How to police the banking system

Will today's long-awaited White Paper be enough to avert the next crisis, asks Economic Editor Sean O'Grady

Wednesday, 8 July 2009

Today's White Paper has two audiences. First, there is the public, who want to know whether they can trust the banks and insurance firms, and the products they peddle. For them, the Government will have plenty to offer, including a flagship scheme to offer the financial equivalent of NHS Direct – independent financial advice delivered by the likes of the Citizens Advice Bureaux and Age Concern. A pilot scheme has been running since April in the North-east and North-west and a national rollout could take place over the next year.

For disgruntled customers and their champions in the consumer press there is even more: the banks and the Office for Fair Trading will be urged to resolve the wrangles over bank overdraft charges; class actions will made easier to organise; investment firms will have to offer "heath warnings" on riskier products. Consumers ought to be happy with the paper. The banks and the City may have to look harder to see what's in it for them.

As every wily manager knows, the best way to get something done in an organisation is to ask two or more people, independently, to get on with the same job. The downside is some turf fights; the benefit is that the job will indeed get done.

So with banking regulation. If the Treasury wants to be sure that we will never again see a run on a British bank, the financial system left in meltdown and billions of pounds of taxpayers' money going on saving the banks, then it might be best to set two men on the job: Mervyn King, Governor of the Bank of England; and Lord Turner, chairman of the Financial Services Authority. The Bank and the Financial Services Authority, it seems likely, will both be given the task of helping to ensure financial stability. Thus, even if the Bank is "asleep at the wheel", the FSA may not be, and vice versa.

The danger of "underlap", as it was called by the deputy governor of the Bank for financial stability, Paul Tucker, should be avoided. And, even if our own regulators are, unaccountably, too dozy to notice some impending crisis, all the other global "early warning systems" that are in the process of being set up now will surely pick up the signals on the radar screen of impending doom – the International Monetary Fund, the new Financial Stability Board, a sort of club of international regulators among the G20, and the EU's European Systemic Risk Council will join them up in the crow's nest. The US Federal Reserve has also been given a more specific and wider remit on managing systemic risks to financial stability. From having virtually no one on lookout, the world will soon be surrounded by alarm systems. It could get confusing if they begin to differ.

In the case of the UK, the most likely outcome is the effective creation of a fourth regulatory body, a joint financial stability council or committee of the Bank and the FSA, probably with an observer from the Treasury (on the grounds that they pay the bills). The Bank's existing Financial Stability Committee will probably be relegated.

However, while we may thus learn the identity of the "who" when it comes to "macro-prudential regulation", we will not necessarily learn much more about the "what" – the teeth of the new body or committee.

The idea is that the banks will be urged to scale back their lending in a credit boom, but increase it in a credit drought, as now. But how? This was the crux of Mr King's complaint at the Mansion House dinner: that the Bank had been given a statutory responsibility, but not the tools to carry its job out. The new body, also, may have to wait some time before it is given its toolbox, for example altering a bank's capital requirements, or those across the system. But even then the Treasury, under either party, may be unwilling to transfer management of the credit cycle to unelected officials. In Mr King's telling metaphor, he and Lord Turner will continue to offer sermons and arrange funerals, but little more. The Treasury view is that they just have to speak up – to use their "power of voice". We will have to await the next election before this issue is properly resolved.

As will the other questions of "too big to fail" and separating the banks' retailing activities from their riskier ones. But the general principle – agreed across the authorities here and abroad – that the riskiness, the interconnectness and in some cases the size of a bank will determine its capital and liquidity requirements. It will take international agreement to sort out exactly how the idea of a "tax on size", as pioneered by Tim Geithner of the US Federal Reserve, can be made to work, and be fair to fiercely competitive international banks.

The remaining Treasury proposals will follow the broad path of the Turner Review, published in March. There will be higher capital and liquidity requirements on individual institutions, so that they "self-insure" themselves and have less recourse to the taxpayer if in trouble. There will be greater disclosure. There will be penalties, again in terms of costly extra capital requirements, for banks that run bonus schemes that jeopardise the wider financial system and economy (the FSA has already published its draft Remuneration Code). We will be promised an end to "shadow banking", and a tighter grip on hedge funds and other highly leveraged vehicles that behave like banks.

The White Paper, in other words, seems well placed to fight the last war; but few expect it to be clever enough to "future proof" the system completely against the next, unknowable, crisis.