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The first is that corporate clients require their commercial banks to offer them the full range of financial services and that to restrict their activities in any way would drastically reduce the financing options available to business and industry. This is palpably absurd. While many corporates may well desire and need a wide range of financing options, they have no need to get them all from the same institution; probably many of them would prefer not to have to do so.

The second objection is that the crisis was caused not-it is said-by the banks engaging in high-risk, high-reward proprietary or principal trading but by old-fashioned imprudent lending, largely against house purchase, as with the subprime market in the United States. The truth of the matter is that both activities made major contributions to the meltdown but, whereas the second can be addressed by straightforward capital-adequacy-based regulation and sensible supervision, the first cannot.

The third alleged objection to a new Glass-Steagall is that, even if such a separation were made, the collapse of a "pure" investment bank can still be a systemic threat-look at Lehman, they say. However, the case for compulsory separation is that it very substantially reduces the threat of systemic risk in a way that nothing else can. Moreover, had the core commercial banking system been thoroughly sound, the collapse of Lehman, although a shock, would not have posed any systemic threat. In any event, I am not arguing that investment banking should be completely free of all prudential regulation, although such regulation would need to be light touch, both for practical reasons and to allow the sector's creativity to flourish adequately-something that is most unlikely to happen in the current climate without a new Glass-Steagall.

Only one serious objection has been raised to the reform that I am suggesting, which is that in the complex modern financial world it is impossible to draw a line between those activities that a narrow bank is permitted to undertake and those that it is not. In particular, it is said that prohibiting narrow banks from engaging in principal trading, or proprietary trading, would be unenforceable because such trading is indistinguishable from a bank's normal treasury operations, when it is merely acting as an agent, notably in hedging its risks. But however difficult it may be to draw a line, it is perfectly possible. Moreover, it is generally agreed, even by the Government, that a new and improved system of prudential supervision and regulation will in any case need to insist on different capital adequacy and other requirements to reflect the different degrees of risk in different activities, so lines will have to be drawn anyway. That is a practical point of the first importance.

A key question is whether the separation that I am advocating needs to be complete institutional separation or whether it can be achieved by the less brutal means of a ring-fence or a firewall within a single institution, with retail depositors being given absolute priority in the event of a failure. While the latter may appear at first sight a judicious compromise, it is in fact seriously inadequate. There are a number of reasons why that is so. First, the characteristic of such ring-fences is that they are not watertight under extreme pressure. The

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ring-fence option rests much more weight than is prudent on the assumption of sophisticated and effective supervision and regulation. In practice, it is likely, if not certain, either that the regulators will be outsmarted by the hugely better paid and more motivated practitioners or that they will be excessively heavy-handed to try to prevent this, and maybe both. As the sage Paul Volcker, whom I remember well as the distinguished chairman of the American Federal Reserve during my time as Chancellor, and who is now an adviser to President Obama, recently observed:

"I am not so naïve as to think that, even with the best efforts of boards and management, so-called Chinese walls can remain impermeable against the pressure to seek maximum profit and personal remuneration".

If the investment banking activities come unstuck, this will inevitably weaken and possibly bankrupt the group as a whole.

Moreover, we have only to look at the United States to see the practical reality. Citibank, for example, has always been a wholly separate, and thus theoretically ring-fenced, corporate entity within Citigroup, but that did not save it. It is of course true that, even with complete separation, narrow commercial banks might still have normal banking exposures to investment banks and other financial companies, although in practice these customarily access the capital markets directly. Normal banking prudence is much more likely to limit the scale and nature of such exposures than is the case with a conflict of interest that arises when the institution and its shareholders have a substantial equity interest in investment banking.

Only a structural reform of the kind that I have been advocating can make financial regulation both effective and realistic, allowing investment banks the freedom to pursue their own often high-risk creativity and innovation without endangering the entire financial system and the economy as a whole. Protection of the economy-and, indeed, of the taxpayer, who has had to bear an unacceptably heavy burden in bailing out the financial sector-could be secured by ensuring, by regulatory requirements and supervision, that the commercial or utility banking sector was always thoroughly healthy. The discipline of the high-risk investment banking sector, which would be forbidden from taking retail deposits, would thus be left largely to market forces, with only relatively light, simple and thus realistic regulation, so avoiding the highly damaging increase in moral hazard that the current "too big to fail" doctrine has brought with it.

