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That was leap number one, but it was not the end of the brilliance. The banks started to lend more and got interested in the so-called sub-prime market of residential property in America. The sub-prime market is not, as one might imagine from reading the newspapers, some sort of ghetto in Cleveland. It is pretty much all the US residential market, apart from 64th Street and Madison Avenue in New York. The banks started to lend more and move down this enormous amount of residential property. Here they came to a second restriction, requiring a second brilliant leap. The reason why I am putting this to the Minister is that I am anxious for him to say what this Bill will do to prevent a recurrence of exactly what I describe.
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The second leap was that, as they went further down the sub-prime market in America, the rating agencies started to say, “Well, this doesn’t look to us like triple-A-rated security”. Apparently you cannot sell anything in the banking world that is not triple-A. The banks hit on a really brilliant, original, creative solution, which was insurance. If they could say to the rating agencies that there was nothing wrong with these loans or investments that they had made and that they deserved a triple-A rating because they were insured, who could argue with that? They were insured and, therefore, they received their triple-A rating.
I hope that noble Lords will forgive me for the history, but they can now see how, when this crisis arose, it was all such a shock and why it is all still unravelling today. The noble Lord, Lord Barnett, said that he did not know. I assure him that not the Minister, not the Treasury, not the FSA, not the Bank of England, not the US Federal Reserve board, not the US Treasury Secretary and not the Chancellor of the Exchequer knew. Nobody knew about what I have just described. So we arrived at a position when the shock arose, when a request that banks routinely make to their customers—that they show them their balance sheet—was one with which the banks themselves could not promptly comply. One day, as the noble Lords, Lord Smith and Lord Barnett, said, the auditors of the banks will explain how this was possible. It is a mystery to me. It would be helpful to your Lordships’ House if the Minister could say in winding up how the Bill will deal with those two specific crucial moments that led up to and made this crisis.
I end by imposing on the House my own small suggestion for how such a crisis can be averted in the future. This does not relate to the two points that I have made, which I leave to the Minister. I was pleased to see that the Government do not regard the remit of the Bank of England as sacrosanct. This Bill amends the remit of the Bank of England, as set out in the Bank of England Act 1998. Proposed new Section 2A(1) in Clause 228, Part 7, gives the Bank a new objective, which is,
- “to contribute to protecting and enhancing the stability of the financial systems of the United Kingdom”.
The Government have opened the door to amending the remit of the Bank of England and I hope that noble Lords will accompany me through it.
Shakespeare taught us that human beings can have a fatal flaw. So, too, can legislation. The Bank of England Act 1998 has a fatal flaw. It has three words too many, which my Bill aims to delete. Section 11 in Part II of the Bank of England Act misdefines the role of the Bank by obliging it to focus on controlling inflation to the exclusion of all else and then compounds the error by defining inflation to exclude all the debt/housing/mortgage problems that caused the crisis.
The record seems to show that the top officials of the Bank of England were like top generals given the wrong orders. The fault lies not with them but with the legislation that created them. This is why I introduced in your Lordships’ House just after Questions today—and I am grateful to the usual channels for allowing me to do so—the Bank of England (Amendment) Bill. I will bring forward an amendment in Committee stage of
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A Labour Prime Minister once won a famous post-war election with the slogan:
“We won the war. Now let’s win the peace”.
One day soon I hope that the Government will be able to say—and we will help them—that we won this economic war. Let us be sure to win the peace, too.
5.27 pm
Lord Peston: My Lords, before getting down to the speech that I have prepared, perhaps I may remark on what my good friend the noble Lord, Lord Saatchi, has just said about the Bank of England remit. When the Bank of England Bill was going through your Lordships’ House, my noble friend Lord Barnett and I tabled an amendment precisely along the lines that the noble Lord, Lord Saatchi, wants to see. Essentially, the Bank of England Bill should have adopted what was in the Humphrey-Hawkins Act for the Fed, whose criteria were inflation and a high level of employment.
Lord McIntosh of Haringey: My Lords, a high level of employment and growth.
Lord Peston: My Lords, that is right. We presented that proposal to the Government. My noble friend Lord McIntosh, who has just reminded me what the provision actually said, was on the Front Bench dealing with that Bill, so he was the one who rejected what my noble friend Lord Barnett and I proffered. My noble friend and I were very annoyed at the time.
