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4 Nov 2008 : Column 13WH—continued

The current situation is indeed dire. Getting back to prudent levels of capital ratios will be extremely painful. If we are not careful, the so-called nice decade will be followed by a very nasty decade, and heading it off will be difficult. Although international regulation is clearly important, domestic regulation is vital. I suspect that it may be much more difficult to get international agreement, but each country ought to be clear that it is important to get its own regulations in place. The Banking Bill now being debated in Committee is a good attempt to get some of these changes on board, but I do not believe that it is necessarily the final solution. As I said, the warning signals were there in Northern Rock, Bradford
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and Bingley, Lloyds TSB, and HBOS and RBS. However, they were not heeded, not picked up, not acted upon.

There seems to be a sort of paralysis, with each country doing its own thing domestically unless it fits in with some international regulation. I fear that if we wait for some sort of international consensus we will not be able to put our as much of own house in order as we should. Delay is dangerous. Although international co-operation and regulation are important in harmonising our efforts, we should not divert our attention from putting our own regulatory structures in place.

Urgency is the key, and the forthcoming meeting in Washington will be extremely important. Examination of the roles of the International Monetary Fund and the World Bank will put the system under pressure. There appears to be a need for fundamental change. I will be interested to discover what approach the Government are taking and what their solutions may be, as they join those discussions.

I believe that two major issues must be tackled—those things that have changed so significantly in recent years. The first is the international operation of banks generally; their enormous size enables them to straddle all sorts of markets, and we need to regulate them effectively across the globe. The second is the variety of activities that those global institutions now undertake, of which banking is only a part. For instance, they deal in insurance and have all sorts of financial departments and sections. In a way, it is that combination of relatively recent factors that have exposed the current regulatory system to failure.

We have not grasped the significance of the increased internationalisation of banks, and we have not grasped the importance of their expansion into all sorts of new areas and the creation of all sorts of instruments. Things have reached the point where we are floundering around trying to find a way to regulate and supervise the system. That prompts the question—and this is the other side of the coin—about whether the regulators should try to grab hold of the banks’ coat tails as they move out into new areas of financial instruments and global operations, or whether we require the banks to reorganise themselves so that they can be more effectively regulated.

We recognise that banks are not the same as any other sort of commercial operation; they are clearly important for the world economy and we require them to act in a certain way. However, if they have constructed themselves into entities that are almost impossible to regulate and supervise, should we not seek ways in which they can be de-aggregated or split apart rather than centralised, so that we can look more clearly at the differing requirements of their individual activities?

Basic banking on the high street is significantly different from the derivatives market in capital terms. However, 99 per cent. of people in this country who require an ordinary, basic banking service from their high street bank, perhaps with a mortgage attached, have great difficulty in securing a new mortgage or obtaining loans for a small business. That is purely because of the activities in another part of that large bank, which have caused these failures. Is it time to look at such mega-institutions and realise that effective supervision, control and regulation is simply not possible under their current construction?

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If the international community is going to be the lender of last resort with the bail-out provided by the taxpayer, it should require banks to change the way that they operate and de-aggregate some of their activities. We need a fundamental reassessment of the way that current banking operations work internationally. If we look at the current size of enormous banks and their range of activities across many different countries and regulatory systems, I severely doubt that we can be sure that we will not encounter a similar situation in around a decade’s time. It is time for a new approach.

Mr. Plaskitt: I am grateful to the hon. Gentleman for taking an intervention, as he is coming to the end of his remarks. Does he agree that there is a certain historical circularity about this? There was a time when banks were legally obliged to operate in separate spheres. I think particularly of the legislation that was passed in the United States after the great depression, and the Glass-Steagall Act that prevented banks from crossing the line that the hon. Gentleman mentioned, and doing retail banking as well as other things. Do present circumstances suggest that perhaps it is time to revisit the issues and the debate that took place when that legislation was repealed, and see whether something similar needs to be introduced and whether that would in fact be possible?

Mr. Breed: I thank the hon. Gentleman for his intervention. That is exactly what I was suggesting. What we have allowed to happen so quickly and over such a range of different issues means that our somewhat shaky regulation is now totally out of place. I wonder whether we should be looking at some of the older models.

The financial services compensation scheme was never designed to bail out a huge high street bank. It was intended for smaller operations that might fail due to poor lending decisions or a structural problem—the big banks would put their hands in their collective pocket and bail such operations out, as they did not want a systemic failure. Can we consider a financial compensation scheme that will require pre-funding for the sort of potential problems that might occur with another RBS? It is almost unthinkable. Investment banks have been allowed to leverage up to such an enormous extent that it has put under pressure their normal banking business, which affects so many of us. The irony is that those who have supported their local bank with their business are the very people who have to put their hands in their pockets through their taxes and bail out the other part of the bank. It is untenable, and we must revisit the idea of separation rather than continuing with the current aggregation.

10.35 am

Justine Greening (Putney) (Con): I would like to start by congratulating the hon. Member for Warwick and Leamington (Mr. Plaskitt) on securing this vital and timely debate. As has been mentioned, his contribution was thoughtful and articulate, and I thank him for giving us the opportunity to debate the issue. He was right to focus on his hypothesis about what went wrong, which largely centred on the banks but included the regulators and the regulatory framework.

