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The Earl of Longford: My Lords, I hope I may interrupt the noble Lord for just one moment. I am naturally following him dispassionately, but I am anxious to know whether he thinks this whole idea of the Bank of England exercising a supervisory role is nonsense, or does he think it could be done better?

Lord Spens: My Lords, if I may, I shall come to that point in a moment. I should like first to put the background in place.

When Mr. Duncan Smith walked into the Bank of England they were aghast. They locked him in a room and called for the police, and he was arrested on the spot. That is all the supervisory department knew about that bank. There are other banks like that. There is Authority Bank and various other banks, including some ethnic banks, where there are problems because many of the people involved do not think that there is a problem for the Bank of England to deal with. What would happen if some 20 or 30 banks went under in one form or another?

Incidentally, there was another major trading transaction at the same time as that of Mr. Leeson. The Midland Bank lost some £500 million in the same period as Mr. Leeson lost £800 million. The difference between the two banks was that the Midland Bank had a shareholder—the Hong Kong and Shanghai Bank—which was capable of absorbing those losses and therefore the bank did not go under. It very nearly went under and it would have done so had it not had a large shareholder.

All of those events took place with the present supervisory structure and team in place. In the case of Barings and the problems which arose when it went under, there were two fundamental problems. The first was the breach of the 25 per cent. rule. That 25 per cent. rule was introduced in the middle of the Guinness/Distillers takeover battle. It was introduced because the Bank of England failed to understand the risks that Morgan Grenfell was taking in underwriting primary issues in the stockmarket some seven or eight times its share capital and reserves, which was the value of the Distillers bid and the Imperial bid at the same time. That 25 per cent. rule was introduced at that time for that reason, not at the instigation of the Bank of England and the supervisory department but of the press, who asked why such a rule did not exist.

That 25 per cent. rule has been improved over the years to how it stands today. However, while Mr. Chris Thompson of the Bank of England resigned because he allowed Barings to go above that 25 per cent. limit, I find it very difficult to believe that he was the only person who knew. I know the Bank of England. I have seen volumes of documents pass from pillar to post, upstairs, downstairs, everywhere in the Bank. They write notes to each other like there is no tomorrow, nearly always passing a decision up and down the line. I simply do not accept that Mr. Thompson did not

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inform his superiors that Barings was going to be in breach of one of the principal obligations of the Bank. It is unheard of for anyone in the Bank of England to be in that position. Yet no one else has resigned. No one else resigned over BCCI when £10 billion was lost. God knows what this Government need to get people to resign at the top.

The second problem at the Bank of England is referred to on page 37 of the report. That problem is the bonuses. In Barings they were getting bonuses of three to one—a multiple of three times their salary. That was paid to 50 or so directors. That makes the bonuses in privatised companies look tiny compared with what is going on in the merchant banking system. That is plain, ordinary greed. Where you have 50 directors receiving bonuses of over £½ million pounds each no command and control system will ever work. Inevitably, they will not look under the stones when they stand to lose that kind of money.

Therefore, to answer the question of the noble Earl, Lord Longford, it does not matter whether supervision and regulation are carried out within the Bank of England or within some other body if the people who do the regulating are incompetent, uncommercial and unprofessional. It will be just as bad. I have this appalling sense of déjo vu; that in a few years time we shall be considering another banking scandal, with the same people in charge and the same people not taking responsibility for what is undoubtedly their own responsibility. As night follows day, we shall have another banking scandal if this team is left in place.

2.44 p.m.

Lord Hollick: My Lords, I too must thank the noble Lord, Lord Eatwell, for introducing this matter while it is fresh in our minds. He has given us a few days to absorb a full report, although there are obvious gaps in it.

The report has been drawn up by the Board of Banking Supervision. It is unfortunate in the extreme that it was not an independent report. There is an undue fondness in the City for self-regulation and there is now a widespread feeling that self-regulation, marking your own card and writing your own report is no longer adequate or satisfactory. The inquiry should have been carried out by an independent body. The report would have had greater credibility, and credibility is at the heart of the integrity of the financial system. That is not to say that an independent body would have discovered anything that the current report has not touched upon; it would simply have had much greater credibility and authority.

I speak as one who has worked in the City since 1968. The report paints an incredible picture of incompetence: reckless, uncontrolled trading, surrounded by a series of breathtaking management failures, underpinned by a universal ignorance of what was going on. I am afraid that the regulator, the Bank of England, shares in it. The report provides a valuable glimpse of how a financial institution operates, particularly one which has businesses throughout the world; and how a regulator also operates in that environment.

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The first point that concerns me is that the management of an organisation should at the least have some knowledge and understanding of the product that it is selling and the service it offers. Running through the report is the fact that no one at Barings had any idea of the business they were in. Apparently, as long as the profits continued to roll in, they were happy. They were unconcerned about the true nature of the product or of the risk. There are touchingly naive pieces in the report. In paragraph 3.57 the chairman of Barings talks about how he found the earnings "pleasantly surprising". Another person questioned said:

    "Yes ... people talked about it almost incessantly ... I have to say that a load of people—all of us, really—found it very puzzling. But I have to say equally, and maybe you will say naively, we accepted it".