Many years later I have reflected on that, and I can now think of a reason why the Government adopted the remit for the Bank of England Bill that they did. After 18 wasted Tory years, with our side coming into power, it was vital that we were credible as regards economic policy making. Central to that credibility would be a commitment against inflation; therefore, I have a feeling that what lay behind the rejection of the proposal my noble friend and I put forward was a desire in the early days to establish the credibility of the new Government regarding inflation.
I freely add the point that it never occurred to me 10 years ago that anything like what is happening today was possible. Indeed, my favourite joke is that, if any student had described the present state of affairs to me, I would have said, “Don’t waste my time. That’s a completely impossible state of affairs”. In some sense, when I cannot sleep at nights I still say to myself that it cannot be happening, I must have missed some essential fact, but that is by the way.
This is a Second Reading debate, so I wish to devote my speech to general principles. Fundamental to this Bill is that banks—or, more generally, deposit-taking institutions—are of special importance to the economy. Most other types of private enterprise do
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As opposed to the Official Opposition’s Front Bench, I am not an apologist for all the bankers; quite the contrary, in this country and elsewhere the bankers have behaved appallingly. They have taken excessive risks, and the reason for that is simply greed. There is no doubt about what the bankers were up to.
The Treasury Select Committee in the other place published a superb report on Northern Rock. It highlighted some regulatory failure, but that is secondary to the main fact that the banks caused the trouble in the first place, with sub-prime lending and the marketing of toxic assets. I say again to the noble Lord, Lord Saatchi, that I keep a list on my desk of all the acronyms. I remember what they are but always have to go back to the original sources to work out what they do, and by the time I have gone back, I have forgotten them again; therefore, I would fail totally in his party game.
As far as I can understand it, there was a great deal of corruption involved in the banks in the United States, particularly with the valuation of assets. We do not know whether there has been any corruption here at all, and almost certainly we never will know. In an earlier debate, my noble friend Lord Myners appeared to say that there would be an inquiry into all this, but he then said more recently that he had been misunderstood and did not promise a full investigation of the banking operations in this country in the past few years. Of course one has to accept his word on that, which I do. None the less, we would be better informed of what the banks were up to, why and who was responsible if we had a full inquiry.
Again as background, we must distinguish the banks’ role as money transfer bodies—that is, as part of the payment system—and as borrowing and lending institutions which are meant to get savings into investment via the loans market. As I understand it—this has been a growing problem for the banks, and others with more expertise can tell us more—the banks make very little money from acting as money transfer bodies; therefore, if they are to make money and satisfy their greed they need to get more into the borrowing and lending business.
Related to that is an important economic proposition: financial institutions such as banks operate essentially by borrowing in a liquid fashion and lending in an illiquid fashion, or, as we used to say, borrowing short and lending long. Such a system is inherently unstable. By this is meant that, in normal times, these institutions can function in a stable way but, subject to an abnormal shock, such as what has hit our system and the world system generally, the effects are transmitted from one bank to another in a self-sustaining and dangerous
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If one bank is in trouble, depositors in other banks will have to ask themselves, “Is that bank unique? What about our bank?” and they will start to do the same thing. All this will happen even if the overwhelming majority of banks are solvent and sensible. In other words, as long as some banks have been behaving wrongly and making unsound loans, depositors will not know which they are; therefore, the whole banking system is placed at risk. If there is general depositor insurance, or other forms of underpinning, there is no incentive for any depositors to go into this any further because they are protected.
What makes matters worse is that, if another shock were to hit the economic system, one that did not originate in the banking system, what were sound loans, again, would cease to be so—not in the least surprising. In addition, people who lose their job or who have their income cut cannot service their loans. This, too, becomes a problem for the banks and is what we are observing. All of this amounts to reminding us how unstable the banking system is and how dangerous it is to let it operate on its own.
