Financial Services (Regulation of Derivatives)

David Heath Excerpts

Tuesday 15th March 2011 Commons Chamber

[Steve Baker (Wycombe) (Con)]

I beg to move,

That leave be given to bring in a Bill to require certain financial institutions to prepare parallel accounts on the basis of the lower of historic cost and mark to market for their exposure to derivatives; and for connected purposes.

I rise not as an expert in derivatives or derivative accounting, but as someone who has wrestled with the problems of the banking system in the company of experts, both academic and practical. I am persuaded that a parallel, more conservative accounting regime for derivatives would mitigate some of the worst risks in the financial system.

Even though banks are governed by overarching EU and Basel rules, it is for British regulators to approve the day-to-day activities of British banks. This is a profoundly important role. My Bill is a moderate proposal that seeks to improve accounting transparency to enable that role, because, as Mervyn King has said,

“banks are global in life but national in death”.

The Bill could be enacted within the current international regulatory framework.

To explain why this measure is profoundly important, I would like to share with Members an analogy of the banking system. Naturally, it will short-circuit some of the details, but even though it remains necessarily complex. Let us imagine that we discover a little-known territory within the EU on which to establish a colony. Let us call it Ruritania and allow its currency to be pounds. We will establish our fledgling colony with four people: a depositor, Alice, who arrives with £103; a builder, Bob—naturally—an entrepreneur, Matilda; and a banker, Mallory, with a colourful recent past in Iceland and Ireland. Interest rates are 0.5%. Mallory establishes a bank and persuades the other three inhabitants of the importance of a healthy banking system, so Ruritania’s constitution contains a limited guarantee from future taxpayers of £10 in favour of the bank. Under central European banking authority devolved rules, Ruritania classifies that guarantee as core tier 1 bank capital, meaning that there is no actual capital, just a taxpayer guarantee.

Alice, seeking to keep her money safe, deposits it in a demand account at the bank. Matilda, the entrepreneur, wants to start a business and approaches Mallory for a loan. The bank retains a supposedly prudent reserve of £3 from Alice’s deposit and lends to Matilda, at 7% interest, the remaining £100 of cash deposited by Alice. Matilda then employs Bob, who wants his year’s wages up front. She hands over the £100 to Bob, which he deposits in the bank. Let us set aside for the moment the fact that the bank just doubled the money supply of Ruritania, as that issue is dealt with in the Financial Services (Regulation of Deposits and Lending) Bill, introduced by my hon. Friend the Member for Clacton (Mr Carswell), which I was glad to support. The banker now has two liabilities: a deposit of £103 from Alice and a deposit of £100 from Bob. Offsetting those, he has two assets: a 25-year loan of £100 and cash of £103. So far, so simple.

Mallory wants a Ferrari today, which he can buy for £20. His compensation contract is 20% of profits, which is not unusual in banking. He therefore seeks to record an instant £100 profit for his bank, and he knows just how to do that under EU bank accounting rules. He phones an insurer active in the credit derivatives market—let us call it GIA—which agrees to write a derivative known as a credit default swap for a fee of 1% per annum. It is a guarantee of 95% of the loan.

The bank quickly establishes a new company, a special purpose vehicle, which buys the future loan cash flows of £275. The credit derivative is written directly with that new company, the SPV. The SPV finances its purchases by issuing two bonds: a 95% senior bond, rated triple A by two august rating agencies because GIA is so rated; and a 5% junior or equity tranche. The bank buys the two bonds with the £100 cash. The funds then flow back from the SPV to the bank to settle that purchase. That kind of circular flow of cash is commonly used. The result is that the equity tranche of £5 is a deduction from the bank’s £10 tier 1 capital. Members will recall that that capital is a future taxpayers’ pledge, not hard cash.

