in which that system came about—it was almost the aftermath of the second world war—one can understand the scale of the challenge that is before us. There is some urgency to it, because of the remaining weaknesses and faults in the international banking system. It is clear that huge stakes are involved, not least because the leaders will discuss the future stability of the world’s financial system and, through that, the future prospects of virtually every nation on the planet. The rewards for getting a new regulatory structure, whatever it turns out to be, right are enormous, but, equally, the costs of getting it wrong are huge.

One thing at stake is what I call the regulatory culture. I do not think that there is now any question in anyone’s mind about the fact that there was a massive regulatory failure in the run-up to the culminating events in October, but the issue is what failed within that regulation. There are already competing views on that, and competing camps will converge on the Washington meeting later this month. Three views are emerging. One group anticipates that reform will lead to some grand new global regulator: one regulator, one set of rules, one set of enforcement proceedings. At the other extreme is the group that wants to stick to the do-it-yourself approach to banking regulation, leaving nations to work out their own salvation. Finally, there is a group coalescing around the middle that wants multiple systems of regulation but with some measure of co-ordination between them to ensure consistency across the different platforms.

It is evident that some of the leaders who will go to Washington will talk up the idea of a new global and interventionist form of regulation of the banking systems in different member states—micro-management, if one likes—but that others who are preparing to travel there are anxious to defend the light-touch regulatory approach. I believe that the United Kingdom Government are in
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that camp. They would take the view that the light touch of the past has benefited the UK by producing growth in the financial sector and thus making a contribution to the economy, but set against that is the question of whether it contributed to some of the problems that have exploded before our eyes. There is not a straightforward bipolar choice between the two options. It is clear that a tension underlies the debate, and I have no doubt that it will surface in the Washington discussions.

The first question is what exactly went wrong, and with the advantage of hindsight, it is now relatively easy to answer that. It is worrying that the regulatory systems that were in force did not call time on what was going wrong, or, if they did, that they did not do it sufficiently loudly or with sufficient weight to bring certain practices to a halt. The sequence is now clear: there was a steady decline in banks’ capital asset ratios. At the time of the Bretton Woods agreement that set up the broad framework that regulates the system, typical capital asset ratios were between 15 and 20 per cent. They have declined steadily since the 1940s and 1950s and are now down to about 8 per cent. That decline in itself need not have led to a catastrophic outcome, but it combined with other things that were happening to become a toxic mixture.

There were ever more complex financial instruments, many of them emerging from the application of new technologies to the markets; ever-increasing leveraging was used by the banks; more bank assets were packaged and distributed internationally; and, in many instances, the risk assessment attached to all of that was effectively outsourced to credit rating agencies that were remote from the actual world of banking. It is generally accepted that that combination led to the catastrophe in the banking system this year.

The extent of the leveraging was dramatic. The Bank of England’s financial stability report published in October showed that UK customer lending by the banks was equivalent to customer deposits in those banks as recently as 2001. By 2008, UK bank lending to customers exceeded deposits by £700 billion—about one half the size of the UK economy. That was a dramatic shift in just seven years, with most of the extra lending offered by UK banks to UK customers sourced from overseas money washing around the international banking system.

With the integrity of much of that funding uncertain, and the fact that its structure was not transparent, we can now see that the whole thing rested to a large extent on asset price inflation, which everyone surely knew could not continue uninterrupted for ever. I suppose that there was an intellectual realisation that that was the case, but it seems that nearly everyone in the banking system was carried away by the exuberance of asset inflation that apparently would not end.

David Taylor (North-West Leicestershire) (Lab/Co-op): I congratulate my hon. Friend on securing this debate on international banking regulations. He said that the structure is not transparent. Does he hope, as I do, that when our astute and highly regarded hon. Friend the Minister replies to the debate, she will refer to financial accounting standard No. 157, which was introduced in the US almost a year ago this week? It looked at the valuation of bank assets and put them on three levels, the third of which deals precisely with the collaterised debt obligations that brought to the surface the fact that
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sub-prime mortgages underpinned much of the American boom. That realisation triggered what we have seen during the year or so since. Perhaps we should be more open about the valuation systems that banks use which sometimes even they do not understand.

