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I emphasise, as many other noble Lords have done, confidence rather than trust in this context, following the work of my noble friend Lord Plant of Highfield. He has pointed out that public trust in many areas of life, not least the financial services, has broken down. In any case, that approach was appropriate to a more naive and deferential age. These days, the public want to have confidence in the workings of the private and public institutions. That is what is clearly lacking in the banks. As was said in the course of the peace process in Northern Ireland, confidence-building measures are prerequisites for progress to be made. I say to the noble Lord, Lord Peston, that I, too, have had PhD students. Here I declare an interest. Following the analysis of the noble Lord, Lord Plant, Professor Andrew Massey, my former PhD student, and his co-author William Hutton, a former banker, stressed in a recent CIPFA publication the need for competence in building confidence. Clearly, competence has been at a heavy discount in the banking world of late.

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In the debate on the Queen’s Speech last Monday, I drew attention to the need to improve standards of corporate governance generally, but particularly in the financial services sector, and to the related issue of achieving a far better gender balance on the boards of public companies. I specifically asked whether the Government would use the Banking Bill as an opportunity to impose a Norwegian-type requirement that 40 per cent of directors should be women. The Minister did not reply to me and has not so far written to me, despite his undertaking. His silence speaks volumes. We now know where the Government effectively stand on the question of gender equality. I invite the Minister to address this issue in winding up, although I am not holding my breath.

Another major defect of the Bill is that it does too little to improve corporate governance more generally. Effective regulation from the top is only one part of the solution. The other, and much more important, aspect is to try to influence the individual and corporate behaviour of main board directors. That is difficult but it must be attempted. A number of actions can be taken to improve the situation. As I said last week, the function of internal audit must be strengthened. Secondly, external auditors must be more aware that they are reporting to shareholders. As I wrote in the foreword to the fourth edition of Professor Andrew Chambers’s authoritative compendium on corporate governance, one of the problems is the near-monopoly of the big four accountancy firms of the external auditing market, which is deleterious in itself because it makes for a far too cosy and complacent culture.

What I believe would really help is the creation by the Government of a standing conference on corporate governance and business ethics to monitor regularly trade and industry practices and to make recommendations for improvement. Such a body would comprise representatives from the four chartered accountancy bodies, the Law Society, the CBI, the TUC, the Institute of Directors, the Serious Fraud Office and the deans of the main business schools. It should also contain a large element of investor representation. A main function of such a body would be to recommend syllabus changes in professional and postgraduate business training to improve professional competence. Apart from making practical proposals, the body would, in its formation, signal the seriousness with which the Government regard the necessity for better corporate governance. Pace the noble Lord, Lord Bilimoria, I suggest that its motto might be not “Back to basics” but “Forward to basics”.

It may be said that this Bill should be confined solely to the matter of regulation, but that will not wash as an excuse. This Government have made a practice of devising vast portmanteau Bills incorporating disparate provisions. Regulation from above must be complemented by better corporate governance from below and this Bill should be amended to secure that. Bailing out the banking system with unprecedented sums from the Exchequer—and more may yet be needed, as noble Lords have pointed out—gives a wholly different meaning to public-private partnerships. Both in the magnitude of the sums involved and the risk being assumed by the Government on behalf of taxpayers, the benefits have been privatised and the

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costs nationalised, in the words of Dr Vince Cable. For that reason alone, every effort must be made to minimise opportunities for further fraud and illegality so that we have a more transparent, ethically professional and accountable UK banking system.

6.29 pm

Lord Eatwell: My Lords, before I turn to the main body of my remarks on the Bill, I will comment on the position stated so forcefully by the noble Lord, Lord Bilimoria, who I regret is not in his place, and echoed by other noble Lords. That position is that returning regulatory powers to the Bank of England would, in some sense, create a more robust regulatory system. Noble Lords who take this view should recognise that, in the decade prior to the Bank of England Act 1998, the Bank of England had a lamentable regulatory record. Johnson Matthey, BCCI and Barings were all significant failures by the Bank of England. Indeed, the Bank of England’s Board of Banking Supervision commented with respect to Barings that the Bank of England did not understand the market that it was supposed to be regulating. I shall return to the Bank of England later in my remarks.