Milton Friedman argued that the problem of the great depression, which was the biggest crisis of modern times—I have always thought that it was greater than we are going through, but I could well turn out to be wrong—was exacerbated by the Fed’s failure aggressively to expand the money supply. Professor Bernanke pointed out that there was also a real side to this, precisely along the lines that I have put forward: if banks in trouble started to demand the repayment of existing loans, as they did in the great depression, that would add to the troubles, financially, and in terms of spending in the economy. Professor Bernanke, at the head of the Fed and the world’s greatest living expert on the great depression, was absolutely certain he was not going to let that happen again. That is why he operated positively—to the amazement of some of us who recognised him as essentially a monetarist—to increase the money supply in the United States and push in the way that he did. He also seems to have persuaded President Bush also to expand fiscal policy. It is interesting that in our country, my right honourable friend the Prime Minister was doing this ahead of what was happening in the US. I assume he had some very good advisers telling him about all of this. I do not know where they were, but clearly they were not in the Bank of England.
The Monetary Policy Committee had the benefit of one of my old students, Professor Blanchflower, who was taught economics by me. He was in a minority of one for nearly all the period that he was advocating interest rate cuts while everyone else was saying no. As I say, none of the other Monetary Policy Committee members was taught by me at all.
To bring all that together, once the thing goes wrong it is not in the least surprising that it continues to go wrong. It is also not in the least surprising that it
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We are, as my noble friend Lord Barnett said, pursuing the right policies, although there are details on which we can disagree. This leads us to the view that the remarks of the German Finance Minister were completely absurd. We know that what he said was for internal political reasons; he wanted Germany to get a free ride on all the other countries in Europe, plus the United States, so that we would push the thing forward and he would gain all the benefits.
Finally, observing the banks now, two things have not changed—again, I echo my noble friend Lord Barnett: the ethos of greed is still with us, as strong as ever, and the same useless people are appointed as overpaid, blind-eyed non-executive directors. We have a new version of Gresham’s law: bad banking drives out good. I hope that the Bill is the first step towards eradicating that.
5.41 pm
Lord Blackwell: My Lords, it is a daunting task to follow such a distinguished economist as the noble Lord, Lord Peston, in this debate, particularly when I find myself in the unusual position of agreeing with much of what he said. I should like to draw attention to my various interests relating to the Bill, and emphasise that I speak here in a purely personal capacity.
Although there are some detailed questions on the Bill that will come out in Committee, and one or two that I should like to raise today, like others, I recognise the need for the Bill. However, my primary question, like that of every noble Lord who has preceded me, is whether those measures are enough or whether we should be taking advantage of the legislation to provide a more complete response. The advantage of speaking at this stage in the debate is that I can put my arguments in the context of those which have been made before.
The Bill is about restructuring and recapitalising banks that are judged to be no longer capable of standing alone without significant risk to the financial system. The first thing to recognise is that restoring capital levels to replace the losses suffered from bad assets is of itself not enough to restore lending to pre-2008 levels. The recent Bank of England financial stability report showed that the leverage ratios of major banks had risen steadily over recent years to reach a median level of 35 times equity capital, with the top interquartile range doubling over the past 10 years from around 25 times equity levels to close to 50 times equity levels. The Bank of England does not do the arithmetic to provide estimates of the average leverage ratio of the banking system, but I think that we can take it from these figures that it has also risen significantly.
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This is just the flipside of the coin of the growth in consumer and business indebtedness over the period. Household borrowing has risen over the same period from 60 per cent to 90 per cent of GDP, and bank lending to non-financial companies is also up a third over the past 10 years from just over 20 per cent to around 35 per cent of GDP. This has been accompanied by a simultaneous increase in government borrowing, which is well over 50 per cent of GDP on any measure.
If we are to bring bank gearing levels and their counterpart in consumer and business borrowing levels back to more sustainable levels, and if we are to close the macro-funding gap between domestic saving and domestic borrowing, about which the Bank of England is concerned, the consequence, notwithstanding the views of the noble Lord, Lord Barnett, must, in the short term, be a severe and painful contraction in the total volume of bank lending. It would be helpful if the Minister would accept on behalf of the Government that, notwithstanding exhortations to lend, a major reduction in bank lending is inevitable until bank gearing levels are reduced. This is the degearing effect, about which we hear so much. Can the Government guide us on what level of degearing they expect, over what timescale, and what impact they believe it will have on total lending volumes and nominal GDP?
