Chapter 1: Introduction|
The financial crisis of 2007-2008
1. The great financial crashes of history tend
to be sudden and shocking, like the bursting of the South Sea
Bubble in the 1720s, and to have disastrous effects on the wider
economy, like the Wall Street Crash of 1929. The scene for the
crisis of 2007-08 was set by international macroeconomic imbalances,
low interest rates, rapid credit expansion and much greater use
of complex financial instruments in a search for better returns,
so that markets became harder to understand. But little heed was
paid to the risks before the bubble burst. As Chuck Prince, the
ex Chief Executive of Citibank, said: "
as long as
the music is playing, you've got to get up and dance".
2. The crisis broke when confidence was lost
between banks around the world. Alan Greenspan, the former chairman
of the Federal Reserve, went so far as to say of modern risk management
models that "the whole intellectual edifice
in the summer of 2007.
The effects on the global financial system were far-reaching.
Interbank lending dried up. The impact on some financial institutions,
notably in the US and the UK, was catastrophic. Huge government
3. The crisis brought an abrupt and devastating
end to an apparently benign period during which the world economy
had experienced sustained growth with low inflation. The world
economy is shrinking for the first time since 1945. The first
priority of economic policy makers around the world has been to
stabilise the financial system. Also vital are their efforts to
limit the impact of the financial crash on the wider economy as
the world faces the worst recession since the Great Depression
of the 1930s.
4. In Britain, several large banks have turned
to the state for support and some have failed altogether. Mainly
as a result, Government debt is rising to levels unheard-of in
peacetime. The impact on the wider British economy has been dramatic.
After 15 years of sustained growth, it is expected to shrink about
4% this year. Unemployment is rising fast. There are concerns
about the City's position as a leading financial centre. The effects
are likely to persist for some time. This report is concerned
mainly with the regulation and supervision of the financial services
sector, rather than the larger question of the role of financial
Financial supervision and regulation
in the United Kingdom
5. This Report examines the supervisory and
regulatory framework in the United Kingdom when the crisis broke
and recommends changes. A key role of regulation is to prevent
crises or to mitigate their effects. The present system failed
to do so. Inadequate regulation around the world also played a
part as the crisis unfolded. There should, however, be no rush
to action. The financial sector is unlikely to embark soon on
risky new adventures. The main objective of policy should be to
change the regulatory regime in order to make future crises on
this scale less likely without stifling innovation.
6. The financial sector is subject to much closer
supervision than, say, manufacturing because banks are critical
to the operation of the economy. As Professor Geoffrey Wood
told us, "Banks are important in a way no other kind of firm
is important. No economy can function without a functioning banking
system. The greatest example of this is, of course, the Great
Depression of the 1930s in the United States. The greatest depression
in recorded history was a consequence very largely of bank failure"
7. Close supervision is needed because bank failures
can have wide-ranging external effectson depositors, taxpayers,
other financial institutions, businesses and the economy as a
wholenot taken into account in day-to-day banking decisions.
Mr John Varley, Chief Executive of Barclays, said: "My view
would be that with the involvement of taxpayers' money, whether
it is in this country or in another country, of course goes a
taxpayer's agenda of some sort" (Q 443). Mr Douglas
Flint, Group Finance Director of HSBC, said it would be "entirely
appropriate for there to be clear accountability to the taxpayers
who have put money at risk, put money up for the capital of banks"
8. Financial regulation is effective when it
addresses these external effects or "externalities",
either by making banks and other financial firms pay for the consequences
of their actions, or by restricting their actions so as to avoid
the most damaging effects of financial failure, at least cost
in terms of reduced competitiveness, discouragement of innovation
or encouragement of avoidance.
9. We use the term "regulation" to
refer to the rules that govern the behaviour of financial intermediaries,
and "supervision" for monitoring and enforcement
of the rules. Most financial supervision falls into three broad
- Micro-prudential supervision checks
that individual financial firms are complying with financial regulation.
It involves the collection and analysis of information about the
risks that the firms take, their systems, and their personnel.
Because micro-prudential supervision uses firm-specific information
to generate a picture of risk and its management, it is often
referred to as "bottom-up supervision".
- Macro-prudential supervision is concerned
with the aggregate effect of individual firms' actions. A lending
decision which appears sensible at an individual bank may engender
system-wide risk if it is taken by every bank. Because it aims
to generate an overall picture of the functioning of the financial
sector, macro-prudential supervision is often referred to as "top-down
- Conduct-of-business supervision is
concerned with consumer protection, inter-firm transactions, insider
trading, and other matters including measures against money-laundering.
10. The purpose of this report is to draw the
right lessons for Britain from the crisis. In particular:
(a) to examine the effectiveness of British banking
supervision and regulation before and during the crisis, and of
policy responses since; and
(b) to recommend changes where appropriate.
At the same time as our inquiry, Sub-Committee A
of the EU Committee of the House of Lords has been conducting
an inquiry into EU aspects of the crisis and the Treasury Committee
of the House of Commons one into the Banking Crisis. Our report
focuses specifically on banking supervision and regulation.
1 "Bullish Citigroup is 'still dancing' to
the beat of the buy-out boom," Michiyo Nakamoto and David
Wighton, Financial Times, 10 July 2007. Back
Testimony of Alan Greenspan, Committee of Government Oversight
and Reform, House of Representatives, 23 October 2008. Back