Under mark-to-market rules, Mallory, by holding the bond on his trading book, records an instant but unrealised profit of £105. After replenishing his tier 1 capital with £5, he shows that £100 clear profit. That profit has been recorded, even though the bank has not received any income from the loan, and that loan might never be repaid. Mallory the banker is not concerned about that, however; he has his Ferrari. Any shareholders are not concerned either, as the bank also declares an £80 dividend.

The banker and his shareholders have taken £100 of the £103 total money supply of Ruritania, declared it as profit and spent it abroad. Mallory likes mark-to-market accounting and seeks to grow his bank by making further investments. He cannot sell the bond on the open market, so he borrows against it through an arrangement with a central bank, known as a repo. He receives £205 in cash from the central bank, and the central bank has a mortgage on his bond.

Mallory uses the balance as collateral for further bets, such as derivatives with other banks and low-priced Irish bank-issued bonds, in the hope of more fast profits. Unfortunately, his bank becomes insolvent when Matilda misses a loan payment, and it cannot refinance the central bank’s funding, so the central bank takes ownership of the bond—Mallory’s bank’s one decent asset. Depositors ask for their funds, but the bank cannot pay. That could be the crisis of 2014.

On our Ruritanian bank’s liquidation, we find that two depositors have claims for £203, but there is only £6 in cash; all the rest had been pledged as collateral and the bank’s assets cannot be sold. There happens to have been another freakishly unlikely collapse. Stakeholders had not realised that the bank’s one decent asset had been repo’d with the central bank, because it remained on Mallory’s bank’s balance sheet right up to foreclosure. Mallory, of course, lives happily ever after.

Financial derivatives and certain other “synthetic” investments are governed by mark to market. Banks record a profit or loss in respect of each derivative by comparing the price of the asset or liability in today’s market with the value of the position on the last balance sheet date. What is wrong with that? Marking to market enables banks to record unrealised increases in value as profits, but that is not the case with loans. The arbitrage between the different accounting regimes for loans and for derivatives therefore incentivises banks to transact business in derivatives. The fundamental driving force behind the phenomenal growth of the credit derivatives market has been profit acceleration using that accounting arbitrage.

Regulators need to be aware of those exposures in order to help avert any future threats. That requires the publication of accounts with derivatives and other investments recorded at the lower of historic cost and their mark-to-market value. If my Bill becomes law, the ability to declare future hoped-for income as profit today and the rest of the absurd activity that I have described would be restrained.

If we want banks to refocus on stimulating the real economy, we need to change those incentives. I therefore ask the House to support this Bill and, in so doing, to correct one of the most damaging and misunderstood weaknesses of the current British banking system.

Question put and agreed to.

Ordered,

That Steve Baker, Mr Douglas Carswell, Andrea Leadsom and Chris Heaton-Harris present the Bill.

Steve Baker accordingly presented the Bill.

Bill read the First time; to be read a Second time on Friday 10 June and to be printed (Bill 162).

[The Parliamentary Secretary, Office of the Leader of the House of Commons (Mr David Heath)]

On a point of order, Mr Speaker. The House will have heard earlier the point of order from the hon. Member for Hartlepool (Mr Wright) about the delay in responses to hon. Members’ questions from the Department for Education. The whole House should be concerned when there has been a delay, and you, Sir, have made clear your views on the issue.

I have now investigated the matter, and it seems as though there is a specific problem within the Department for Education in that there has been a technical failure in the IT system that it uses to track parliamentary questions. The problem has now been identified and fixed, and officials are working towards providing outstanding responses as quickly as possible. The hon. Member for Gateshead (Ian Mearns) will today have received a letter explaining the delay in those terms. I hope, Mr Speaker, that normal service will be resumed as soon as possible, and I know that the Department would wish to apologise to any Member of the House who has been inconvenienced by the delay caused by these circumstances.

[Mr Speaker]

I thank the Deputy Leader of the House for what he has said. The situation is clearly both regrettable and unsatisfactory, and it is much to be hoped that it can be avoided in future. However, the speed with which he has investigated the matter will, I think, be appreciated by all right hon. and hon. Members.