However, this is not the whole story. Some 35 years ago, I confess that I wrote a rather unexciting doctoral thesis that predicted that in such periods of credit tightening, banks would end up rationing credit to small business customers because the price mechanism would not adjust lending volume quickly enough to restore balance sheet equilibrium and meet regulatory ratios. Although that thesis has gathered much dust over the years, I fear that we are in just such a situation now. The banks which have been wholly or partly nationalised, as the noble Lord, Lord Barnett, described, are no less immune to that problem despite their greater access to secure capital. Bank managers are simply saying no, because they have no other way of trimming back their balance sheets in the time available. The Bill will not fix that problem.
The second and, perhaps, greater short-term problem is, as others have said, that of liquidity. As we know, the shortage of liquidity is not necessarily directly related to capital levels. As the Minister agreed yesterday in the debate on statutory instruments, Bradford & Bingley was judged incapable of standing alone because of its concerns about liquidity, despite having a tier 1 capital ratio of close to 10 per cent. Underlying the shortage of liquidity is the continued unwillingness of banks to lend their surplus liquidity in the wholesale market for fear that when they need the liquidity back it will simply not be available. This, too, is adding to the pressures on banks to rein back their lending and this, too, will not necessarily be fixed by the measures in the Bill.
I accept that, as the Minister said, the Government and the Bank of England have taken steps to address the liquidity issues through purchasing qualifying assets by the Bank of England, selling insurance to guarantee wholesale lending and other measures. Although these schemes have undoubtedly helped, they clearly have not yet solved the liquidity problem, as evidenced by
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What do we do about this? One response posed by the opposition Front Bench is to guarantee lending to small businesses; that may be part of the solution. Another possibility, mentioned by the noble Lord, Lord Newby, and which should be explored, is to allow regulatory ratios to be relaxed at the trough of the cycle so that we do not expect banks that have just been hit by the equivalent of a one in 200-year exceptional loss immediately to rebuild their balance sheets to the point where they can withstand an equally severe loss happening again immediately.
I wonder whether, in this exceptional situation, as described by my noble friend Lord Saatchi, there is a case for going back to first principles and rethinking more fundamentally what banks are and how they should be structured and regulated. The definition of a bank, set out in Clause 2, is fairly conventional. The truth is that as every economics course teaches, banks are indeed unique and special in their ability to manufacture money supply, where every loan also becomes a new bank liability and where, ever since we moved away from gold specie, bank deposits have counted as a reliable and trusted part of our currency.
As the noble Lord, Lord Smith of Kelvin, and my noble friend Lord Saatchi said, the underlying dilemma we have with the current situation is that banks have taken low risk deposits from customers—deposits viewed by those customers as a trusted part of the money supply—and used them at the edges of their balance sheets to take on highly risky and highly leveraged investments. When those risks come home to roost, as every so often they will, we are faced with the problem we now have of propping up the banks or allowing a collapse in confidence in the money supply. Clearly, a collapse in confidence in the money supply is something which the Government cannot allow. This is not like some other utility. Confidence in the money supply and the currency constitutes the central essence of confidence on which the whole economic system rests.
I propose a possible solution to the problem posed by my noble friend Lord Saatchi. Perhaps we should think radically, call a spade a spade and simply say that all deposits in regulated banks are de facto part of government guaranteed money supply in which consumers, businesses and, indeed, other bank counterparties can have total confidence. The corollary is that institutions which call themselves banks and fall under this protective umbrella would have to meet very tight prudential regulatory requirements. In particular, they would have to limit themselves to low risk conventional loans and investments, something akin to the assets that most depositors have in fact assumed their banks would hold in order to protect their cash deposits. That would not, of course, prevent other financial institutions, or indeed other parts of the same institutions, accepting funds for investment and investing those in more risky assets. However, they would be clearly segregated from those institutions
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My problem with this Bill, therefore, is not that what it proposes is not sensible or necessary given the circumstances we face, but that ultimately it may be inadequate because it is based on perpetuating an unstable banking structure that links government-guaranteed money supply and risky market investment activities within the same legal and financial structures. As my noble friend Lord Saatchi said, this problem has been made far greater than ever before by the multiplication of financial instruments that have allowed banks to extend into areas of risk and investment that were never available in the past.
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