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All that investors in the global market ask is to be given free rein to choose their investment managers. Instead, the proposed brave new world for hedge funds and private equity risks forcing EU-based investors to abide by a system of rules whereby they will have to instruct EU-based managers and place their assets in EU funds. A more sensible approach would be to examine how and why hedge funds became so powerful so rapidly. Perhaps the homogenising of mainstream institutions in the financial sector as a result of interdependencies and the converging effect of regulatory creep gave rise to the demand for a new diversity of off-balance-sheet methods to manage assets and credit. In particular, in the aftermath of the Enron scandal a decade ago,
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stricter regulations that were introduced to control off-balance-sheet activity simply resulted in an explosion in special purpose vehicles, which were created to bypass a culture where stifling regulation presented a massive competitive advantage to those institutions able to reap the benefits of economies of scale.

I am not here to bury hedge funds, but equally I would not give them untrammelled praise. There is little doubt that the emergence, in reaction to regulatory overkill, of a largely unpoliced, unsupervised hedge fund sector had significant distorting effects on the entire financial system. Additionally the huge, largely unregulated profits derived from the most successful hedge funds had a perverse effect on the strategies employed by investment banks whose profits could never emulate those obtained in the tax-free, "regulation-lite" regimes enjoyed by the funds. As those profit margins became ever more the talk of the City half a decade or so ago, unrealistic expectations of compensation were ratcheted up.

By 2004, senior banking executives watched enviously as hedge funds' profits soared and the brightest and best of their junior staff were poached to make their fortunes in those funds. In retaliation, many leading investment banks elected to allow the emergence internally of "virtual fund" teams specialising in the riskiest but potentially highest-return sectors. More often than not, such star teams negotiated and were granted special shadow profit-sharing status internally. I must accept that that proved to be the worst of all worlds, giving those teams the green light to indulge in relatively unprecedented risk-taking, all the time underwritten by the banks' colossal balance sheet. That seemingly safe umbrella encouraged ever greater leverage and the spectacle, even in the good times, of such a small proportion of banks' profits being retained. Naturally, that strategy was questioned only after the credit crisis exposed the folly of allowing an inherently riskier culture of hedge funds to pollute the banking system.

I am glad that I have had the opportunity to speak at some length, and want to conclude with this thought on hedge funds: it is right for policy-makers to engage intellectually with the proposition that the rewards and super-profits should be justified only in return for exceptional performance, rather than as an arbitrage for tax and regulatory breaks; but that requires a much more systematic analysis than the European Commission has provided of the structure of the financial services sector. Scapegoating hedge funds and the private equity industry cannot be a sensible first step on that path.

3.25 pm

Dr. John Pugh (Southport) (LD): I congratulate the hon. Member for Selby (Mr. Grogan) on securing the debate and keeping us on our toes by leaving us marginally uncertain as to its exact title. I thank him, too, for sharing his 10-point plan with us. Why he is not Chancellor of the Exchequer I do not know. I assume it is because he is far too cheerful.

Down this end of the Chamber, we have a caucus of northerners-or we did have when the hon. Member for Pendle (Mr. Prentice) was here-but none the less we have no doubt about the importance of the City and the financial sector to the UK and world economies, the British balance of payments and Government revenues.
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It is critical. We also have no doubt that that is built around a degree of integrity, probity and good regulation, connectivity with the rest of the world, length of experience and downright financial skill. We can, I suppose, praise that without necessarily overestimating it. I sometimes get very big brochures sent to me by the City of London, telling me how it pretty well accounts for most of the UK economy. I am never quite certain whether the information includes all businesses with a head office in London as belonging in the City, or whether it estimates appropriately the substantial economic contribution made by London outside the City. It is also worth mentioning in passing that certain cities, such as Edinburgh, have proportionately-though not in size-a bigger financial sector even than London's.

We should not, however, underestimate the importance of the City. Look at what goes wrong when things go wrong there. We suffer in our constituencies and across the land. There has been a long and heated debate in the north and throughout the country about the relationship of the City to the wider economy, and in particular the relationship between manufacturing industry and commerce and the City, manufacturing generally being something rather grim up north and City life being something rather sophisticated down south. A refrain that has gone on for decades-as long as I have been thinking about the economy and politics-is criticism of the City for a degree of short-termism and for being attracted by property rather than production, services rather than sustainability.

