Banking Supervision and Regulation - Economic Affairs Committee Contents


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"[1].

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 … collapsed" in the summer of 2007[2]. 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 bailouts followed.

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 services.

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" (Q 66).

7.  Close supervision is needed because bank failures can have wide-ranging external effects—on depositors, taxpayers, other financial institutions, businesses and the economy as a whole—not 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" (Q 443).

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 categories:

  •   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 supervision".
  •   Conduct-of-business supervision is concerned with consumer protection, inter-firm transactions, insider trading, and other matters including measures against money-laundering.

Scope

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

2   Testimony of Alan Greenspan, Committee of Government Oversight and Reform, House of Representatives, 23 October 2008. Back


 
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