The essential point is that broad or universal banking, for a number of reasons, greatly increases systemic vulnerability, so there is a strong public interest in preventing it. This is the conclusion that is now being reached by President Obama in the United States, on the advice of Paul Volcker, whom I quoted a moment ago. Whether the American Congress will allow him to implement it remains to be seen, but it is most encouraging that, in a letter in yesterday's Wall Street Journal, it has been strongly supported by no fewer than five former US Treasury Secretaries from both parties.

Meanwhile, that is also the conclusion that has been reached by Mervyn King, the Governor of the Bank of England, as his eloquent testimony on a

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number of occasions, including to both the Economic Affairs Committee of this House and the Treasury Committee in another place, has made clear. Indeed, in his most recent appearance before the latter committee, the Governor went further and addressed the argument that, however desirable a structural separation of the kind that I have been discussing may be, it is not something that the UK could do on its own without grave damage to the competitive position of the City of London.

I know that my honourable friend George Osborne, while largely accepting the case for structural separation, has been concerned about this. With a financial sector that is five times as big in the UK as it is in the United States, relative to the size of the economy as a whole, the Governor pointed out that, in fact, the boot is on the other foot. He told the Treasury Committee:

"The only way we can really sustain a large financial centre in London ... is if we can make sure that it doesn't impose a prospective burden on taxpayers".

Only in this way can we fully restore global confidence in the British economy, with all that that implies.

The point is this: there are some who argue that having a banking and financial services sector as large as ours, in relation to the economy as a whole, makes us uniquely vulnerable-a sort of Iceland writ large-and that it should be a deliberate object of government policy to reduce it. I reject that. The City of London has historically been a great source of strength to this country and should continue to be so in the highly competitive globalised world of the future. However, it will be source of strength, rather than a source of weakness, only if it is made much more robust by the essential structural change that I have outlined.

I began by remarking that the overriding object of this Bill is to ensure so far as is humanly possible that a banking meltdown such as we have recently experienced does not occur again. The structural reform that I have been advocating is not a sufficient condition for this, but it is, without doubt, a necessary condition. The Government's failure to recognise this is the greatest single error in the regulatory regime that they are now seeking to put in place.

Lord Williams of Elvel: I am all in favour of sinners who repent, but does the noble Lord recall that in the 1980s the Conservative Government supported the big bang and deregulation almost endlessly, which gave rise in the end to the repudiation of the Glass-Steagall legislation in the United States? If he repents, perhaps that is good. In general, I support his arguments, as I argued against them when he was in the Government.

Lord Lawson of Blaby: I thought that that error might be made by someone, which is why I took the precaution of bringing the opening page of chapter 32, "Fraud and the City", of my memoirs. I will not read the whole thing, but it begins:

"It might seem surprising at first sight that a Government, and a Chancellor, so committed to deregulation, including financial deregulation, should have spent so much time over, and been so concerned with, financial regulation. Indeed, some have seen it as a tacit admission that financial deregulation went too far. But this is to be confused with words".

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Incidentally, this was published in 1992, so we have a lot of benefit of hindsight. It continues:

"Financial deregulation in no way implies the absence of financial regulation for prudential purposes and for the prevention, so far as possible, of fraud. Economic freedom, as much as political freedom, is possible only within the framework of the rule of law".

I went to considerable lengths to improve in the Banking Act 1987 prudential regulation of the financial sector in this country.

5.06 pm

Lord Desai: My Lords, I wish this would go on a bit longer as we have a lot to learn. I welcome the Bill. Like the noble Lord, Lord Lawson, I take the view that, no matter what you do, the system will have crises and cycles. All you can do is learn from the previous crisis, do your best repair job and wait for the next one. The most interesting problem that we have seen recently is not that the banks failed-banks have been failing for ages. Indeed, it was the failure of Overend and Gurney which resulted in the Bank of England getting the power to become a lender of last resort and to do much more supervision over banking. At that time, banking was an innovation. Each time there is a wave of financial innovation, the regulators lose control over the system, the system crashes and on we go. That is roughly my view.

We have to examine this legislation in terms of whether it will take care of what we have learnt from previous crises and whether it makes adequate repair or caution for such a crisis recurring. I do not believe that the system in the 1990s was perfect. I came to your Lordships' House in 1991 and I remember Barings Bank and the BCCI going. At that time, the Bank of England also had the problem that, while it had to regulate and supervise, it was also supposed to encourage the City to be a big player on the international field. There was a conflict between welcoming many more banks to work in the City and regulating them, which was a problem.