This Bill is one of the most important measures to come before us in this parliamentary Session. Everyone knows that the success of financial services is a vital component of this country’s economic future. The Bill seeks to create a new framework for the operation and protection of those services, at least as far as banking is concerned. Yet, while being important in itself, the Bill is surely, as many noble Lords have said, but a first step in the series of measures that are needed to transform the operation and regulation of financial services in this country and, indeed, internationally, as the Prime Minister noted following the G20 meeting in Washington in mid-November. Because this is but a partial measure—a first step—it is vital that the measures in the Bill are crafted from a coherent and consistent analysis that will carry over to the later legislation that will complete the pressing task of financial markets reform. This first step must not be a false step, jeopardising what follows.

In these difficult times, it is particularly important that the Bill should embody a thorough understanding of the lessons that should have been learnt from the bitter experiences of the past two years or so. To identify those lessons, there is no better place to start than Mr Alan Greenspan’s evidence before the US House of Representatives on 23 October. He stated:

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief”.

He went on to say:

“This modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year”.

Mr Greenspan was honest, almost painfully so, about the intellectual and practical failure of the policy stance that he had adopted for 10 years as chairman of the Federal Reserve board. But the actual content of his mea culpa is in fact wrong and betrays a serious lack of understanding of what has happened. The issue is not whether banks would manage their risks efficiently, but whether they could do so.

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Greenspan has failed to take on board the fact that the financial risks taken by firms have significant externalities; that is, they impose costs and risks on society as a whole far greater than the costs and risks experienced by the originating firms. Just as it is impossible for a single energy user to manage the risks of climate change—that depends on the operation of the system as a whole—so it is impossible for an individual bank to manage the totality of risks to which it is exposed. That, too, depends on the operation of the system as a whole. It is this systemic risk that has been so brutally revealed in the disappearance of liquidity from financial markets.

Systemic risk is an ever present characteristic of financial markets; it is embedded in their DNA. It is, therefore, totally wrong to attribute what has happened to black swans or similar highly improbable events. Systemic risks are ubiquitous in markets of white swans. They are totally normal and have reappeared regularly, albeit in different guises, for the past 300 years. Financial regulation should focus on systemic risk, not that of individual firms. That is the first lesson that Mr Greenspan and we should by now have learnt. Regulation is essential because, in the presence of systemic risk, free, competitive markets are inefficient and prone to crisis.

The classic example of systemic risk is the bank run, which was well described by my noble friend Lord Peston. The failure of bank A, due to imprudent loans, provokes a run on bank B, even though bank B is solvent. However, because its lending is longer than its deposits, it is illiquid, and the run forces it to collapse. The second lesson that should have been learnt from recent events is that this classic example of systemic failure is hopelessly out of date. In the past 30 years, the structure of financial markets has changed fundamentally; it has shifted from a bank-based to a market-based system. Financial intermediation has moved from banks into markets—into long chains of securitised counterparty transactions—and financial crises are now manifest in financial markets in general rather than in banking markets in particular. Hence, crises no longer take the form of bank runs; instead, market gridlock is the source of systemic risk. Despite popular belief, the failure of Northern Rock was certainly not the result of a bank run. Northern Rock was brought down by gridlock in the commercial paper market long before the queues formed outside its branches.

I shall sum up the lessons that we ought to have learnt. First, systemic risks are endemic to the financial system as a whole and cannot be managed by individual firms. Secondly, systemic risks stem today from gridlock in financial markets, not from bank runs, and gridlock may originate anywhere in complex chains of counterparty transactions throughout the financial system. Thirdly, therefore, detailed knowledge of the operation and structure of firms and markets is essential to the effective regulation of systemic risk.

The question that we face is whether these lessons are embodied in the Bill or whether it has failed to reflect the lessons of recent events. One cannot this evening test all elements of the Bill, but I shall consider three parts of it. First, on the target of the special

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resolution regime, the main purpose of the Bill is, of course, to create a special resolution regime for banks and, to a certain extent, building societies and credit unions. A bank is defined in Clause 2 as,

The creation of special resolution regimes is well established in the US and is long overdue in the UK. The Government are to be applauded for bringing them forward.

However, in the light of our second fundamental lesson of recent events—that systemic risks stem from gridlock in financial markets—the clause defining the targets of the regime is unreasonably restrictive. It means, as the Government have just now recognised, that the special resolution regimes could not have been applied to Lehman Brothers, yet the collapse of that firm is probably the most serious financial policy failure of the post-war era. What should we learn from the Lehman failure? Systemic failure may not originate in banks; instead, it may originate anywhere in the complex structures of financial counterparties, whether they are investment banks, special purpose vehicles, hedge funds, or elsewhere. Confining the special resolution regime to banks is long out of date. I look forward to hearing the Government’s amendments in Committee, which should rescue the Bill from this archaic anomaly.