Mr. Plaskitt: I am grateful to my hon. Friend for making that point. He is absolutely right. Of course accounting systems and procedures are very much part of the suite of issues that must now be examined. I shall touch on that subject again when I come to the Basel accords, as there is an overlap between the point that he made and the issues that arise in that context.

I was discussing the asset price inflation that drove all the recent occurrences, and the chain of causality that began to unravel. It is now well known that the problems were initially exposed by the downturn in the US housing market, which in turn exposed the sub-prime lending that had been going on. Those issues were rapidly transmitted through the international banking system and led to banking collapses in some instances, as well as the threat of collapses on a wider scale. That in turn led to a crisis of confidence in the banking system, which in turn sent LIBOR spiralling, thereby producing the current global slowdown in economic activity.

All those events almost brought the international banking system to the brink of a catastrophic collapse, which was averted only by the concerted and co-ordinated action of Governments around the world injecting £3 trillion of resources into the banks. It is worth recording the scale of the losses, as is it known, although those figures may change as time goes on. Government intervention at the moment is designed to cover potential known losses in the UK banking system alone of some £122 billion; in the euro area, the loss is estimated at $784 billion and in the United States it is $1.57 trillion.

To return to the UK, the Government recapitalisation that I just mentioned, which averted a complete catastrophe in the banking system, has lifted the capital ratios a bit, from an average of about 8.5 per cent. to about 10 per cent. However, we learn from the Bank of England’s financial stability report that even at these levels, UK banks would still need to shed about £1 trillion-worth of assets—almost equivalent to the size of the UK economy—to get their leveraging levels back to what they were in 2003. That is a striking illustration of the extent of the problem and the degree to which that overhang is still there and remains to be dealt with, even after the banking rescues have taken place. That will only be done either by a very long-term correction, which would mean correspondingly tight credit and slow growth for a long time, or, possibly, even more state support on top of what we have already seen.

We also have to address the moral hazard question that has come about as a result of the Government intervention. Put simply, banks now know that they will be bailed out. What has long been suspected has been confirmed; they are too big to fail. Does that raise a question—I am interested to know what the Minister thinks about this—about the incentives for banks to behave responsibly in future, knowing, as they now do, that they are too big to be allowed to fail? The Government intervention, which was clearly the right thing—I am not questioning that for a moment—has brought into
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existence the concept of shadow equity which, in effect, is behind every banking institution and is funded by every taxpayer.

The next question, as I mentioned at the outset, is what exactly happened on the regulatory side and what can we learn from it. It breaks down into three sub-questions. First, who are the key players in setting international banking regulation? Secondly, were the failures administrative or systemic? Thirdly, how can the failings be corrected? The first and most obvious key players are the International Monetary Fund and the World Bank, which were brought into existence in 1944 under the Bretton Woods agreement. Those institutions were established to step in where markets failed and to mitigate the anticipated excesses of global capitalism. They were also designed to prevent beggar-thy-neighbour policies, which everyone meeting at Bretton Woods believed had contributed to the economic and political catastrophes of the 1930s. I am sure that they were right in that conclusion, but it is interesting to look at the IMF’s remit, because it reflects what the debaters at Bretton Woods were trying to prevent from happening again—their perspective was the need to avoiding the problems of the inter-war years. The IMF’s remit focuses heavily on trade and trade regulation, as well as on exchange rates, but it says little about preserving financial stability.

Looking at the history of Bretton Woods, there was an interesting argument at the time between those who wanted to bring out of the conference global institutions, global rules, global financial governance and, possibly on the part of some, a global currency—an interesting echo of the debate around the table in Washington later this month—and those who argued for sovereign independence for states in their banking and trading systems, but with the means of co-ordination and general oversight and with the existence of reserve funds to give support to countries in trouble largely as a result of trade deficiencies. That is a different context from the one that we now face.