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A further aspect that I will mention before moving on to the substance of my remarks, concerns those Governments who, with the amount of credit that was being pumped into the economy, saw the short-term benefits from greater spending and apparent economic growth. It was difficult for Governments to call time on that, which perhaps challenges the point raised by the hon. Member for Croydon, Central (Mr. Pelling) on where the responsibility should lie.

There is no doubt that underlying all of this is the importance of the financial services sector, particularly to our country, but also broadly across the world. Britain is no different from any other country in that the financial services sector is the financial heart that keeps the economy going. Over the last year and a half since the credit crunch first hit, we have experienced a form of financial heart attack that is now having painful effects on the broader economy. When the capital adequacy rules, which were meant to ensure that banks, credit institutions and investment firms had a minimum capital base in order to protect them against such risks, were stress tested, they failed the test. The crisis that we are debating has shown up our flaws not only at home but internationally.

Let us look at our home economy and at what has happened and gone wrong. The Opposition are working with the Government on the Banking Bill, which should address some of the issues that have come out of our own experience. The reforms in that Bill, which will enable banks and regulators to act sooner through the special resolution scheme, will be important. It will be easier for authorities to rescue banks that have got into trouble by using the bank insolvency procedure. That will enable an orderly wind up and will be of benefit. Behind that is the issue of the tripartite approach. When the hon. Member for Warwick and Leamington was speaking, it struck me that in a sense, the question we face in Britain is the same as that faced the world over, although at a different level.

In Britain, one institution, Northern Rock, was challenged and essentially went down. It had been looked after by the Financial Services Authority as a single bank, but it ultimately posed a systemic risk. The problem with the tripartite scheme was that that broader systemic risk was not picked up and addressed rapidly enough by the Bank of England. At the international level, if there are stresses in one country—Iceland, for example, or the United States where the problems started—it impacts across the world. A similar challenge is understanding how one localised problem, whether a bank within an economy, or a particular economy within a global system, will impact overall and what difficulties will occur.

One measure that we have proposed, which would address one of hypotheses raised by the hon. Member for Warwick and Leamington about the inflation of banks’ balance sheets, is for the Bank of England to have oversight on debt and credit levels in the overall economy. In terms of responsibility for flagging up problems or having an early warning system, as the hon. Member for South-East Cornwall (Mr. Breed) has suggested, there is no doubt that giving the Bank of England a remit to look at overall levels of debt and credit flowing around the economy would be a welcome change. The Bank could make regular reports to the FSA, which could look at how that overall risk might
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impact on individual institutions. Obviously, some of those issues were addressed, as the hon. Member for Warwick and Leamington has said, by the Bank of England’s financial stability report last month.

Even so, setting aside some of the more domestic difficulties that we have faced, reforms clearly need to take place at the global level. As the hon. Gentleman has said, we have relied on the Basel accord and the Basel II reforms when it comes to capital adequacy rules. However, in practice, that has caused problems—we can see that simply by looking at what happened. We can look at the theory and have an intellectual debate, but the adequacy rules have demonstrably not provided a sufficient guarantee against banks failing.

I should like to touch on some key aspects of that—I know that the hon. Gentleman wants to listen to the Minister’s response to his questions—the first of which is the fact that liquidity risk was possibly ignored too much. Therefore, banks that had very low liquidity, such as Northern Rock, were still able, as the hon. Gentleman has said, to stay within the rules. That is clearly a problem. We need also to look at how the existing rules can lead to what seem to be sub-optimal or dysfunctional asset allocation, for example, because of zero-weighting of AAA-rated assets.

The hon. Member for South-East Cornwall has mentioned forcing banks to compartmentalise their operations. I understand why he takes that view, but I wonder whether it would not be jumping to a solution too quickly. Banks could be compartmentalised into retail and investment banking for example, but, actually, the genesis of the problem was ultimately in retail banking and mortgages. When we look at the problem, we see that there was a bad understanding of risk—we keep coming back to that. It is therefore about understanding the reality of risks faced by, and capital structures of, the banks concerned.

Mr. Pelling: Was not the real problem the avarice of banks, which determinedly pushed out securitised obligations that were not properly checked? Many of the tranches were given automatic AAA-ratings, so senior management and investors did not really look at the detail of the real risks that they were taking.

Justine Greening: The hon. Gentleman is, of course, right. I have set out some aspects of the problem, but a range of things went wrong collectively to lead us to today’s situation including, of course, the ability of the credit rating agencies and the way in which they rated some of the debt when it was being packaged and sold on. It seems that because of the way in which the credit rating agencies are incentivised and how their businesses run, they signed off more debt, which is part of the problem that we are dealing with. That, combined with—I am sure that banks would challenge this—an excessive reliance on the risk ratings given by agencies, as has been said, may appear as the sub-contracting of risk assessment to outside agencies. If such ratings are done as an independent check, and if ratings simply validate an internal assessment of risk, they can be of benefit. However, there is no benefit if there is no internal initial assessment of risk.