As we have already heard, what they accepted was very substantial bonuses. In the case of Mr. Baring, the bonus would be £1 million for the year in question. In the case of the chief executive, Mr. Tuckey, it would be £1.6 million. So, take a big bonus and walk on the other side of the street and close your eyes.

That is extraordinary. I speak as someone who has worked in the City. We have our fair share of crooks and what I believe the noble Viscount described as "estuarial" employees and colleagues. However, I have never seen incompetence, ignorance and naivety on that scale before. They believed that trading was risk free. An organisation which has been established for 200 years should know one thing: nothing is risk free. There is no such thing as risk free. If there is, then please let me know of it first. There is no such thing as a risk-free financial transaction.

The puzzlement of people at Barings did not lead to curiosity. That absence of curiosity was the fundamental flaw; people did not inquire about what had happened. The report suggests a massive failure in management, operating and financial controls. That is wrong. There were no management, operating or financial controls. It was the absence of basic management, operational and financial controls that we see throughout the whole saga.

The control of the financial services business, the control of the bank and particularly the control of the securities trade business require careful and strict supervision, both within the bank, the institution itself, and outside. At the least, there must be a division of responsibility. Fundamentally, there must be a segregation of funds: clients' funds and proprietorial trading funds. There must be arm's length funding of the whole system, otherwise the system itself becomes contaminated.

The whole control of a financial institution is predicated on the basis that out there somewhere—you do not know who it is or when he will turn up—there is a rogue trader. There is always a rogue trader and you have to plan on that basis. Simply shrugging your shoulders and saying, "There's a rogue trader and we got knocked over" is not good enough. He should not have been there and Barings should have had controls in place which would have contained that rogue trader and found out at a much earlier stage what was going on. Rogue traders are not unique to the London market

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and these problems are not unique to the London market, although we seem to have had more than our fair share of such problems in recent years. This report will provide the other institutions in the City, and in other financial centres, with a very useful text about how not to run the securities business. Looking on the brighter side, one of the effects of the Barings débâcle, the Barings disaster, is that it has "sharpened up" many other people. They have suddenly been shaken out of their complacency.

I turn now to the role of the regulator. Speaking generally, this role must in the first instance be to protect the interest of the general public, particularly those members who are not, to use the City expression, financial sophisticated. I guess that in this case that would include everybody who worked at Barings! The need to protect the general public then leads to a need to avoid systemic risk; that is to say, a domino effect, with one institution toppling over another. The third aspect of regulation is to provide comfort in the professional markets; that is, the non-retail markets. It is important that we look at regulation in these two lights: the retail (consumer) side and the professional side.

It is true that on the professional side there are financial institutions which compete with one another and seek to profit out of one another's mistakes. There is a view, which I think is correct, that they can look after themselves to quite a large extent. They do not need to be protected to the same extent. Nevertheless, they need to know that there is a regulatory environment which works, which is effective and which ensures that the worst excesses—as we saw in the case of Barings—are properly regulated and do not continue to put the financial system at risk.

It is important to remember that what a regulator cannot and does not, do is provide a financial guarantee. It would be quite wrong for a regulator to do that. When the Minister repeated the Statement, he talked about "moral hazard". By definition, risk cannot be eliminated in a financial system. Otherwise, it would require a public body, using public funds, to stand behind every single financial institution. However, there is another hazard. I would call it regulatory hazard: the absence of adequate regulation. If the supervision system does not work satisfactorily, that can weaken markets and can weaken the integrity of markets. In the case of the City of London, which is an extremely valuable national asset, it can undermine the smooth working and standing of that market. Credible regulation for professional markets is very important. There needs to be confidence in regulation. Otherwise, there will be a loss of competitiveness.

My noble friend Lord Eatwell referred to some events that have happened subsequently: the sale of one or two of our leading merchant banks to European banks. There is no question but that the failure of Barings has made the climate for medium sized financial institutions much colder and much more difficult. The cost of funds has gone up and their competitive place in the market place has been undermined.

We talk about systemic risk. There is a systemic consequence of a bank such as Barings failing. I do not say that that is the sole reason why Warburgs is now

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owned by a Swiss bank or why Kleinworts will shortly be owned by a German bank. However, the failure of Barings was a contributory factor. It made life far more difficult for those people.

The regulation of Barings, as the report explains at length, falls considerably short of the standard that is required by a regulator. I find that very surprising. I have been regulated by the Bank of England in various capacities for more than 20 years. I am not sure whether it is because of my estuarial background—I come from a different estuary; namely, the Test rather than the Thames—but I have found the Bank of England to be careful, methodical and inquisitive, taking a close interest in what I and my colleagues do. That seems to come as no surprise to my noble friends.

The Bank of England has had a good and continuing relationship with auditors. It does not simply rely, as it appears to have done in the case of Barings, on what the management tells it. If one is in the position of a regulator and relies solely on what the management says, one is on a loser. If the management do not know what is going on, one is in the dark. It is very important that the Bank of England uses its powers under Section 39 to ensure that it has a good working relationship with the auditors and the internal auditors. That appears not to have been the case so far as Barings were concerned.

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