I think that people can see structural weaknesses in the IMF. I raise that point because if the discussion is going to be about the IMF as a key player in the restructuring of the regulation of international banking, other questions need to be addressed before reaching that conclusion. The first problem with the IMF as currently constituted is that it is seen around the world as the advocate of the Washington consensus. The US dominance of the IMF as an institution is undeniable. The US is the only member of the IMF with a 17 per cent. vote on the board, and that 17 per cent. is crucial, because most major decisions taken by the IMF require an 85 per cent. vote and the United States alone has the veto. In addition, US influence over the IMF has been ramped up over the years. Every time the IMF wants to renegotiate the quotas it has to gain US congressional approval to do so. Congress, not unreasonably, poses ever more conditions as a quid pro quo for supporting the revamping of the quota system, so it has its hands on the IMF’s policy stance, and that is recognised around the world.

The IMF, in the present context, is seriously underfunded. Discussions are taking place, in which our Prime Minister is involved, to try to resolve its funding situation. However, even if the funding is sorted out, questions still have to be asked about the IMF as an institution and about its
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stance, because the Washington consensus is now damaged goods after the sub-prime catastrophe. One wonders whether the IMF will suffer reputational damage and whether that can be put right. It is not just about recapitalising the IMF; it is also about revising its role. People are calling for it to have an enhanced role in the supervision of international banking and to provide early warnings; to be a genuinely global supervisor and to have a strengthened brief on financial stability. All those things are needed—I do not think there is any question about that—but if any of that is to be achievable in a robust, sustainable way, there must be fundamental reform of the governance of the IMF. I am interested to hear what the Government think about that.

The second major institution that we have to consider is the Basel Committee on Banking Supervision, including the accords that have grown out of it, which was not set up by the G10 until the 1980s, long after the Bretton Woods discussion. The Basel accords eventually plugged the gap in the IMF’s remit, but they did so a long time afterwards. They have not come out of this saga very well either, yet a great deal of store is being set on their coming to the rescue of the international banking system. Basel I, the first set of accords, was long ago acknowledged as weak, which led to all the negotiations that ultimately resulted in Basel II, which is still advocated by many as the gold standard of financial supervision. However, the experiences of the past year show that Basel II, too, has fundamentally failed. Long negotiations led up to Basel II, throughout which the banks lobbied hard for a system based on two core principles: internal risk rating—the banks doing their own assessment of their exposure to risk—and low capital thresholds. In the negotiations that led to Basel II, the banks got both those things, so they really won again.

It is worth looking at some of the detail of Basel II, which allows banks with sophisticated risk-taking models—that is now most of them—to select their capital adequacy ratio from an la carte menu of options provided by the Basel Committee. Basel II also means that banks can use their own measures to determine their exposure to risk. There is no independent, externally verified risk measurement. The banks measure their own exposure to risk.

Basel II also allows the banks to allocate their risk weighting to each of their assets, including off-balance sheet assets. To read what the banks said when Basel II was negotiated gives the impression that they thought that they were moving into a world with a huge regulatory hurdle, but Basel II was the guidance that told banks that it was fine to reduce capital charges on lower-risk lending—that is Basel II’s phrase, not mine—which was defined as retail loans and residential mortgages. It is extraordinary that it said that it was okay to have lower risk protection on those loans because they were safe.

Mr. Andrew Pelling (Croydon, Central) (Ind): I entirely agree with the hon. Gentleman’s sentiments about the weaknesses of Basel II, but if there were a revision, it might be worth keeping one of the benefits—releasing the banks from the obligation of relying on oligopolistic suppliers of credit ratings—and having some discretion, because of the great failings of those American rating agencies.

Mr. Plaskitt: The hon. Gentleman makes an absolutely valid point. I am not trying to suggest that the whole Basel system should be dumped in the basket and
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forgotten. I am merely raising a suite of concerns about the content of Basel II, because I am worried that if world leaders, when they discuss re-engineering the architecture of banking regulation, assume that everything must proceed in the way that the accords previously proceeded, that will not be enough. That does not mean that there are not robust and important features in the Basel system, because there are, and they will want to retain them. I am pointing to the weaknesses, which will have to be addressed if we are all to have confidence in the new system, and if it is to be a permanent, not a temporary, fix.

