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There are two aspects of the proposals for RBS that I find curious. It is required to divest itself of its insurance wing and to reduce its overseas operations. These are both highly profitable parts of the bank. If the object of the plan is a return to viability, how do you justify compelling the bank to divest itself of extremely profitable assets? The Government appear to be content with these demands, so I have to ask whether they were consulted in advance. Was there a discussion with the Government about it? If there had not been this process, would the Government through their shareholding have compelled the bank to behave

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in this way? Were they in favour of breaking up the bank? Press comments have referred to these measures as Europe punishing the bank for the receipt of state aid, but that is not compatible with the Commission's objectives as quoted above, nor is there any sign of this being justified as a competition measure. Indeed, it may not be justified in those terms in any event because what barriers are there to entry into the market? I am not sure that there are any.

I do not want to labour the point, but I feel that we should have a further comment by the Government on this issue. Is there a detailed justification for these measures, and if they are thought to be inappropriate or disproportionate, is there any remedy, or do we end up concluding that this is another case where the terms "prejudice" and "ignorance" would be appropriate?

8.36 pm

Lord Willoughby de Broke: My Lords, I begin by congratulating the two chairmen and members of both committees for producing these two stimulating reports. What I did not grasp until I started preparing for this debate is that the questions that the reports address are not remotely new. Banking crises have been erupting periodically for centuries. Sovereign default on loans is an everyday hazard for banks, just one example of which was the downfall of the Medici banking family in Florence. The difference now is that the roles are reversed. It is banking default that threatens sovereign structures.

As long ago as 1825, there was a dress rehearsal for the present crisis. The then director of the Bank of England put it thus:

"We lent [money] by every possible means and in modes we had never adopted before; we took in stock on security, we purchased exchequer bills, we made advances on exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the bank ... Seeing the dreadful state in which the public were, we rendered every assistance in our power".

As the noble Lord, Lord Skidelsky, said, plus ça change, plus c'est la même chose. Nothing seems to have changed in the intervening 184 years except that the decimal point has moved a couple of places to the right. Central banks are still taking on collateral whose value remains unquantified. Even credit default swaps, about which the noble Lord was very rude indeed, have an historical precedent. It is no good Citibank or Goldman Sachs congratulating themselves on paying themselves huge sums of money for original thinking. Back in the 12th century, King Baldwin II of Jerusalem secured a loan using his beard as collateral. No doubt he, too, thought he was doing God's work.

Having looked back, let us look forward to find out what can be learnt. Both reports make the central point that there should be no rush to action or quick fix. The report of the noble Baroness, Lady Cohen, concludes by saying:

"But there should be no rush to all-embracing new legislation".

Taking that into account, I should like to touch on two points which I think deserve further consideration. The first is the question of deposit insurance, and I wonder whether this is the right way to go.

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Let us take the example of Icesave, which is dealt with in chapter 7 of the report on EU regulation. Deposit insurance by definition must make depositors risk-insensitive. Why should they care when the taxpayer will pick up the tab? As soon as Icesave went down the tubes, local authority treasurers, charity treasurers and university and college bursars who had placed money with Icesave came bleating to the taxpayer for help.

I had a deposit with Icesave. Icesave was an accident waiting to happen. It was quite clear that that was the case; you had only to read the financial pages early in 2008 to know that it was time to pull for the shore. If a simple peasant could work that out, what were the overpaid council and charity treasurers and college bursars doing with their minds idling in neutral? Depositors should understand that a deposit is nothing more than a loan and thus carries a degree of risk. If depositors want a risk-free deposit they should buy gilts or put their money with NS&I. State protection-or, more accurately, taxpayer protection-for depositors carries a double risk as state support stokes future risk-taking by banks. It is only rational behaviour for banks to double their bets: if the bets come off they win; if they do not, the state guarantees their losses. As Vince Cable pointed out, the gains are privatised and the losses socialised. I hope the Government will look carefully at the danger of taxpayer guarantees.

This brings me on to the equally difficult question of how to deal with financial institutions that are too big to fail or, as the noble Lord, Lord MacGregor, said, too difficult to manage. The banking supervision report looks at this problem in some detail, making a number of sensible suggestions to de-risk the taxpayer. I should like to add something different to the mix. I suggest, rather diffidently, that there may be lessons to be learnt on banking structure from the unlikely source of hedge funds. Noble Lords will be aware that hedge funds were the villains of choice as the cause of the banking crisis; subsequent analysis has, however, shown that they had little or nothing to do with it. Why? Because, unlike banking, the hedge fund sector does not consist of a small number of large players but a large number of relatively small players. On the face of it, prudence and hedge funds seem unlikely bedfellows, but please listen to this quotation:

"It may be coincidence that the structure of the hedge fund sector emerged in the absence of state regulation and state support. It may be coincidence that the majority of hedge funds operate as partnerships with unlimited liability. It may be coincidence that, despite their moniker of 'highly-leveraged institutions', most hedge funds today operate with leverage of less than a tenth that of the largest global banks. Or perhaps it might be that the structure of this sector delivered greater systemic robustness than could be achieved through prudential regulation. If so, that is an important lesson for other parts of the financial system".

