Banking Reform

Sajid Javid Excerpts

Monday 29th November 2010 Commons Chamber

[Mr Meacher]

I mentioned light-touch regulation in the City of London, which we have had since the Thatcher era and through the Blair era. I believe that that needs to end. We want not excessive but adequate and proper regulation, and for the past three decades, in the so-called neo-liberal era, we have not had it.

Derivatives should be approved by the regulatory authority before they can be issued. At that stage, they can be either prohibited or accepted, perhaps with certain conditions attached. The key point is that transparency is essential. It is worth noting that the recent Dodd-Frank Wall Street Reform and Consumer Protection Act seeks to achieve that by requiring that all derivatives are traded on public exchanges.

Linked to that is the role—or perhaps the scandal—of the credit rating agencies in allocating a spurious status to some highly dubious securities. Light-touch regulation in this country has evaporated into virtual deregulation. Credit rating agencies were paid by the very institutions whose credit worthiness they were supposed to be assessing. By granting the highest rating, as they so often did, they made it easier for the banks that were securitising and further repackaging debt to create the greatest possible number of securities with the lowest possible regulatory cost. That practice should never have happened, and I believe that it should always be prohibited where there is a serious conflict of interest, as there was in that case.

[Sajid Javid (Bromsgrove) (Con)]

rose—

[Mr Meacher]

I know of the hon. Gentleman’s expertise in this matter, and I will give way to him, but I will not give way subsequently because I want to speak for only about a quarter of an hour.

--- Later in debate ---

[Sajid Javid]

Does the right hon. Gentleman realise that the price of credit derivatives over the past three or four years has been far more accurate as a predictor of default risk than the credit ratings given by rating agencies?

[Mr Meacher]

The hon. Gentleman makes a good point of which we need to take account, but I still think that the credit rating agencies potentially have an important role. They are listened to in the market, are the basis on which financial transactions take place, and should be trusted, but in the present circumstances they are certainly not. However, I am grateful for his question.

On bonuses, there is outrage among not just Opposition Members but, for example, right-wing Governments in Germany, France and Sweden, that a banking system that owes its continued existence to massive Government intervention should pay itself mega salaries and bonuses entirely out of line with the top of business, let alone ordinary taxpayers. There is outrage especially because those gigantic bonuses often drove the recklessness in the first place. The overweening power of the banks attracts almost universal hostility, especially given that 90% of investment bank profits, in an era of austerity, are directed not at strengthening balance sheets, at shareholders through dividends, at customers through lower fees or at taxpayers, but at bonuses.

France, among several others, has demanded a mandatory cap and that there should be no guaranteeing of bonuses, but Whitehall, as usual of course, argues that it would not be practical. However, if the G20 Governments insisted on limits and made continued liquidity provisions dependent on compliance, no bank could refuse. I believe that Her Majesty’s Government should now be taking the lead in the G20 not in succumbing to lobbying from the City of London and the British Bankers Association, but in reining back bonuses on a much greater scale than we have so far seen, and to much lower levels, and in ensuring that they be paid only in exceptional circumstances.

On the broader question of averting future financial crises, attention has so far largely focused on enhancing capital control, but that does not actually have a good record in this regard. At the outset of this latest crisis, virtually all financial institutions across the globe had capital adequacy of between one and two times the minimum Basel regulatory requirements—at least at that level, and in some cases twice as much. Basel III, which has just reached its provisional conclusions, is scarcely any improvement. The core top-tier capital requirement is only 4.5%, and the contingency capital requirement is only 2.5%. Of the EU’s top-50 banks, 45 already meet that standard, and Basel III is actually proposing that the requirement not be introduced until 2019. This is simply nowhere near good enough. A much better possibility might be counter-cyclical capital controls, enforcing different levels of bank capital at different stages in the economic cycle. I can see the point of that, but I suspect that it would leave open the problem of the degree of ratchet and the timing of it. I suspect that that would be far too problematic.

An alternative approach—many have talked about this—is the introduction in Britain of something like the Volcker rule, restricting banks from undertaking certain kinds of speculative trading, notably proprietary trading. Of course that would certainly stop banks doing what they are doing at the moment, which is trading on their own books with the money of depositors. The key point, however, is that it would not overcome the too big to fail problem when applied to investment banks. For example, I do not think it would prevent a repetition of the collapse of Lehman Brothers; neither would it address the interconnectedness—the Chancellor was speaking about this a few moments ago—of today’s banks, with counter-party relationships and exposure between commercial and investment banks, and insurance companies. That is the problem. I say this with regret, but any rule-based reform is almost certain to face the risk of regulatory arbitrage, because financial institutions invent ever more sophisticated products that are simply aimed at getting around regulatory controls. I therefore do not think that what I have described is an adequate answer. For all those reasons, the force of argument and the balance of advantage point strongly towards separating retail from investment banks, in establishing distinct, narrow banks that are conservative, transparent institutions with no financial instruments or incomprehensible balance sheets.