I am running through some of the consequences of Basel II. Adam Applegarth cited Basel II compliance when he told the Treasury Committee last October that it was fine for Northern Rock to increase its dividend rather than to shore up its capital. He said that that decision was based on the regulations implied by Basel II. The accord’s weaknesses have also been identified by the Bank of England in its financial stability report, which points to the weak treatment under Basel II of trading book assets and risks relating to off-balance sheet exposure. Many analysts argue that if Basel II were fully implemented, it would lead to lower capital asset ratios—even lower than the average 8 per cent. that it envisages.

Despite that, the Basel system in general has many advocates, and many of its features are perfectly respectable, but important institutions around the world still address the current issues of banking regulation using Basel II as the platform on which to build everything. For example, the European Commission proudly cites Basel II as the foundation on which it is writing its capital requirements directive, which is currently being debated by MEPs. Further refinements are being made to Basel II, some of which were set out in documents published in September. They call for regular stress testing, ensuring the alignment of risk-taking with liquidity exposure, and maintaining a cushion of quality liquid assets as insurance. Those are welcome reforms, but they are based on the core principles of Basel II, some of which are now exposed as fatally weak. It is worth remembering that the Basel accords are not law; they are simply guidance. They have no direct enforcement mechanism, and are entirely dependent on the interpretation of each country’s central bank or regulatory authority. Nor is Basel II’s remit comprehensive enough to embrace all aspects of the toxic mixture of banking practices that have imploded.

That tour of the institutions is the main part of what I want to say. It is relatively easy to agree a list of weaknesses: inflated balance sheets, assets of uncertain value, complexity of new instruments, dangerously high levels of leverage, too much dependence on wholesale funding, dangerously low capital asset ratios, and insufficient understanding of the level of global interconnectivity between the different practices and instruments that banks have introduced.

David Taylor: Will my hon. Friend add to his list of problems the fact that all the banks that failed in the US, Britain and the EU had a clean bill of health from auditors who were dependent on those banks for their appointment, fees and other income? Should we not have a more independent process? For example, PricewaterhouseCoopers charged Northern Rock
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£2.4 million in 2007, of which £1 million was for consultancy. How can those auditors—other examples proliferate—be as objective as they need to be in the interests of depositors and the economy?

Mr. Plaskitt: I anticipated that when I reached this stage of my speech other hon. Members would want to add to my list. I do not disagree with my hon. Friend, and I am happy to take on board the point that he made. Whatever is on the list and whatever anyone wants to add to it, it points in its sum to systemic failure on the part of regulators. In reply to my first question on whether the failure is administrative or systemic, the evidence points more to systemic failure.

Regulators did not, or could not, keep up with the pace, extent and technical nature of changes in financial markets. They did not have the right tools for the job. It is relatively easy with increasing hindsight to agree on what is needed. Hon. Members may want to add to this list, but I shall give my requirements: timely early-warning devices, higher levels of transparency across the system, more cross-border supervision, counter-cyclical instruments, and re-engineering of risk measurement and management. How that can be done is the hard question. The main tools in the box are the International Monetary Fund, the World Bank and the Basel accords, and beyond that the interpretations by a host of different regulatory systems of what those accords say. However, they could also be described as the major contributors to the 2008 financial disaster.

I said that aspects of the matter are urgent, and in seeking an urgent response, there is a tendency to grasp the tools to hand. Clearly, there is urgency about the agenda, but in seeking to bring about a new global regulatory framework, there is a necessity for a great deal of reflection and careful building because there is so much at stake, but that calls for time, so there is tension in the discussions between time to get this important matter right, and the urgent need to avoid further calamities. That is a key tension, and I am sure that it will be a feature of the discussions in Washington and the follow-up work.

It is not easy from our perspective to know how those tensions in the system will work out, but it is important that Parliament considers, and engages in, the issue. That is all I am trying to highlight today. I hope that it will give the Government an opportunity to say more about their thinking as they prepare for the Washington meeting. If it will help the Minister, I will collapse all that I have said into three basic questions. What is the Government’s analysis of what went wrong, and does it match mine? What are the key components of any new global regulatory architecture that is fit for purpose? Can they be securely based on existing institutions, or does a workable reform require us to conceive new institutions for global financial governance?

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