Who wrote that? It was not some financial scribbler in the financial press. No-it was taken from a paper called Banking on the State,written by the Executive Director of Financial Stability at the Bank of England, Andrew Haldane. I leave the thought with the Minister that that paper was written by an adviser at the Bank of England; it deserves careful study.

On the question of EU regulation of our financial services, the committee asked whether the EU is the right area for action, going on to recognise the dangers

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of over-regulation and a resulting loss of global competitiveness. It also usefully underlined London's pre-eminence in financial services, pointing out that London would lose much more than any other member state from ill thought out regulation. What it did not say, perhaps out of misplaced tact, is that there is an EU bias against London's success. The German Finance Minister, Peer Steinbrück, in an interview with the BBC on 23 September, said:

"There is a clear lobby in London that wants to defend its competitive advantage tooth and claw ... We will deeply change the rules of the game for financial markets".

However, I draw some comfort from the unequivocal statement in paragraph 94 of the report, which says:

"Witnesses told us that giving binding powers to any EU body was not possible under the EC Treaty".

It went on to say that,

So far so good, but can the Minister explain how that squares with his Written Answers to the noble Lord, Lord Pearson of Rannoch, on 21 July this year? He asked the Government,

The Government's reply, through the Minister, was:

"The European Commission has indicated its intention to use Article 95 of the EC treaty as the legal basis for its proposals to establish a European System of Financial Supervisors. The European Commission has confirmed that day-to-day supervision of financial institutions should remain at the member state level".-[Official Report, 21/7/09; col. WA365.]

I gather that this proposal, as the noble Lord, Lord Trimble, mentioned, will be subject to qualified majority voting. So it seems that when the debate gets political, the UK can simply be outvoted.

This subservience to the EU's political agenda has recently been cruelly spotlighted by the sorry story of the Royal Bank of Scotland's mugging by the Competition Commissioner, Neelie Kroes. She forced disposals on Stephen Hester, the chief executive of the Royal Bank of Scotland, in discussions that he termed "bruising". He said at his press conference that,

That is a not a very good result, is it? The noble Lord, Lord Trimble, who is not in his place, was absolutely right that the Commission seems to have decided that it wanted a political trophy and the Royal Bank of Scotland fitted the bill. The Treasury did not really seem to understand the damage that this could cause to the bank until too late in the day. In fact, it was behind the game all the way.

Will the Minister tell the House, therefore, what the position is? Will control of our financial system rest with the UK or the EU?

8.47 pm

Lord Desai: My Lords, I join other noble Lords in welcoming these two reports. They are both excellent, and, as the noble Lord, Lord Skidelsky, said, we

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should make them more widely available to universities, economic analysts and whoever needs to be educated in the details of this matter.

I start my observations on a very different note by saying that crises not only happen, but are a natural part of capitalism. Crises are the way in which capitalism cures its problems. They are not accidents; they are systemic. Therefore, while we must do all that it is possible for us to do to mitigate the effects of crisis, I do not believe that any system of regulation devised by the human brain, either singly or collectively, will be able to prevent the next crisis. It will happen as sure as eggs is eggs and we will again find that the regulatory systems are inadequate and devise new ones. That is because human ingenuity, if there is enough profit incentive behind it, can always outstrip any amount of existing regulation-we at least know that much.

Our first task as we devise these systems is to make quite sure that the costs of the crisis are borne by those who benefit from the boom. Here, we have all failed. We have not been able to separate the goats from the sheep or, I should rather say, the rabbits from the foxes. There is no doubt that the retail depositor of a modest kind-it may up be to €100,000 or £100,000-needs protection, but those who deal with investment banks, hedge funds and other such intricate instruments deserve no pity whatever. Shareholders or bondholders of banks deserve no rescuing. They should be grown-up people; they have taken risks, and they should take the consequences. I, for one, am not at all persuaded by the story told us by the City and Wall Street and all that-that somehow there was a risk of systemic failure. It was a mistake to rescue Bear Stearns; had we not done so, Lehman Brothers would have learnt some lessons and sobered up long before. So Lehman Brothers went, which sadly cost enormous sums to the taxpayer, but I would have liked to see what would have happened in a more robust environment.

