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As other noble Lords have noted, the financial services sector is vital to the UK economy. At around 8 per cent of GDP, according to PricewaterhouseCoopers it contributed over £24 billion in corporation and payroll taxes to the Exchequer in 2008. The sector supports 300,000 jobs in the capital and underpins 700,000 sought-after jobs elsewhere in the UK. The City is the most international of the world's leading financial centres. Many globally mobile businesses and individuals choose London. Their taxes help to fund our public services. Those businesses do not need to be here but they choose to be, partly because of London's wider attractions but also because of our historic strengths in the sector.

In his 2009 report for the London mayor, Bob Wigley listed our strengths: a deep talent pool, world-class support services underpinned by a stable legal framework and, at least until recently, a predictable and competitive tax and regulatory regime. To surrender or dilute these strengths would be an act of self-harm that would embolden our rivals and undermine our economic prospects. Therefore, as I see it, the criterion against which this Bill should be judged is whether it will nurture a sustainable financial services community in an increasingly competitive world and, as a prerequisite to that, whether we can rebuild a valued and trusted financial community.

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The G20 communiqué last April noted:

"Major failures in the financial sector and in financial regulation and supervision were fundamental causes of the crisis. Confidence will not be restored until we rebuild trust in our financial system".

Trust is fragile; it is much easier to lose than to acquire. The City's reputation clearly has suffered both globally within the industry and locally among the British public. There is little that we can do by legislative decree to restore trust. The banks must acknowledge that their public image has been damaged by aspects of the behaviour of some and they must be seen to put their own houses in order. What we can do is address shortcomings in Britain's regulatory framework so as to underpin both trust and competitiveness.

When reviewing the Bill's specific provisions, I start with the perhaps counterintuitive thought that tough regulation can be a source of competitive advantage. Rules that are effective and consistently enforced make Britain a safe and attractive destination for global business. I welcome in Clause 1 the creation of the Council for Financial Stability to deal with cracks in the tripartite structure and I can see the arguments for more radical change that noble Lords on the opposition Benches have set out. However, in this debate on the structure of regulation, I would also emphasise the importance of calibre and conduct. As the fallout from the credit crunch made all too clear, we need more experienced and, dare I say, possibly better-paid regulators who have the wisdom and discretion to enforce the legislation that we enact and the codes and rules that flow from it.

I also welcome the duty in Clause 8 for the FSA to promote international regulation and supervision in support of financial stability. It is important that our agencies contribute to the search for international common ground. As a key player, we can provide insight and leadership, but in pursuing more effective regulation we should be like a pacesetter, not a runaway leader. We must not get too far ahead of the pack. We need to find the balance between leadership and imposing too many costs, especially unforeseen costs, on our financial sector versus others.

I understand the Government's concerns over pay. There has been public outrage at the bonus policy of some banks whose survival has been the result of public support. However, progress has been made. Banks will adhere to the FSA's code of practice on remuneration and, I understand, have agreed to meet the Pittsburgh principles and to support in principle the Walker review's recommendations both on corporate governance and on pay disclosure. However, I fear that the proposals in Clause 9 go too far. Giving the FSA powers to override freely negotiated contractual arrangements fundamentally undermines transparency, certainty and predictability, which are the gold standard of good regulation.

Similarly, I understand the ambitions for recovery and resolution plans, the so-called "living wills", in Clause 12. However, what is appealing theory is often poor practice and I fear that we are moving too far, too fast. There is no international agreement on how these plans should work or any clarity as to what a British model would look like, yet the FSA will be subject to statutory obligations. I ask the Minister

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whether it would be better if we waited for a workable template that could be promoted by the FSA under Clause 8 before we move forward. Surely we should be wary of saddling ourselves for all time with overengineered solutions to an extraordinary shock, the fallout from which remains unclear. Ten years from now, in a post-credit crunch era, when trust is restored and international conditions more certain, hindsight will probably tell us that we overegged here or inappropriately egged there. Sir Hugh Casson once said:

"The British love permanence more than they love beauty".

Let us seek the beauty of efficacy rather than the ugliness of permanence. Will the Minister consider adding a sunset clause to those provisions that radically increase the powers of the regulator so that Government and Parliament can actively reconsider their salience in a few years' time?

Sir Win Bischoff, in his report to the Chancellor last year, argued that for Britain the future is about partnership between the financial services sector and the wider economy, as well as the partnership between the UK and the financial centres of the emerging economies. The other partnership required is between Parliament, Government and the sector. We need to move on from bashing the banks and start focusing on how they can continue to be a strong source of competitive advantage for Britain.