The latest crisis was not because the banks misbehaved because they were large banks-although that was one element. The much more important element, which we had not experienced for some years in developed economies, was that there had been six or seven years of excessively cheap credit, thanks to the global imbalances. At the same time, the pattern of global trade ensured us a low rate of inflation. Normally, under the monetarist idea, if you have too much credit, inflation happens and the system checks itself. We have learned that; I fought all those battles many years ago. This was the first crisis of the global system and we were not able to take it on board. The Chinese surplus balances were providing cheap credit for us, and the Chinese exports which earned that surplus credit were keeping inflation low. The Chinese were acting almost like a drug dealer by loaning back to the drug addict the money he had just paid to buy the drug.

You have to look at what the banks did in the context of this excessively cheap credit environment, with low inflation and central bankers not able to provide the kind of regulatory warning that they should have. We have it now in the memoirs of Alan

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Greenspan. We know, basically, that central bank after central bank failed either to tell their Governments to balance their budgets or to provide any kind of regulatory interest rate policy, except when it was too late. The problem was not that we had a crisis-many economists were muttering about one, we just did not know when it would happen-but that it cost us too much to rescue these banks. I agree with the noble Lord that, in a system of free market, the process of greed and so on has to be regulated by the force of the market. However, if you remove the threat of bankruptcy, you remove that regulatory mechanism, and that is where the problem was.

I, being a Hayekian libertarian, among other things, would have preferred the banks to go and for us not to have rescued a single bank. We were told that all sorts of dire things would have happened. I doubt that. The next time around, we ought to do some simulations as to what those dire things would be if it happened. So we rescued the banks despite all the warnings of moral hazard that Mervyn King muttered.

I should like to put one question to my noble friend-I am sorry that I have not given him notice of it. What will be the final cost of the bank rescue? Has he any estimate of what would happen if banks get better and restore profitability and we are able to get rid of all this bank equity that we have bought? What will be the final cost-not the current cost-to banking? It may turn out to be much smaller than what we are currently facing.

I like the Bill because it says what we can do next time around to minimise the cost of rescuing banks which are about to fail. The living will is an early warning system to the banks that they have to look after their own health; it is like a health check for banks. It will provide the Council for Financial Stability with an early warning of the banks that are likely to fail. That is a good thing. So the next time around we might not have to shell out as much money as we did this time.

However, there is a problem which I would urge the Council for Financial Stability to think about. We have found out that when the system fails, it is not only one bank that fails; the failure of one bank affects all other banks. Where we had systems of micro-prudential supervision, we are now talking about macro-prudential supervision- and I can assure your Lordships that most people do not know what macro-prudential supervision means.

Most people do not even know what financial stability means because we have not really worked out those concepts in detail in serious, mathematical computer modelling. These things have been done by physicists but not by economists. One of the tasks of the Council for Financial Stability will be to work out the theoretical part, to conduct research and development as to how it will know when the next financial crisis is likely to occur and not be surprised by it.

I would much rather worry about the interconnections within the banking system which spread the contagion. For example, Lehman Brothers, which, although it was not very large by any definition, still caused a lot of problems because of its interconnections with the rest of the system. Those are the problems which the

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Council for Financial Stability will have to address. If it can deal with them in terms of research and development, and if the living will can be done robustly, this Financial Services Bill will make a lot of difference.

5.16 pm

Baroness Hogg: My Lords, before attempting to contribute to this debate, I must declare a number of interests. I am chair of 3i Group, whose asset management subsidiary is regulated by the FSA. I am also an adviser to the FSA and, perhaps most importantly, in May I shall become chairman of the Financial Reporting Council, a very modest part of the regulatory architecture that we are discussing here. I am also chair of Frontier Economics, which has done a good deal of work in the field of regulation.

I therefore rise not so much to oppose the Bill, which has a number of valuable elements, as many noble Lords have said, as to plead for full consideration of the options for change. This is not a time for half-cooked solutions. The reconstruction of financial regulation was rushed, as the noble Lord, Lord Lawson, said, by the incoming Government in 1997. In giving the Bank of England independence in the operation of monetary policy, the Government won many plaudits, although the real test of this will not come until we have successfully negotiated an exit from our current parlous fiscal position. That will require very close co-ordination between the Bank of England and the Treasury, in which neither can see itself as entirely independent.

Meanwhile, the counterpart to a much applauded enhancement of the Bank's monetary role was a deliberate demotion of its role in financial supervision. It was thanks only to Lord George fighting a doughty rearguard action that the Bank retained as much capacity in this area as it did. Despite his protests, the Bank's crucial role as guardian of the financial system, informed by its knowledge of the different elements, was effectively demoted.

