Bank Reform Won’t Work

'The subtitle of the Financial Services Bill should be "We think Gordon Brown got it wrong"'

The Bank of England is full to bursting with economists, but must still have room, somewhere, for a student of the classics. He should force his colleagues to read A.E. Housman’s lecture on the application of thought to textual criticism. They could learn from it. 

A critic, Housman says, must not expect to find faults and make corrections by rule and by rote: “He is much more like a dog hunting for fleas. If a dog hunted for fleas on mathematical principles, basing his researches on statistics of area and population, he would never catch a flea except by accident.” 

In the City, the regulators have been busy at their task of disinfestation, relying on rule and rote. Behind them stand the lawmakers, always ready to write new rules when the old ones seem to flag. In less than a third of a century, they have given us three Banking Acts and two Financial Services Acts. Have they kept the City’s fleas from jumping and bloodsucking? Apparently not. Better luck this time.

A weighty Bill is now on its way through Parliament, with another on the slipway close behind it. This first Bill’s subtitle should be “We think Gordon Brown got it wrong.” He freed the Bank of England to set interest rates, giving it a target for inflation, but took away its power to regulate banks. This went to the Financial Services Authority, at the far end of the Docklands Light Railway, while the Bank looked after financial stability at the other end. It was an easy guess that some bank would fall between the tracks. So it did. Others followed. 

Inflation behaved itself, helped by ever-cheaper Eastern imports and by an index which conveniently left out the cost of housing. So house prices took off, and the Governor of the Bank was reduced to preaching sermons which his hearers mildly resented. Then he turned out to be right, and they resented him bitterly.

Hence the new Bill, which will create a new pyramid, capped by a Financial Policy Committee with the Governor in the chair. Those further down the pyramid must comply with its stated wishes or explain why they haven’t. While still in embryo, this committee is asking the Treasury for powers to give directions — for instance, to make banks hold more capital against loans made to over-excited markets. The housing market, for example, next time round? Watch the sparks fly. 

Next in line will be a reform Bill, aimed at “casino banking” — more politely called investment banking, and loosely defined as the business of taking financial positions on a bank’s own account. Major banks found this business most rewarding, until the bets suddenly went wrong and threatened to bring them down. Were they too big to fail — and if so, were they too big? Then they needed reform.  

So they will be made to put insulation round investment banking and keep it separate from the rest of their business. If one of their swashbuckling dealers suddenly bets the house and loses untold sums, at least they will not have to shut the doors of their branches, impoverish their customers or throw themselves on the mercy of the hapless taxpayer — so long, that is, as the insulation holds. This Bill is going to take some drafting.

In practice, the reformers may find that their work is done for them. Investment banking in its hectic heyday looked set to make fortunes for everyone — dealers, partners and even shareholders — but, of course, their interests differed. The shareholders learned the hard way that they needed deep pockets. Sandy Weill, who assembled Citicorp of New York as a financial one-stop shop, now thinks that it would be better if taken apart. Barclays’ new chairman, Sir David Walker, may start to think the same way. 

Even so, banks will still find means of getting into trouble. The mistakes of a sanguine manager, as Walter Bagehot said, are far more to be dreaded than the thefts of a dishonest manager. Sanguine lenders at Northern Rock and Halifax Bank of Scotland contrived to wreck their banks without going anywhere near a casino. They proved once again that the surest way to lose money is to lend it to people who don’t pay it back. The regulators let it happen.

City memories go back to the days when its banks had no regulators — or none, specifically, with the force of law behind them. Instead, they were supervised and monitored by the Bank of England, and the Bank was the arbiter of credit, which was and is their lifeblood. All this worked, so far as it did, because the Bank was at the centre of the markets and uniquely well informed.

Since then supervision has made way for regulation, and one Act of Parliament has made way for another, with a sixth and seventh now in prospect. 

By now it must be plain that more and tighter rules are not enough, and may be a standing temptation to push each rule to its limits. What has been missing — the ingredient without which no reformed system can work — is effective information. 

The Bank, from its place at the top of the pyramid, ought to be able to see and hear what is happening, but will have to work at it. The City’s markets have changed, its place within them has changed, and the years of focusing on the inflation rate have served as a distraction. All those economists will need to get out more, and to take their line from Housman. 

A critic, so he tells them, has to deal with the frailties and aberrations of the human heart, which are not susceptible of hard-and-fast rules. This truth is what governs a critical dog in its search for fleas: “They require to be treated as individuals.” Bankers, too.

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