Secondly, let us look at Clauses 33 to 48 on the transfer of securities. It is important to note that the impact of these clauses is contrary to the Government’s objectives as set out in the G20 communiqué of 15 November, to which Her Majesty’s Government subscribed. The G20 communiqué placed considerable emphasis on the need to develop efficient clearing mechanisms for financial instruments. However, the passage into law of Clauses 33 to 48 would seriously compromise the attainment of that objective. Indeed, it would seriously compromise netting in general.

The reason for this is that the Bill grants sweeping powers of contractual override. This will mean that lawyers will not be able to issue “clean” legal opinions for netting exposures. This will in turn require parties to recharacterise their short-term lending transactions on a gross basis, rather than a net basis, hence increasing regulatory capital charges and market risks. Essentially, the broad stabilisation powers would drive up the costs for British banks engaging in netting, yet the Government have committed themselves to increased netting, not less. This contradiction is an unintended consequence of the Bill and I will be proposing ameliorating amendments in Committee.

Thirdly, on the roles of the FSA and the Bank of England, my final test of the Bill’s provisions against the lessons of recent events concerns two proposals at each end of the Bill. These are Clause 7, the trigger clause where it is proposed that a stabilisation power,

and Clause 228, proposing the establishment of the Financial Stability Committee of the Bank of England. As I have argued, a fundamental characteristic of financial markets today is that systemic risk resides in the structure of markets and firms. In the current

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division of regulatory responsibility, the Bank of England has the main responsibility for managing systemic risk but has no direct knowledge of firms. That knowledge of markets and institutions, if it resides anywhere, resides in the Financial Services Authority. Hence it is indeed appropriate that the FSA should have its finger on the trigger. The Bank of England does not have the detailed supervisory knowledge of not just banks but the structure of financial institutions as a whole to perform this role.

There is a problem, however. The FSA has no direct responsibility for systemic risk; that responsibility rests with the Bank of England. The FSA knows about firms and markets and the Bank of England has the responsibility for managing systemic risk. This dangerous dichotomy, already too evident in recent events, could be overcome by making the new Financial Stability Committee, to be established by Clause 228, a combined committee of the Bank and the FSA, jointly and severally responsible for financial stability. This would have the dual advantage of informing the Bank’s stability analysis about the actual operations of firms in disintermediated markets and ensuring that systemic risk became a basic tenet of the FSA’s operational philosophy. In other words, the Financial Stability Committee could be an operational bridge between the FSA and the Bank of England—the bridge that has been so conspicuously lacking in recent months.

If a joint committee is to be an effective bridge, however, not just between the Bank and the FSA but between markets and systemic risk, it must be composed of and advised by the informed, the sceptical and the contrary. The last thing that we need is another committee of City grandees who are richly incentivised to spot the bursting of the bubble and notably fail to do so. In view of the remarks that he made in his maiden speech, I think that the noble Lord, Lord Smith of Kelvin, would agree with me. A contrary Financial Stability Committee should have behind it a well resourced research department. Experience of the past year has shown that it was only the lowly research teams that spotted well in advance the danger of sub-prime mortgages; they were ignored, but it is about time that they had a voice at the high table. A joint Bank/FSA Financial Stability Committee would be the perfect mouthpiece. I will be proposing amendments in Committee that would establish the Financial Stability Committee as a joint committee of the FSA and the Bank of England and would ensure that its membership extended far wider than the narrow extent currently envisaged in the Bill.

This is a good Bill, but it could be an even better Bill. Some of the lessons of the so-called credit crunch have emerged only in the past few months, after the Bill was drafted. We have the opportunity and the responsibility to bring it right up to date.

6.43 pm

Lord Stewartby: My Lords, the debate today has been on a higher level than much of the public comment in the press and news bulletins. I am glad to be able to take part in a debate which is beginning to identify some of the underlying difficulties that have arisen in these exceptional circumstances.

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I have no current interests to declare but I have been involved with banks or banking throughout most of my working life. I worked in a merchant bank in the 1960s and 1970s. In the 1980s I was the Minister responsible for the then Banking Bill and the then Building Societies Bill. In the 1990s I became director of an international bank and chairman of its audit committee. I was also for a time on the boards of the Securities and Investment Board and of the FSA. I say this because I have been trying to look at the picture from many different angles. There is one thing that comes back to haunt me and which I cannot understand. This is what I would like to talk about this evening.