With the supervision of financial institutions passing to the FSA, a gap opened up in our arrangements. Responsibility for macro-prudential supervision simply disappeared into that hole-how right the noble Lord, Lord Desai, was to say how difficult a role that is. As a result, it is now widely acknowledged that we have suffered particularly badly from what economists call "the fallacy of composition", whereby individual institutions were assessed, more or less well, but the aggregate effect of their actions was not.

I appreciate that the Bill is intended to reverse this by bridging the gap with the creation of the Council for Financial Stability. I am sorry to say that I simply do not think that this is enough. A committee that meets quarterly to consider reports prepared by one or other of its constituent members is surely not a full answer to the crises that can erupt 24/7 in markets and that are characterised by rapid contagion. Like the noble Lord, Lord Desai, I think that those interactions are the real challenge for macro-prudential supervision and that we should not be distracted from it by focusing on the scope or breadth of individual institutions. I cannot, with the best will in the world, see what this part of the Bill really adds. I presume that the Treasury,

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the Bank and the FSA already hold high-level meetings at least quarterly; they do not need an Act of Parliament to do so. I presume that they already discuss reports prepared by one or other of them; they do not need an Act of Parliament to share views. The key point is that the Bill does not resolve the question of where ongoing institutional responsibility for macro-prudential regulation lies. Responsibility for rapid pre-emptive action cannot be blurred and is not resolved by papering over the current arrangements.

Of course, however, there are many other extremely useful elements in the Bill, such as the strengthening of the FSA's powers and implementation of some of Sir David Walker's proposals. It is the key issue of responsibility for macro-prudential regulation that I believe deserves further consideration. Such consideration should surely include the proposal by the shadow Chancellor to bring macro-prudential and financial institutional regulation back together, reversing the actions of 1997. This will itself raise a number of inevitably difficult issues, so he is to be commended for saying that he would take time over such restructuring. He would not, in other words, repeat the hasty change of 1997. We cannot simply put the banks back under the Bank without creating a dangerous regulatory gulf between, for example, banks and insurance companies. We have to take care that a recognition of the interdependence of so many elements in our financial markets and the rest of the economy does not lead us to create a regulatory behemoth.

Making a split between macro-prudential and financial regulatory parts of the FSA, on the one hand, and its consumer protection activities, on the other, is, in my view, a good answer, executing it successfully will take great care. As this part of the FSA became more of a microeconomic regulator, the boundary between it and the competition authorities would need to be redrawn if we were to avoid regulatory overload. However, the suggested separation makes sense; it would enable both sets of issues, macro-prudential and microeconomic, to be looked at more clearly. Lessons could be learnt from other regulated industries where similar issues of consumer protection arise and a similar reconciliation of the role of the sector economic regulator and the competition authorities can be achieved.

Over the past decade the FSA has been bedevilled by a tug of war between those who believed it should focus all its attention on the treatment of customers and those who believed it should be focused on the risks to the financial system. While those objectives should be synonymous in the long term, in the short term they are not and may lead a regulator to be looking in the wrong place at the wrong time.

I note that the Bill makes some recognition of the fact that one institution has been asked to do too much by spinning off the FSA's educational role. I believe that we should give proper consideration to more radical change. This is not just a tidying-up job; it requires detailed consideration to create a regulatory system that is clear, focused and accountable.

Perhaps I may end by noting that at the FRC we are fully cognisant of the responsibility to play our own modest role, with the review of the combined code in

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tandem with the Walker report; sponsorship of the stewardship code-for which I know the Minister has been such a moving force; and the constant review of the quality of financial reporting, accounting standards and audit quality. The key challenge here has been finding the appropriate dividing line between the FSA's responsibility for regulating the practices of financial companies and the FRC's responsibility for codes of corporate governance practice that apply to all companies.

In reviewing the combined code-and here I pay tribute to the magnificent work of its current chairman-the FRC did not want either to create two separate classes of companies or to load non-financial institutions with inappropriate guidelines. It is important that the FSA can play a full part in seeking to get this balance right, not only in the UK but in European councils where so much is now decided with respect to standards affecting UK companies and their accounts, auditors and investors.

A strong financial sector-on this I agree very much with the Minister-continues to be of inestimable value to the UK. Deep and liquid quoted equity markets have enabled many UK companies to survive the economic storms of the past year. Investors have stepped up to the plate with a long list of rights issues. The largest private equity industry outside the US, in proportion to our economy, will be an important source of growth capital during the recovery, the more so given that banks' continuing need to rebuild capital will continue to constrain lending.

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