The boom was very long-63 quarters, as one report says, of uninterrupted growth of GDP. It was one of the longest booms in recent history, and we had forgotten that all booms come to an end and that in the 1970s we had a banking crisis, as well as a deep recession in the 1980s and another recession in the 1990s. We just did not have a recession around 2000, so we got carried away perhaps. We should get back to the idea that we live in a system that naturally has cycles. It is unstable and cannot be made permanently stable. That is a major virtue of the system; it is not a problem, but a virtue. To the extent that we devise protective institutions, we should protect the retail depositor and perhaps-although it is too late this time-the taxpayer, rather than banks and bankers.

I move to the recommendations of the reports. Clearly the big element is macro-prudential supervision. Unlike the noble Lord, Lord Skidelsky, I am not so against models. I think that I can say without any false modesty that in this Chamber, at least tonight, I have done more modelling in my life than anybody else-econometric modelling, I hasten to add. I see in the evidence from Jon Danielson, whom I know very well, taken by the committee chaired by my noble friend Lady Cohen, that the models that the banks used are fragile because their samples are very small. If your

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samples are small, it is natural that you have very unrobust parameter estimates. They do not become good just because we call them models, and they are not perfect just because we use mathematics. Aside from the idea that there is uncertainty and not risk, even the risk can be modelled much better than we are doing. We have tolerated extremely bad econometric modelling, which has cost us enormous sums of money.

I should like to see an institution such as the IFS-something independent that would look after financial modelling and macro-prudential modelling. It should not be part of the government or the private sector but funded with sufficient resources that we can rely on its judgment about how the system is modelled. Nobody has even given me a precise definition of what "system stability" means. We are talking about financial system stability, but there are no definitions of it. I could sit down and make a definition, but to incorporate it mathematically would require enormous amounts of data and a very sophisticated technique, in which parameters drift around rather than stay constant and so on, but I think that it can be done. It is our duty, as far as possible, to improve our knowledge base much more than at present. People are getting paid enormous sums for doing bad work and it is our duty to invest in much better knowledge of how the banking system works or does not work.

The best that we can do is not so much prevent crises but improve our mopping-up operations. Importantly, the report talks about the problem of Iceland and the related problem of the EU. When push comes to shove, a bank needs a state behind it to rescue it. Only the state has powers to print enough money to lend to the bank that is bankrupt. Unfortunately, the problem is that the state can only print its own money-it cannot print foreign money-and, in the case of Iceland, the liabilities were in foreign currencies. By the time the bank went bust, the assets were all toxic. The state of Iceland did not have enough dollars, sterling or euros to be able to bail out its own banks.

Even if we had the most sophisticated supervisory system of the type the report recommends, the EU and its fiscal authority has no money. It does not have sufficient money to bail out a really serious big European bank. It would fall to individual European states to take bits and pieces of a large multinational, multibranch bank and rescue it. Although one example is cited in the report in which France and Belgium each rescued part of a bank that was operating in those countries, in a global banking system we would have to devise better rules about who finally pays for the rescue of a bank that is going bust. As I said, I would prefer not to rescue banks at all, but if we are going to rescue them, we need clear rules, especially in the context of the EU, when some are in the eurozone and others are in a different system.

To the extent that we can separate out the rabbits and the foxes to protect the rabbits and shoot the foxes, the hedge fund problem is not serious. People who subscribe to hedge funds are grown-up enough to know what risks they are taking. If they do not, they should not be there. We should leave the hedge funds alone and let them do whatever they do because that is a sector of professional high risk-takers who know

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what they are doing and are amply rewarded for the risks that they take. We should look after the small person, but more than that we must look out for the taxpayer.

I want to say something about all the structures that have been set up. Despite the FSA and the various other bodies that we have, what has actually worked-here I differ from the noble Lords, Lord Willoughby de Broke and Lord Trimble-is that the European Commissioner for Competition has the best policy about what to do with banks: break them up. Prudential supervision may not work, but if you can enforce rules of competition and see to it that no bank gets too big-whether a pure retail or a mixed bank-we may yet have some insurance against the likely failures and, if they do fail, the cost of rescuing them would be modest and not enormous.

8.58 pm

Lord Forsyth of Drumlean: My Lords, I begin on a sour note by saying that I do not know what the business managers were thinking by putting this debate on at this hour of the night. Here we are discussing the most important issues facing our country, and indeed the world, at nine o'clock at night-an hour after the other place has gone to bed. The chairman of the FSA, the noble Lord, Lord Turner, stayed for all of seven minutes. If Parliament does not take its own committees and reports seriously, how on earth can we expect to restore people's faith in the parliamentary system, which is another major issue facing us this at this time?