I am amazed and appalled by the events in the financial markets, and banking in particular, which have occurred in the last year or two, especially in recent months. The question which does not seem to get much coverage is: how did it all come about? Connected to this is the question: how are we going to prevent it happening again? We read comments to the effect that no one foresaw what was coming and that there was no advance warning. That is not entirely true, however. There were big imbalances and tensions building up in the world economy, the difference between China’s surplus and the US deficit, overheated investment markets and housing in many countries, and overgeared instruments for leveraged buyouts. These were all signs of excess and they put some people on notice.

About two years before the Northern Rock affair exploded, the Governor of the Bank of England issued a statement that the market was mispricing risk. That was a crucial observation by one of the key players; it came from a source who knew what he was talking about. It seems, however, to have had little impact. It does not seem to have affected the way in which the FSA looked at individual institutions; it does not seem to have changed broad banking policy in any way. It all went on gloriously as before, as if there were no icebergs in the ocean.

Inevitably the crisis has led to suggestions that we need more regulation. We may do but we also need better regulation and we need much better supervision. Supervision is ultimately the ingredient that has failed and which set off this whole process. Regulation is a matter of setting rules and the nature of regulation may well change as result of current events. Supervision is the oversight of the actual business of institutions and therefore where in this case and others the damage will have begun.

How could the crisis have developed on such a scale, with nobody realising what was happening until the last moment? It has involved many banks in many countries and the puzzle is what caused everyone in key positions in or in relation to those institutions to have a complete mental block at the same time on the nature of these instruments. This must be the worst collective failure on a colossal scale in economic history. Too many of the important players seem to have suspended their critical faculties.

Within banks there are managers, traders and dealers at the coalface; there are risk departments and control systems; there is a head of risk who reports to the board and to the audit committee; there is an internal

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audit structure and beefed-up forms of audit committee, which not only look at figures and data but carry out stress testing. They think they are on top of things.

Of course, it was the banks’ fault in that they bought piles of what transpired to be toxic financial waste, but others should also have noticed. The first to have done so should have been the external auditors, but those who perhaps above all should have noticed were the rating agencies, which seem to be covered with a lack of glory in this whole story. The supervisors are critical in this. Sub-prime mortgages are a high-risk asset, no matter what wrappings you put round them. You can call them an SIV, a CDO or any other acronym, but basically they consist of dodgy risk, and those who entered into them on such a substantial scale seem not to have focused on that at all.

How can such a crisis be stopped from happening again? I think that supervision will have to be thought through from first principles. It is important, and I am glad, that the FSA is beginning to undertake this but I hope that it looks at the issue in a way that reveals why the institutions affected took on and built up such huge positions in instruments and types of business that they did not properly understand.

Of course, we will get new proposals on regulation. In some respects that may be a very good thing, but it will also probably be influenced by overseas interests, because co-ordination in an international market is very important. The right personnel must be employed, and the people who carry out an extended and, one hopes, more penetrating process of supervision must become a source of key information about the nature of the assets on the balance sheets of deposit-taking institutions. There is no getting away from that.

What about the future? We are in the middle of a storm at the moment but we have to think beyond that. When we get beyond it, I hope that the regulatory function, which is separate from the supervisory function—although they overlap—will apply in a form that enables the supervisors, in their turn, to make a proper and well informed judgment about the nature of the institution over which they have supervisory responsibility.

6.52 pm

Lord Lipsey: My Lords, Second Readings are an opportunity to debate what is in a Bill. However, they are also an opportunity to debate what should be in a Bill but is not. This Bill provides for pre-funding of the Financial Services Compensation Scheme—which has not been much talked about this afternoon—and that is something that may or may not turn out to be needed. However, it does not provide for the other changes that should be made to the Financial Services Compensation Scheme, and it is to those that I wish briefly to devote myself this evening.

I want to start with a positive note about the scheme. Two of the big problems are being solved. Paying back depositors if an institution went under used to be jolly slow, but Loretta Minghella and her team did a fantastic job with the Icelandic banks in speeding up that complicated process. It bodes very well for the future speed of compensation.

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There is another major problem on which I am optimistic. The compensation scheme has a £50,000 limit and therefore does not cover someone who makes a short-term, very large deposit—for example, someone who sells his house and puts the money in the bank—and the next day the bank goes under. At the moment, that person is not protected beyond the £50,000 limit, and that will have been very scary for some people in the atmosphere that prevailed in the autumn. However, without going into detail, I think that that problem will be resolved by the FSA in the near future.

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