This is a slightly artificial debate, and all sorts of qualifications are needed, as well as recognition of the positive role that the City has played in the economy as a whole. However, the picture for most of our lifetimes has been of the growth of the services and financial sector in the economy and the decline of the manufacturing sector, even below EU levels, and even given our acceptance of the fact that we all have a problem resisting the modern challenge of China, India and the like. Coupled with that has been the rise of new financial giants. We have mentioned some of those: hedge funds, private equity and venture capitalists within and without the banking sector. It is easy to see it, sometimes, in terms of a further tilt away from the long-term investment in which the mutuals engaged and long-term investment in general.

I know that there are some pretty solid defences of current City fashion, and the hon. Member for Cities of London and Westminster (Mr. Field) did a good job of presenting such defences. I, too, have read the handouts from private equity houses and organisations that emphasise that they are not a bunch of shameless asset-strippers, as they are sometimes characterised by people who do not qualify their remarks sufficiently, and that in fact they re-engineer companies, reconfigure them and in some cases provide more employment and certainly greater profits. I know too-it is a perfectly valid point that has been made several times in the debate-that they are not responsible for the credit crunch. That was the result of very traditional high street banks, which formerly nobody was agin, behaving rather badly and uncharacteristically, in a way that suggested more than a flirtation with casino-type finance. The hedge funds, on the other hand, have had very limited interest and
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involvement in the mortgage market. However, it has to be said-it was mentioned, I think, by the hon. Members for Selby and for Cities of London and Westminster-that hedge funds did play a part in accentuating financial panic because they are such big players and deal in bank shares, often at critical moments and often with money borrowed from the banks.

If we want to avoid the evils that have beset us recently-the frauds, the Madoff affair, which was essentially a hedge fund affair, the foolishness that has characterised patterns of investment, and the instability that has been all too prevalent recently-we cannot duck the problem of regulating the new financial giants. We cannot back away from that. We must consider the possibility that something needs to be done if not because those organisations are responsible for the past but because, as the hon. Member for Selby said, there might be problems in the future, particularly given the fact that these giants are moving huge amounts of money around the globe and they are relatively opaque financially. They are big players that add enormously to liquidity, which is often said in praise of them. However, they engage in aggressive market behaviour while, ultimately, bearing few of the social costs.

When we talk about hedge funds, we have to put it on the record that 50 per cent. of them, for whatever reason, are situated offshore in places such as the Cayman Islands. I am not saying that they are in league with the pirates of the Caribbean, but we would prefer them to take their fair share of social responsibility, particularly as they have a powerful social effect. I recognise that many operate onshore in the USA and the UK, but they should be prepared to pay up in tax terms for the advantage of working in a well regulated economy. That said, it also has to be pointed out that last year, according to my figures, hedge funds alone paid £3.2 billion in tax revenue, which the UK can scarcely do without at the moment.

I do not want to be generally damning because if we look into what a hedge fund is supposed to be, we would find that the definition is a little more fluid than one might expect. There are different kinds of beast under the label of hedge funds. The French do not use the words hedge fund; they use the expression "fond spéculatif" because not all such funds hedge. The case for a degree of regulation beyond self-policing is quite strong, but the extent of that regulation is the issue. Fundamentally, we all agree that we want to secure the economic advantages that the funds bring, but we also want to ensure that the social benefits are provided, too. As the hon. Member for West Suffolk (Mr. Spring) said, it is a matter of balance and getting that balance right.

I put it on the record that it is not a straightforward equation-that the more regulation that we have, the more capital flight we will get. Mention was made of the Indian financial market, which is regulated much more restrictively than the British markets at the moment, but is still attracting significant capital and investment. There is a debate to be had and Mr. Rasmussen, if nothing else, has started it. He has the Mayor of London going, and there are all sorts of views about whether or not this is a Euro-plot against the British hedge fund industry, which accounts for 80 per cent. of the European total. Nevertheless, the debate is well worth having and should be conducted in a relatively mature way. The insurance companies are having another sensible
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debate about solvency. To some extent, there has not been a great deal of discussion about the type or quality of debate. In this place, we have talked more about who is to regulate, and not how people are to regulate.

The bottom line for me as a northern MP, whatever regulation or fiscal policy we have, is that we must move away from short-termism, or make regulation much tougher. Moreover, we must move the economy in the direction of sustainability in financial and economic terms and not encourage an environment of the fast buck.