6.36 pm

Lord Stewartby: My Lords, towards the end of a debate of this kind, most of the key issues have been identified and discussed by other noble Lords, but over the years I have had the advantage, if advantage it is, of looking at many of these questions from different points of view. In the 1970s, as head of the treasury department of a merchant bank, I used to report to the Bank of England, while in the 1990s I was a member of the board of the Financial Services Authority. Also, for a number of years I was chairman of the audit committee of an international bank. I find myself absolutely astonished, appalled and baffled by what has happened over the past two or three years and I have been trying to get to the bottom of it. I shall pick out just two or three of the key issues that we need to address.

The first is who should take the lead in the critical area of supervision. This is not a matter for dogma or for personalities; it is a matter of practicality. The conclusion that I come to is that the Bank of England seems to be better situated to deal with these things than the FSA. There is a difference of style and culture between the two. The style of the FSA tends towards the legalistic. I am not at all surprised that it is now felt that the FSA in later years paid a disproportionate amount of attention to consumer issues at the expense of the supervisory side. That may have had an impact on its performance. The Bank of England has much greater practical experience of markets. Being close to and understanding the markets lies at the heart of the most difficult aspects of banking supervision.

One can identify practical examples of where the Bank seemed to have got the message rather earlier and more thoroughly than the FSA. I do not want to run down the authority because I respect its chairman,

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just as I respect the Governor of the Bank of England. However, the FSA was more detached from the market system, which you need to know about if you are going to be an effective supervisor. If the idea is to have one authority embracing these functions, it should probably be the Bank of England and not the FSA. I am encouraged by what has been said by the noble Lord, Lord Turner, about the supervisory enhancement programme-rather a typical title for what is really an executive and administrative exercise-but I very much agree with my noble friend Lord Blackwell that there is confusion in many people's minds between regulation and supervision.

Regulation is about making rules and setting up a structure in which the regulated bodies have to conduct their business. Supervision is a question of micro-prudential issues, institution by institution. That requires a very different cast of mind. The central problem of the crisis of the past two or three years is that things were being done by a large number of substantial institutions in many countries that, when aggregated, produced a global financial crisis. But nobody seems to have been looking at them closely enough to see the macro side as well as the micro that was in front of them and at which they were meant to be looking.

I constantly scratch my head and try to work out what sort of reaction to these dangerous activities was felt inside the institutions and by their auditors. There were the operatives who implemented the policies of taking on what would become toxic assets and dealing with complicated derivatives. There were the management and board of those institutions. There were the internal audit department, the audit committee, the external auditors and the supervisors. Everybody got it wrong. If I am not out of order to quote Her Majesty, she got it absolutely right with her killer question when she went to the LSE. She asked:

"If these things were so large, how come everyone missed them?".

It is a question that needs an answer.

I do not know how, on such an enormously wide and varied scale, the principal financial bodies could really have missed everything. Were they not looking or were they looking in the wrong direction? We need to know more in detail how these things came about. If you have a problem, you need to know what has gone wrong in detail and why before you can put it right. I hope that the measures in the Bill will contribute to a much sounder system in future, but that will depend on people asking the right questions and, on past form, one cannot be 100 per cent confident that that will happen.

There has been a tendency to use mathematical models to measure risk. Such models have their use but they are only as good as the assumptions that you feed into them. More and more it seems as though some of those mathematical models were rather off beam. The Governor of the Bank of England, at least two years before the Northern Rock crisis, issued a warning that he felt that the markets were mispricing risk. They were indeed. It took a while for that to become evident, but I do not think that anything happened at the FSA end. I do not think that the FSA asked of every institution that it was supervising,

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"What does the governor's remark mean in this case? Have we looked at the areas where things could be mispriced that would cause danger to the institution itself?". We still have a whole raft of unanswered questions and, at the outset of consideration of a Bill such as this, we have to face the fact that there is still a lot that we do not know that we need to know.

My noble friends Lord Lawson and Lord Blackwell and the noble Lord, Lord Barnett, mentioned the separation of different kinds of banking. I have tried to work out how you would do that in practice and how you could have an effective firewall between the two. My noble friend Lord Blackwell said that you could have two separate incorporated bodies as subsidiaries of the same parent. In theory, that might work, but, in practice, you would have two bodies performing very different types of business but where the capital and implicit guarantee of the funds of the body were separated from an area where business was being done on an entirely different basis. It might work, it might not, but it is an important point and should be looked into further.

Many of the problems of the past few years have come through having monetary policy too loose for a long period. It is not just the property bubble; there were other areas, which I will not say more about now. We should not lose sight of the fact that the tremendous pressure on the acquisition of assets came from surplus funds in the system. That casts doubt on whether the consumer price index can really carry on on its own as the important point of reference.