Overall, market risk was not effectively measured. We had backward-looking models that looked at what had happened. Clearly, nobody is ever more sure about a
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trend than the prevailing market wisdom the day before the trend stops. There was a growing certainty about the continuation of asset price inflation. That raises the question of introducing rules that are more counter-cyclical when it comes to credit and capital adequacy, rather than the pro-cyclical environment in which we found ourselves.

Transparency was part of the problem. Consumers will, in the coming years, be far more willing to ask whether a bank is a sound financial institution. The big thing that we have not talked about today is how the public will view banks—they may be far keener to see financial information on banks with which they plan to make debt, mortgage or savings transactions. That could be one of the more fundamental—and helpful—changes. A critical consumer eye could now come into the equation, alongside any regulatory reforms that might be introduced.

A final caveat is that we must be careful that we do not use a regulatory-reform blunderbuss to tackle the problems. There are several problems, and we therefore need a more sophisticated approach than saying simply, “Let’s have more regulation.” Rather, we need smart regulation. If we look at the recent US experience of the Sarbanes-Oxley legislation in response to Enron, we can see that inappropriate, heavy-handed regulation often does not achieve its objective. We need to be careful that we do not go down that route, and it is especially important for us to be watchful.

Obviously, there will be a new US President this week, and we must carefully ensure that we work at an international level. The Prime Minister has pointed out that we will need leadership from the US to navigate us through these challenging times. Up to now, we have had a vibrant financial sector in the UK, which is important to our economy in terms of jobs as well as providing its lifeblood. We need to ensure that any reforms do not unnecessarily hinder competitiveness without providing more financial stability. We do not want to jeopardise our financial sector’s future success and growth, and we have to get it right first time.

We need to find a blend between international co-operation and domestic reform. There is no doubt that a one-size-fits-all regulator would be an excessively constraining and over-the-top response. We need something a little more sensitive than that—something that results more from co-operation. It is clearly in the common interest to achieve co-operation in new reforms, rather imposing something on countries. We need to get this right. As the hon. Member for Warwick and Leamington has pointed out, the challenge is momentous and immediate, and we need to rise to it. Clearly, over the coming months, we will focus on it and, hopefully, get it right first time.

10.48 am

The Exchequer Secretary to the Treasury (Angela Eagle): I should like first of all to congratulate my hon. Friend the Member for Warwick and Leamington (Mr. Plaskitt) on his great foresight and timing in managing to get a debate on this crucially important topic. We have had a fascinating glimpse in the debate of the complexities of the issues with which we are dealing. That gives a great deal of credit to my hon. Friend and to everyone who has contributed.

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Current international financial conditions are unprecedented. In addition to the work that the Government are doing domestically to restore faith in the banking system, there must be a global response to what is a global economic crisis. My hon. Friend mentioned Bretton Woods and Basel, and I will deal with both, but he was right to bring them to the attention of the Chamber. The Bretton Woods framework of 1944 reflected the determination of leaders and economists such as J. M. Keynes to avoid the disastrous economic nationalism that led to the great depression and which helped lay the groundwork for the rise of fascism and ultimately the calamity of the second world war. In the decades since, the Bretton Woods institutions have been a key element both in supporting international co-operation and countries that have been hit by negative shocks, and in providing the long-term financing and assistance necessary for sustainable growth. At the same time, the way in which the institutions work has certain drawbacks. As my hon. Friend pointed out, they are anachronistic in many ways and reflect a different world. If I have time, I will outline how the Government intend to approach the reform of such institutions.

Over the years, we have added to the Bretton Woods framework. In the mid-1970s, the Basel Committee on Banking Supervision was created to set common standards for financial regulation around the world. Following the Asian financial crisis, we created what is now known as the G20 to bring together emerging markets and developed countries to address the serious economic problems of the time. In the late 1990s, we created the Financial Stability Forum, which has improved the quality of banking regulation and promoted a more international approach to financial market developments. Nevertheless, recent events have confirmed that the world economy has changed irrevocably. The Bretton Woods framework was created for a world of 50 relatively sheltered states. We must now consider whether it is time for another wave of reform—I think that the case for that is overwhelming—to create a global financial system that is fit for a modern and more interconnected, globalised, IT-driven world. We must do so while we continue to address the immediate effects of the ongoing financial crisis at home and abroad. Effectively we need to do both things in parallel, and that approach has been reflected in all of the comments in our debate.

The turbulence in international financial markets has the potential to affect every country around the world, so a co-ordinated international response is required. We need national action, but that will not solve the problem on its own. National systems of supervision are simply not in an adequate position to respond to the huge cross-continental flows of capital in this different, more open, more globally interdependent world. The first step has been taken to stabilise market conditions. The British Government, as part of a co-ordinated international effort, have taken rapid and well-targeted action to recapitalise the banking system. The Bank of England has doubled the amount of liquidity that it provides to banks, and we have guaranteed new lending between the banks so that we can get lending working again. That action has strengthened confidence in the banking system, put financial institutions on a firmer footing and provided support for the real economy.

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