I shall close with a little story that encapsulates the debate. I hope that the hon. Member for Cities of London and Westminster will sympathise with the plight of the company that I describe. I represent a seaside town which for decades had a profitable sweet factory, making a product called Chewits. I did not eat it much myself, but it sold well at the seaside. I went to see the company when it was in process of retooling; it was profitable and doing rather well. It employed people who had to operate at a relatively skilled level and it provided a good mix of employment. It was then bought by a City company. The machinery was sent to eastern Europe, the skilled work force was sacked, the job mix in the town was worsened, the carbon footprint of production was increased and the land was sold for housing. The UK economy did not benefit, but profit was made in the City. That may be the operation of a free market, but I question, in those circumstances, whether it is wise.

3.35 pm

Mr. Mark Hoban (Fareham) (Con): I congratulate the hon. Member for Selby (Mr. Grogan) on securing the debate, even though it had a changing title. As my hon. Friend the Member for Cities of London and Westminster (Mr. Field) and the hon. Member for Southport (Dr. Pugh) said, it was until relatively recently entitled "The Impact of the Hedge Funds on the UK Economy" and we had all geared up for that. None the less, the broadening of the title gives us the opportunity to make some more wide-ranging remarks about the City.

I will, if I may, be critical of the hon. Member for Selby, who used lazy shorthand in the title of the debate. He will have offended people who work in Canary Wharf or in the west end, and people who see themselves as part of the financial services sector but who are not located in the City. He has also forgotten about the people in Whitely, just outside my constituency boundary, who work for Zurich Financial Services, and the 300 people who work in the Lloyds Bank call centre in my constituency. They are all part of the financial services sector, as indeed are the staff of banks and insurance companies and the stockbrokers who are dotted across the whole of the UK.

When we talk about the size of the financial services sector and the contribution it makes to the UK economy, we should remember that it is a sector that is based across the whole country and not just in the Square Mile. We must be careful to remember that because it represents a means by which the financial services sector can start to re-establish trust with people by reminding them that it is an integral part of our lives. The debate about hedge funds and the activities of the people in the
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City and the insurers remind us that they have an impact on our lives. Today, we have talked about hedge funds in a bit of a bubble, but who are the investors in hedge funds? It is not just high net worth individuals; it is our pension funds. Two thirds of the investment in hedge funds come from pension funds, including that of the Church of England. There is therefore a direct relationship between the returns that they make in those funds and the benefits that we enjoy in our pensions. We cannot view the City in isolation, and nor should the City or the financial services centre think of itself in isolation from the rest of the economy.

The hon. Gentleman had a 10-point plan. I will not go through each of the 10 points, but I want to pick up on a couple. Bonuses, for example, are an important issue for people to understand. Over the course of the past two years, the taxpayer has supported the banking system through the stakes taken in RBS or Lloyds, which we supported, and the indirect guarantees and indemnities that are on offer to the financial services sector. The current stability of the banking system is a consequence of taxpayers' support, not just here but across the world. That support was given to help its balance sheet and not its bonuses, and banks must remember that as they come into the bonus round over the course of the next few months. The bonuses are a product of taxpayers' support and they should not lose sight of that.

On the hedge fund directive, which both the hon. Gentleman and my hon. Friend the Member for Cities of London and Westminster discussed, we must remember that it is not just about hedge funds. It is the alternative investment fund management directive and it affects hedge funds, private equity and endowments. The Wellcome Foundation and the endowment of Oxford university are affected by it, as well as the funds in Germany that are used to finance wind farm investment. Most Latvians find the finance for their houses through funds and they will be affected by the measure, too. What is happening across Europe is that people who thought carelessly that the measure was just about those nasty big hedge funds are now realising that it has much greater impact.

Why are hedge funds attractive? It is because people want to invest in them and they want the returns from them. However, I think that some people feel under pressure from hedge funds, whose activist nature creates and promotes change in financial markets and economies. In some economies, people are reluctant to accept that change is a good thing in that way.

Some people think that there is a zero-sum game here for Europe-that by introducing tougher regulation on hedge funds, Europe will see business moving from London to Frankfurt or Paris. However, it will not move to Frankfurt or Paris. That business will move outside the European Union: it will go to Singapore, Geneva or New York. The regulatory drive in Europe risks making Europe uncompetitive and forcing jobs and business not out of London, but out of Europe. That is an argument that we need to make, not just here in Westminster but in Brussels and in other European capitals.