6.46 pm

Lord Eatwell: My Lords, it is now a year and a half since the collapse of Lehman Brothers and since that fateful weekend when the UK banking system teetered on the edge of collapse-a collapse only prevented by the decisive action taken by this Government with a bank rescue plan that was, in due course, copied around the world.

The rescue was, as we now know, a remarkable success. Indeed, it has been almost too successful in that many bankers, with their notoriously short attention span, have already consigned the crisis, and their role in it, to history. Fortunately, the Government and the regulatory authorities have taken a very different view. Every major financial centre has undertaken a wide-ranging review of the structure of the regulatory system. In Britain, the new thinking was launched by the Turner review in March last year, followed later by the Treasury White Paper, in July, and by several valuable Bank of England studies. The de Larosière committee set out proposals for EU reform last February. The US Treasury published its own White Paper nine months ago, and in December the Basel Committee on Banking Supervision published its own comprehensive proposals.

These studies display a remarkable degree of unanimity. All acknowledge serious shortcomings in regulatory analysis prior to the crisis. Those shortcomings derived from the philosophy of banking regulation embodied in Basel II, the conventional wisdom in the decade before 2007. That conventional wisdom decreed that greater transparency, more disclosure and more effective

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risk management by individual firms would manage risk effectively. The result was a regulatory system that was highly market sensitive and strongly pro-cyclical-in other words a regulatory system that encouraged herding, fed panics and, by ignoring the system-wide costs of risk-taking by individual firms, weakened the defences of the financial system as a whole in the face of extreme events. All in all, the Basel II philosophy resulted in a regulatory infrastructure that made the downturn much worse than it might have been.

To give them credit, the authorities everywhere have rapidly reset their regulatory compasses. They now argue for a new approach that, in professional jargon, is known as macro-prudential regulation, which was referred to earlier in the debate. Broadly, that means that the activities of firms should be regulated according to the impact they have on the stability of the system as a whole-the macroeconomy.

What sorts of measures flow from this approach? They include, first, that regulators should take particular notice of the interconnections in the financial system, tracing as best they can the pathways through which financial contagion can spread. This requires a detailed knowledge of markets that in this country is found only in the FSA, but that detailed knowledge must be projected on to a system-wide template. Secondly, it requires that any institution which poses systemic risks-be it a bank, a prime broker, an insurance company or a hedge fund-should be strictly regulated. Thirdly, systemically relevant institutions should undertake pro-cyclical provisioning. That means accumulating capital in good times to provide a buffer against downturns. Fourthly, "leverage collars" should be enforced, relating the ability of the banks to expand their balance sheets to macroeconomic conditions-note, macroeconomic conditions, not the circumstances of the individual firm. Fifthly, measures must be taken to ensure that firms can fail without endangering the stability of the system. As if this was not enough, all this must be implemented on an international scale because systemic risk is a characteristic of global markets.

This is a truly radical agenda. Let us suppose, for example, that pro-cyclical provisioning became the norm. The economy is booming; tax revenues are rolling in, sustaining a healthy fiscal balance; house prices are rising; borrowing is easy; everyone is happy, and a general election is approaching. Then the regulator sharply slows down the economy by severely restricting bank lending. Just imagine the furore. But that is the sort of approach that macro-prudential regulation will demand.

Lying behind this radical approach is the sort of radical thinking that everyone involved in financial policy should be confronting. As an aside, that is why it is disappointing to encounter yet again the intellectual vacuum that characterises the contributions of the Official Opposition. From the Opposition Front Bench we heard nothing that remotely amounted to a vision of how the content of financial regulation might be reformed. Instead, as nature abhors a vacuum, all that the Opposition propose is a shuffling of institutions that will condemn the FSA and the Bank of England to at least 18 months of bureaucratic restructuring, when they should be getting on with the job of complex

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regulatory reform. Those of us who were involved with the pre-FSA regulatory system, and who worked on the transition to the FSA, witnessed the degree to which these bureaucratic upheavals paralyse effective regulation for an unexpectedly long time.

How does the Bill measure up to the new approach that all serious students of regulation propose? I must confess that I searched in vain for the new vision. I would be grateful if, when he sums up, my noble friend will indicate where the essence of the new macro-prudential approach is to be found in the Bill. If there is to be pro-cyclical provisioning, which measures in the Bill will help to implement those procedures? How does the Bill face up to the Bank of England's concerns that this provisioning should be based on clear but simple rules rather than discretion? Which authorities are to be accountable for devising and implementing such rules? Does the legal apparatus introduced in the Bill permit the introduction of macroeconomically defined leverage collars? If so, how are such measures to be related to the overall stance of macroeconomic policy?

