Financial Services (Regulation of Derivatives)

Steve Baker 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.

Use of the Chamber (United Kingdom Youth Parliament)

Steve Baker Excerpts

Tuesday 20th July 2010 Commons Chamber

[Philip Davies]

Of course I do. The hon. Gentleman must have been living on Mars for the past year. He said he attended last year’s debate; I spoke for about an hour and a quarter on the subject then, although I cannot remember the exact length of time. He claims he was present, but I made it blindingly obvious that I am against this. For the benefit of the hon. Gentleman, who obviously cannot remember the debates he takes part in, I will try to rehearse tonight some of the same arguments I made then so that he can get a better understanding that I am actually opposed to this.

[Steve Baker (Wycombe) (Con)]

I thank my hon. Friend for saying that, as I was going to ask him to rehearse those arguments. Also, does he agree that this is possibly the most vibrant, passionate and sincere debate we have had in this Parliament, and that that is, perhaps, a case for ending the system of whipping?

[Philip Davies]

I am sure my hon. Friend’s comments will have been noted diligently by the Whip on duty, my hon. Friend the Member for Scarborough and Whitby (Mr Goodwill). Some of us in this House believe that all votes are free votes really, and that, at the end of the day, Members can vote entirely as they please. They might want to take heed of what the Whips are encouraging them to do, however, as I must say to my hon. Friend the Member for Wycombe (Steve Baker) that usually their advice is very sound, but occasionally it is not, and I suspect that on this issue it may not be quite as sound as it usually is.

I am sure my hon. Friend’s suggested innovation will be taken seriously by my hon. Friend the Member for Scarborough and Whitby. Indeed, he is sitting in his position on the Front Bench and writing diligently as I speak, so I think the name of my hon. Friend the Member for Wycombe has gone in the book. I wish him well for his future career, but I fear it may be as elevated as mine.

--- Later in debate ---

[Philip Davies]

My hon. Friend is right about that technical difference between the Youth Parliament and this one. I am not sure that that negates the point made by the hon. Member for Cheltenham (Martin Horwood); any Parliament should be made up as it sees fit. However, I do not particularly accept his premise to start with. He is scrabbling around trying to find what is different about the UK Youth Parliament as opposed to any of these other worthy bodies.

I will tell you, Madam Deputy Speaker, what is different about the UK Youth Parliament and its relationship with this Chamber. What is different is that we have, in my opinion, the sight of a lot of very sad people trying pathetically to ingratiate themselves with young people in their constituencies, which is absolutely painful to behold. They think that this is a trendy course to follow. If they want to try to look trendy with their constituents, they will argue that they want to have the UK Youth Parliament sitting here so that they can go back and say, “I’m trendy, I supported you.” It is frankly rather pathetic. That is the only difference between the UK Youth Parliament and all these other bodies, however hard hon. Members scrabble around for differences between it and anything else.

[Steve Baker]

I am not sure that there are that many young people in my constituency judging from many of the meetings that I go to. I think that my hon. Friend is being quite disingenuous towards those of us who are taking this debate very seriously. I came here this evening to hear what he had to say, in all seriousness, to persuade me that I should not vote to let young people come and sit here for one day to express their respect for British democracy. I must say that after all I have heard from him, I am increasingly persuaded that we should let young people come and sit here.

[Philip Davies]

My hon. Friend is perfectly entitled to take that view. He said that he wants to listen to the arguments; well, I have got on the record only one paragraph of my speech because I have been dealing with hon. Members’ interventions. My hon. Friend is a very diligent local MP, but I am sure that if he looks a bit harder, he will find some young people in his constituency, and then he can ask how many of them are desperate to come and have a debate in this Chamber. I think he will find that that is not near the top of their list of priorities. I could be wrong.

Information for Backbenchers on Statements

Steve Baker Excerpts

Tuesday 20th July 2010 Commons Chamber

[Mr Hollobone]

My hon. Friend makes an extremely good point, and I hope that he, too, makes a representation to the Procedure Committee. The difficulty that we all face is that if the Government were to make all announcements on the Floor of the House, there would not be much time left for other business—Government or otherwise. The difficulty is striking the right balance between the most important policy announcements and the others.

We saw a very good example of that today on the occasion of the urgent question about the Office for Tax Simplification. I am perfectly prepared to accept that the Exchequer Secretary had very good intentions in releasing a written ministerial statement, but as a humble Back Bencher I must express my personal view that on a day when we were discussing Treasury matters, it would have made sense for him to come to the House to make an oral statement.

The difficulty faced by my hon. Friend the Exchequer Secretary lay in the need to achieve the right balance between what is a really important statement and what is not. Today Mr Speaker rightly accepted an urgent question because he felt that it concerned a matter that he felt needed to be discussed on the Floor of the House. However, I think that if we can clarify the protocol, with the guidance of the Procedure Committee and input from hon. Members, the Exchequer Secretary, if faced with a similar situation in the future, will be crystal clear about what should be announced on the Floor of the House and what should be released in the form of a written ministerial statement. That is an illustration of the fact that the present system is not working properly.

[Steve Baker (Wycombe) (Con)]

I am put in mind of, I think, Pericles in Athens. He said that while only a few might originate a policy, anyone could judge it. Would my hon. Friend care to reflect on where we are more broadly in our country in terms of the internet? Nowadays, when a policy is announced anyone can indeed judge it, and can immediately start to communicate about it. Could my hon. Friend perhaps put that in the context of the House of Commons?

[Mr Hollobone]

My hon. Friend is clearly better educated than I, especially in the classics, and I commend him for that. He has also made a very good point. As well as 24-hour news media, we now have the internet and all its ramifications.

I do not particularly mind how people comment on Government policy announcements. I do not mind whether they do so by means of a written note, internet traffic or any other means, as long as the House hears about the policy first. I want the Press Gallery to be full. When an important announcement is made by, say, a Minister from the Department for Transport, the Press Gallery is full because members of the press want to hear the news on the Floor of the House first. When it is pre-released to the media, the Gallery is empty.

I have spoken for too long—[Hon. Members: “No, no!”] I shall take those expressions of mock affection as they were intended.

I want to end my speech not by being teacher’s pet, but by genuinely saying to you, Mr Speaker, that many of us who are in the Chamber and many Members who are not present genuinely admire what you have done with regard to statements. I want to reprise what you said two days after your election as Speaker, because I consider it to be important and a good base on which to proceed. On 24 June last year, Sir, you said:

“Just before we move on to the main business, I want to make a brief statement of just three points. First, as I said on Monday, when Ministers have key policy statements to make, the House must be the first to hear them, and they should not be released beforehand. Secondly, in statements, I ask the Front Benchers to stick to their allotted times. I also ask that the Back-Bench Members taking part each confine themselves to one, brief supplementary question. In the same vein, I hope that Ministers’ replies will be kept to a reasonable length. Finally, I always expect that those speaking in this Chamber will be heard, so that an atmosphere of calm, reasoned debate is maintained.”—[Official Report, 24 June 2009; Vol. 494, c. 797.]

It is possible that not all those boxes have been ticked—and if so, it is probably largely the fault of us Back Benchers—but your central point, Sir, about the need to ensure that policy announcements are made to the people’s representatives first on the Floor of the House, was absolutely spot on. It is the job of this motion, and of subsequent action, to ensure that we bring that about.