I enjoyed being on the committee and was hugely appreciative of the enormous time and effort that people put into giving evidence. I started the inquiry wondering, "How on earth did we get into this mess? How could so many clever people get things so profoundly wrong?". And that is what I would like to focus my remarks on this evening, as well as on chapter 2 of the report, which deals with the causes of the crisis. My noble friend Lord MacGregor has dealt with the recommendations. I would like to pay the Minister a compliment-he looks shocked, but I very much appreciated the positive way in which the Government responded to so many of the recommendations, and, indeed, the careful way in which the Minister has played the very difficult hand that he was given just over a year ago.

The first thing that we need to get straight, as my noble friend Lord Trimble said, is that this financial crisis was not caused by sub-prime lending in the United States. That has certainly been disastrous but, as my noble friend Lord Trimble said, it is a symptom, not a cause. The global imbalances and the lethal combination of very low interest rates and exceptional amounts of liquidity are the root causes. The Chinese have been saving vast amounts, accumulating about $3 trillion of monetary reserves. Other countries, such as Singapore, Korea, Taiwan and the oil-producing states, have done the same, while here and in the United States we were on a spending binge financed by cheap borrowed money.

The noble Lord, Lord Butler, put it brilliantly in a speech in the debate on the economy back in May:

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"Indeed, my view, at the risk of offending both Front Benches, is that the prosperity of the past 15 years owes less to the brilliant management of Governments or the financial authorities than to an extraordinary combination of circumstances; we had a supply of cheap manufactured goods from the Far East, a flow of cheap labour from eastern European countries and an abundance of cheap credit ... The trouble is that the prosperity has been built on major imbalances in the world economy. It has been built on consuming countries, including the United States and the United Kingdom, consuming more than we were earning and living on the credit of the exporting countries".-[Official Report, 7/5/09; col. 679.]

If you want to get to the bottom of a difficult problem, ask a former Cabinet Secretary to summarise it in three paragraphs; that, I believe, does it. Our report echoes those sentiments.

What worries me is that these imbalances, as the noble Lord, Lord Skidelsky, pointed out, have not gone away. Just as banks such as Northern Rock can collapse when their supply of credit vanishes, so can countries. It is pretty unusual for developing countries to be exporters rather than importers of capital. Against that background of cheap money, Alan Greenspan cut interest rates whenever there was a market setback, and Gordon Brown set an inflation target which excluded housing costs and created the conditions for an explosion in house prices, funded by cheap mortgages. As an asset bubble developed, with house prices growing by 25 per cent in one year, the Bank of England did precisely nothing. Gordon Brown had taken away its responsibilities for macro-prudential supervision and given them to the FSA, which was too busy creating bureaucracy to see what was happening in individual banks such as Northern Rock, let alone to take a view on the overall financial picture.

If this sounds like hindsight, look at the debate on the Bank of England Act 1997. The then shadow Chancellor, Peter Lilley, warned:

"With the removal of banking control to the Financial Services Authority ... it is difficult to see how the Bank remains, as it surely must, responsible for ensuring the liquidity of the banking system and preventing systemic collapse".-[Official Report, Commons, 11/11/97; col. 731.]

At the heart of this UK banking crisis is a regulatory failure and a failure of monetary policy. Gordon Brown is the author of both. He wrecked the supervision of the banking system in our country and encouraged the debt culture by boasting that he had ended boom and bust. By removing the safety barriers he made a serious crash inevitable. Not content with having caused real damage to pension funds by adding to the tax burdens on them with the changes on dividend tax, he is now talking about imposing yet another tax on pension funds and our other financial institutions-which, fortunately, his colleagues, with whom he was helping to save the world, have disengaged from. Of course he and the noble Lord, Lord Myners, now lead the chorus vilifying the bankers, but the Prime Minister, as Chancellor, was all over them once. James Crosby, the CEO of HBOS, was made deputy chairman of the FSA, the body responsible for banking supervision, and given a knighthood. Sir James was later asked to advise and report on sorting out the crisis in the housing market. He was ideally placed as HBOS went down with 40 per cent of its loan book in property, and, amazingly, with equity stakes in some of the companies to which the bank was lending money.

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The chairman of HBOS, Dennis Stevenson, was given a peerage and made chairman of the House of Lords Appointments Commission, the body which decides whether people are of sufficient calibre to make a regular and significant contribution to the Lords, as your Lordships know. Since his appointment a decade ago, in 1999, the noble Lord, Lord Stevenson, has spoken three times in this Chamber, and I can find no record of his ever having voted.

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