There is another lesson that we should draw from the hedge fund directive. When the directive was being drawn up, the Government failed to recognise the wider impact that it would have. I think that Lord Myners is
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rectifying that, but it would have been far better if the Government had been engaged much earlier while the directive was being thought about, rather than just waiting until it was published. Can the Minister tell us if the Chancellor of the Exchequer spoke to the Commission the week before the directive was published, because I understand that the Chancellor's French and German counterparts did? It would be helpful to know if the Chancellor was able to put a word in to stop the directive from being published. It seems that the French and German Finance Ministers were rather more successful in getting their views known.

Mr. Grogan: Just to be absolutely clear, the hon. Gentleman suggested that the Chancellor should have stopped the directive, so is the position of the official Opposition that there should not be a directive at all? What is the position exactly?

Mr. Hoban: There needs to be proportionate regulation of the sector, which recognises the risks and responds to them. My hon. Friend the Member for Cities of London and Westminster talked about the Financial Services Authority. The FSA has been very effective in regulating hedge funds, because the regulation is proportionate to the risk. The directive, as it is currently drafted, is not proportionate to the risk. It is a rather muddled document. Furthermore, because of the lack of due process in putting it together, the costs of the directive could potentially outweigh its benefits. We want proportionate regulation that reflects the risk that these funds pose, not regulation simply for the sake of it.

Let me speak briefly about the wider financial services sector. Clearly, the actions of certain banks and financial institutions created the financial crisis that we see today. There was a failure to recognise the risk that certain financial institutions took on through the way that mortgages were sliced and diced and repackaged into collaterised debt obligations, or CDOs squared, tripled or even cubed. There were complex transactions that meant that there was a loss of understanding between the product that people bought and the underlying mortgage.

There was also a failure to understand the risk attached to these instruments. I do not know what other Members read on their holiday, but "Fool's Gold" by Gillian Tett is a book on the subject that is well worth reading. She sets out in it how little some banks understood about these instruments when taking them on. Their creators-JP Morgan-actually took on very few of them and came through the financial crisis in good shape.

Mr. Mark Field: I have a suggestion; in many ways, it is a "back of the envelope" suggestion. It is that unless the senior directors of a bank can explain, within two sides of A4, a product that they are trying to create, such a product should not be marketed by that bank.

Mr. Hoban: My hon. Friend makes a good suggestion. There was a disconnect between the directors and the boys in the engine room: each seemed to think that the other knew what they were doing. I just wonder if that disconnect was not a cause of the crisis.

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There are some regulatory issues that we need to address. Clearly, the capital requirements in place for banks had not been fully thought through. The capital requirements under Basle II encouraged procyclicality in lending and they encouraged banks to lend more in the good times. The Spanish banking system had countercyclical capital and it has come through in a much more robust state than the UK banking system and other banking systems. Obviously, we need to get the capital requirements right.

We also need to ensure that there is a proper matching of capital to risk. Certain banks were able to make some quite risky investments and engage in some quite risky trading activities because they had a strong retail base. We should ensure that capital is much more closely aligned to the level of risk in trading activities and capital should also reflect the riskiness of bonus structures. If remuneration structures lead to a certain type of activity, capital should match those structures too.

The regulatory structure in the UK needs reform. We have argued that there should be a "twin peaks" approach, whereby the Bank of England would act as a prudential supervisor and a new consumer protection agency would act as a consumer champion. It is interesting to note that France-a country with which we do not necessarily see eye to eye on these issues-is looking at moving to a "twin peaks" approach, with the Banque du France, France's central bank, acting as a prudential supervisor, just as in the Netherlands and Australia there is a separate prudential regulator and a separate conduct of business regulator.

That structure is important as it would reinforce the importance of prudential supervision. Our existing regulatory regime, whereby the FSA acts as the prudential regulator and is also responsible for the conduct of business, rather meant that the prudential aspect got lost in recent years, because the accountability of the regulator drove it towards more conduct of business regulation. Our reforms would tackle that problem by ensuring that the regulatory structure properly addresses both prudential supervision and the conduct of business rules that really regulate the way in which consumers buy products from insurers, banks and others, and receive advice.

There is no magic bullet that will solve the problem, only a series of interventions that we need to make. We need to get the capital provisions right and we need to get the regulatory structure right. However, we also need to ensure that the financial services sector sees itself as an integral part of the UK economy. It is only by getting those structures right and by building up that trust that once again people will be content to see the City continuing to grow. People talk about "the imbalance" and say that the financial services sector is too big. The answer is not to shrink that sector, but to grow other parts of the economy. That is the message that we need to think about when we look at the impact of the sector on the UK as a whole.

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