--- Later in debate ---

[Sajid Javid (Bromsgrove) (Con)]

I thank the right hon. Member for Oldham West and Royton (Mr Meacher) for securing this debate, which is a valuable one to be having in the House. I draw the attention of hon. Members to my entry in the Register of Members’ Financial Interest, which is a legacy of my spending 18 years in the banking industry. Before Labour Members get a bit too excited by that revelation, as many have unfortunately done in the past, I should say that for the past three or four years I felt that the profession of banker was possibly the worst to have in the eyes of the public, but that was before I became a Member of this illustrious House.

The motion states that we want to

“prevent a recurrence of the financial crash”.

Obviously we are all united on that, but it is important that we examine the causes of the crash, which we could debate for a long time and go round in circles. I am sure that many rational people will disagree on the responsibilities of banks and bankers. I may have misunderstood the motion, but it seems to suggest that banks are entirely responsible for the financial crash. That is wrong and it does not do justice to Members of this House or to our constituents in preventing something like this from happening again.

The financial crash happened because too much money was chasing too few assets—financial assets or real assets such as real estate. There are three principal reasons for that, the first of which was that world financial reserves, particularly in the east, were growing at a substantial rate. Indeed, they continue to do so, as more people in the west consume goods from the east. To give just one illustration, China’s financial reserves in 1990 were $165 billion but today they are $2.65 trillion. Those reserves needed to find a home.

The second reason is that commodity prices have grown substantially, partly as a result of the growth of the east and other emerging markets, and that has led to a substantial increase in sovereign wealth funds, both in the middle east and in other markets. Those funds also needed to find a home, and they created a colossal wall of money when combined with the financial reserves.

The third reason is something that bankers have called the “Greenspan put”. Alan Greenspan became chairman of the Federal Reserve in 1987, just before the Wall street crash, and one of the first things he did when he found a problem in the financial markets and a potential crisis brewing was to lower interest rates as quickly and as substantially as he could. That happened again when the US Federal Reserve led the way after the dotcom bubble burst in 1991, again when Russia had problems and there were problems in Asia, and it has just happened again. Bankers have got used to that approach and it results in what the markets call a “put”, whereby they feel they can sell assets if things go wrong. That has encouraged bad behaviour and a moral hazard: the idea among many bankers of “heads we win, tails the taxpayers lose.”

In addressing these issues, we must not forget those key facts about what caused the crisis. However, bankers did play a significant role and there are things about banks that we need to examine. Although there are issues to address in respect of financial derivatives, I would not make that the key priority. The first thing to examine is the idea of retail banks and commercial investment banks acting as one entity, because that seriously needs to be looked at.

I started working in the banking industry in New York in 1992. Under the Glass-Steagall Act, which was in place at the time, the bank I worked for had to have a completely arm’s length relationship with its retail banking division. That made a big difference to the risks the bank took or even contemplated taking. That situation changed in the late 1980s in Britain, when the big bang took place and the implied Glass-Steagall arrangement disappeared, and it formally changed in the United States in 1999 when that Act was removed. It is vital to examine that. The second thing to look at is, as has been mentioned, banking capital itself.

[Mr Chuka Umunna (Streatham) (Lab)]

Would the hon. Gentleman be prepared to share his thoughts on whether we should return to a Glass-Steagall model, which I understand the Clinton Administration did away with when in office?

[Sajid Javid]

There are some considerable merits in that model and given what has happened we should consider it seriously. I hope that the Vickers commission does that.

Secondly, we should consider the banks’ capital requirements. It is right that under Basel III capital requirements should be lifted. The core tier 1 capital requirement will be lifted from about 2% for banks to about 7%. Some points are still missed, however. The focus is far too narrowly on the default risk of assets and we have strange incidences even with default risk—for example, under the new proposals industrialised sovereigns are still considered to be risk free. As we speak, Ireland’s 10-year Government bonds are trading at more than 11%, Spain’s 10-year bonds are trading at more than 6% and Germany’s are trading at more than 2.5%, but they are all treated as zero-risk weighted and no risk capital will be set aside. No account is taken of liquidity, either. One of the largest problems for banks over the past three or four years was lack of liquidity, but the capital requirements do not take full account of that.

One of the biggest mistakes that made Britain’s situation far worse than that of other countries was the change in regulation when Tony Blair’s Government first took office. The jobs of people at the Bank of England, who knew what they were doing, were taken over by people at the Financial Services Authority, who did not know what they were doing. I remember an FSA audit where the chief auditor of my credit derivatives book, which had a market value of more than €100 billion, was a 27-year-old with a degree in biology. It is no wonder that problems started to happen. We do not necessarily need more regulation, just smarter regulation.

There are many issues to consider that we could debate for a long time. Banking regulation is one such issue, but we do no service to our constituents if we merely focus narrowly on it when we consider the lessons of the financial crisis.