The essential problem with the Bill is that, in Churchill's famous phrase, it is a pudding without a theme. However, it contains some very tasty plums. Among the plums are the establishment of the Council for Financial Stability and the addition of the financial stability objective to the list of objectives of the FSA. Having spent a considerable amount of time and effort in the debates on the Banking Bill trying to persuade my noble friend that there should be such a council and that the FSA's responsibility for stability should be recognised, and having been rebuffed on the former and severely lectured to the effect that the latter was totally unnecessary, I cannot but welcome these measures-

Even in the absence of an overall macro-prudential vision, there are a number of other plums that provide useful sustenance. The requirement that the FSA promotes international regulation and supervision is one such welcome measure, though I must confess that I thought it did that already. Will my noble friend explain how in practice its activities will change? What will the FSA do now that it did not do before?

The measures on short selling address an obvious systemic problem and are welcome, but I worry that they deal with the symptom and not the disease. The disease is the general problem of herding, notably the simultaneous deleveraging that the Basel II standardisation of risk modelling so actively encourages. Herding is a product of the homogenisation of the marketplace, a homogenisation greatly enhanced by the liberalisation of financial markets and the conglomeration of financial institutions that has been one of liberalisation's consequences. Without direct measures to address the phenomenon of herding, the temporary suspension of short selling is a sticking plaster on a gaping wound.

The requirement that institutions develop recovery and resolution plans is also a welcome addition to the armoury of measures designed to reduce systemic risk-in this case tackling, at least in part, the problem of "too big to fail". I have one concern with the provisions as drafted. The recovery and resolution

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plan drawn up by an individual institution will necessarily be based on the risk parameters as observed by the institution itself. It will not be possible for the institution to take into account the systemic costs of its recovery plan, or indeed of its resolution procedures. The need for the authority to take explicit note of systemic issues when assessing recovery and resolution plans should be in the Bill, and I intend to bring forward amendments to that effect.

I am sure that the provisions with respect to remuneration will be a major focus of public attention. I confess to being agnostic on this matter. Clearly, if remuneration practices actively encourage greed and excessive, even immoral, risk-taking, and hence increase systemic risk, they should be constrained or eliminated. However, given the market and regulatory structures existing in the run-up to the crisis, even if all bankers had been models of moral rectitude, the result would not have been much different.

There is one measure that is not in the Bill that I believe would significantly improve the quality of regulation in the UK. When I joined the board of the old Securities and Futures Authority in 1997-I had the pleasure of serving with the noble Lord, Lord Hodgson-I harboured considerable suspicion about the role of practitioners in self-regulatory organisations. Would they not simply look after their own? During my time at the authority, observing the performance of practitioners at first hand, I changed my mind completely. Far from looking after their own, the practitioners were typically tougher than the staff. Practitioners who were given responsibility for regulatory decisions "went native" as regulators. Their commitment was to "the industry". They were concerned with the maintenance of integrity and fair market dealing that would be to the ultimate benefit of the financial services industry as a whole.

I was also impressed by the very high level of expertise that the practitioners brought to guiding the work of the staff of the SFA. These were people who worked in the markets on a daily basis and were at the leading edge of their various disciplines. I am very sad to say that the Financial Services and Markets Act was a notably anti-practitioner measure. Practitioners were corralled into advisory bodies, well away from statutory decision-making responsibilities. From my time on the FSA's Regulatory Decisions Committee, I can testify that this was a major error. The quality of enforcement work I saw at the FSA was considerably inferior to that performed at the old SFA. If we are to improve the expertise that is brought to bear on UK financial regulation, we need to find new ways of involving practitioners directly in the regulatory process. I will be considering whether the Bill can be amended to achieve that goal.

One final comment: it is commonly argued that regulatory reform can take place only on an international scale, and that all national measures should be suspended or postponed until full-scale international agreement is reached. This is a wonderful device for kicking reform into the long grass. It is also nonsense. Most of the important regulatory innovations in the past 40 years were launched unilaterally or by one or two countries. The first Basel capital accord was a bilateral deal between the UK and the USA when the noble Lord,

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Lord Lawson, was Chancellor of the Exchequer. Moreover, the structure and content of the UK regulatory system has never been the same as that in the US, to no obvious detriment. We must push ahead as fast as we can. The multilateral system will fall into place in due course.

Eighteen months or so on from Lehman Brothers, it is disappointing that a comprehensive reform package is not before us. What is in this Bill is worth while, but it is less than a halfway house. There is much more to be done before the regulatory system catches up with the last crisis, let alone prepares for the next one.

7 pm

Viscount Trenchard: My Lords, I am grateful to the Minister for introducing this debate. I must declare an interest, in that I am employed by Mizuho International plc, which is regulated by the FSA, and I am a director of other investment companies.

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