I want to return to the daunting agenda in front of the G20 and in particular—this will come as no surprise to my right hon. Friend the Financial Secretary—to focus on finding a way forward for the future regulation of the global banking system, coming away from the problem we have at the moment, which is a Balkanised regulatory system trying to deal with global institutions.
As Lord Turner says in his very welcome report, the seams in this garment first split in the United States. It is interesting to see the response of the US Government, which is to try to begin harmonising their own regulatory platform within the United States, a much more fractured system than we had. That will lead them to come up with something rather similar to our FSA. But as Henry Paulson, the former Treasury Secretary, said recently, that in itself is a multi-year undertaking. It might just bring the USA more or less to where we are now. At the same time, we are part of negotiations within the EU to bring forward the capital adequacy directive. This will be fairly slow progress, yet the task is urgent and the solution required is on a wider and global scale, and not on the scale currently being addressed.
I want to urge the Government that, in their talks on this, they look not just at the scale on which regulation must be achieved in the future, but the method. In doing so, I want to urge caution about relying too much on the Basel approach, which has informed the process up to now. We should remember that that approach has no legal basis and is silent on the issues of compliance and systemic risk and that, within it, the banks have been setting the terms of trade. The system is built on internal risk basing, which involves banks defining and measuring their own risk and their own extended cover. It relies on value-at-risk measurement, which is simply a mathematical approach relying on inferences from past behaviour and was rightly described by Lord Turner in the report as "highly misleading". It also relies too much just on the instrument of capital adequacy ratio. There is no oversight of accountancy methods or of liquidity. It is simply a conventional device that is inappropriate for regulating what are now a swathe of very unconventional financial instruments.
Finally, the Basel agreements also have a narrow view of what constitutes banking. They are silent on the issue of shadow banking and on off-balance-sheet banking. They have not been able to keep pace with the degree of leverage or securitisation in the system. In fact, a lot of banking activity has gone on outside the boundaries of the Basel system, but even the banking activity that has taken place within it has resulted in country regulators engaging in a race to the bottom to prevent financial flight to other countries, because national competitive advantage in the end always trumps regulatory concerns.
The question is where we go now. The first thing that needs to happen, and is beginning to happen, is the restructuring of the banks themselves. That is happening on an institution-by-institution basis via recapitalisation, extracting the toxic assets and underwriting inter-bank activities, all of which are essential. However, they will not in themselves be enough, which is why we are also now beginning to hear resurfacing the argument about whether we need to separate out retail banking activity from investment banking activity and in some way or other re-introduce the now famous Glass-Steagall-style legislation that emerged in the United States after the 1929 crash. The argument is simple: the US banking system worked pretty well while the Glass-Steagall legislation was in place; the problems that have arisen came post-repeal; so let us reintroduce Glass-Steagall. That is a very simplistic misreading of the chain of causality, because some of the banks that failed were not crossover banks at all. The structure that has now emerged is in any case far too complex to unpick, but there are some principles within the Glass-Steagall-style regulation that are relevant. There is a need to look at firewalls in the system, not simply firewalls between retail and investment banking, but ones that will help to address the issue of proprietary trading and the activity of hedge funds.
We also need major regulatory reform, in my opinion. I think that there is a G20 consensus on the fact that that is needed, but the approaches that I see various key players taking are quite different. The right issues have been identified: capital adequacy, credit ratings, accountancy standards, remuneration policies, counter-cyclicality and the need for early warnings are all on the agenda, and they all should be. But the questions are what tools there are for tackling that challenge and whether the required geographical scope that is required can be met. What will replace the now failed and defunct Washington consensus? Some say a revised Basel system, but that is fatally flawed and will not in itself do the job. Others say that the IMF should be strengthened, but we need to remember that that too has no legal remit over regulation and is in itself tainted by its association with the Washington consensus.
Alternatively, there is reference to the Financial Stability Forum and the introduction of the new colleges, but that in itself is not the answer. The colleges have no legal basis. They cover only the largest financial institutions, and the supervision that they carry out is built around the structure of the large firms individually. Even the colleges are not looking at the risk of systemic failure. They meet only a couple of times a year and they do not change the relative responsibilities of the supervisors. They have no formal decision-making powers. It is still a case of the financial institutions driving the agenda of regulation, not vice versa.
The colleges are certainly better than the gaping hole that currently exists, but on their own they are still only a paper-thin safety net. That might feel all right while the banks are on the defensive or on the back foot, but it will not last unless we take the opportunity to address the fundamental imbalances in the system.
We need to go much further than the devices that have been suggested and consider the possibility of achieving a treaty-based international agreement on minimum standards, particularly in relation to transparency and information sharing, which in future will be critical if we are to have effective safeguards against systemic risk. Risk taking by an individual player in a genuinely open competitive system might not be so bad, but we have learned that when all players are taking the same risk simultaneously, that presents the threat of systemic failure. The problem is that we do not have a regulatory structure that operates on the same scale.
I am not suggesting some form of world regulation or a world Government to do that, which would be impractical, nor do I want over-regulation. In the architecture that I propose, there will still be national regulators and the colleges, but if we can achieve something like that, which is essential if we are to avoid a repeat of the present crisis, for the first time there will be some basic rules of operating on the same scale as the operating of the major players. We have not had that, and we will need it in the future. It is the only way of correcting the fundamental imbalance.
I hope we will not try to rely on the working of the Basel system alone, or on the IMF alone, or on the Financial Stability Forum or on the colleges. They all have a part to play. I entirely agree with that, but the total that is needed is greater than the sum of their parts. For that reason, I hope the G20 will consider the opportunity that is now presented to devise some form of treaty-based, and therefore international and genuinely global, banking regulation. Without that, I fear that at some point we could end up repeating what is happening now.
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