Motion to Take Note

Part of Financial Regulation: EUC Report – in the House of Lords at 8:47 pm on 10th November 2009.

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Photo of Lord Desai Lord Desai Labour 8:47 pm, 10th November 2009

My Lords, I join other noble Lords in welcoming these two reports. They are both excellent, and, as the noble Lord, Lord Skidelsky, said, we should make them more widely available to universities, economic analysts and whoever needs to be educated in the details of this matter.

I start my observations on a very different note by saying that crises not only happen, but are a natural part of capitalism. Crises are the way in which capitalism cures its problems. They are not accidents; they are systemic. Therefore, while we must do all that it is possible for us to do to mitigate the effects of crisis, I do not believe that any system of regulation devised by the human brain, either singly or collectively, will be able to prevent the next crisis. It will happen as sure as eggs is eggs and we will again find that the regulatory systems are inadequate and devise new ones. That is because human ingenuity, if there is enough profit incentive behind it, can always outstrip any amount of existing regulation—we at least know that much.

Our first task as we devise these systems is to make quite sure that the costs of the crisis are borne by those who benefit from the boom. Here, we have all failed. We have not been able to separate the goats from the sheep or, I should rather say, the rabbits from the foxes. There is no doubt that the retail depositor of a modest kind—it may up be to €100,000 or £100,000—needs protection, but those who deal with investment banks, hedge funds and other such intricate instruments deserve no pity whatever. Shareholders or bondholders of banks deserve no rescuing. They should be grown-up people; they have taken risks, and they should take the consequences. I, for one, am not at all persuaded by the story told us by the City and Wall Street and all that—that somehow there was a risk of systemic failure. It was a mistake to rescue Bear Stearns; had we not done so, Lehman Brothers would have learnt some lessons and sobered up long before. So Lehman Brothers went, which sadly cost enormous sums to the taxpayer, but I would have liked to see what would have happened in a more robust environment.

The boom was very long—63 quarters, as one report says, of uninterrupted rates of growth of GDP. It was one of the longest booms in recent history, and we had forgotten that all booms come to an end and that in the 1970s we had a banking crisis, as well as a deep recession in the 1980s and another recession in the 1990s. We just did not have a recession around 2000, so we got carried away perhaps. We should get back to the idea that we live in a system that naturally has cycles. It is unstable and cannot be made permanently stable. That is a major virtue of the system; it is not a problem, but a virtue. To the extent that we devise protective institutions, we should protect the retail depositor and perhaps—although it is too late this time—the taxpayer, rather than banks and bankers.

I move to the recommendations of the reports. Clearly the big element is macro-prudential supervision. Unlike the noble Lord, Lord Skidelsky, I am not so against models. I think that I can say without any false modesty that in this Chamber, at least tonight, I have done more modelling in my life than anybody else—econometric modelling, I hasten to add. I see in the evidence from Jon Danielson, whom I know very well, taken by the committee chaired by my noble friend Lady Cohen, that the models that the banks used are fragile because their samples are very small. If your samples are small, it is natural that you have very unrobust parameter estimates. They do not become good just because we call them models, and they are not perfect just because we use mathematics. Aside from the idea that there is uncertainty and not risk, even the risk can be modelled much better than we are doing. We have tolerated extremely bad econometric modelling, which has cost us enormous sums of money.

I should like to see an institution such as the IFS—something independent that would look after financial modelling and macro-prudential modelling. It should not be part of the government or the private sector but funded with sufficient resources that we can rely on its judgment about how the system is modelled. Nobody has even given me a precise definition of what "system stability" means. We are talking about financial system stability, but there are no definitions of it. I could sit down and make a definition, but to incorporate it mathematically would require enormous amounts of data and a very sophisticated technique, in which parameters drift around rather than stay constant and so on, but I think that it can be done. It is our duty, as far as possible, to improve our knowledge base much more than at present. People are getting paid enormous sums for doing bad work and it is our duty to invest in much better knowledge of how the banking system works or does not work.

The best that we can do is not so much prevent crises but improve our mopping-up operations. Importantly, the report talks about the problem of Iceland and the related problem of the EU. When push comes to shove, a bank needs a state behind it to rescue it. Only the state has powers to print enough money to lend to the bank that is bankrupt. Unfortunately, the problem is that the state can only print its own money—it cannot print foreign money—and, in the case of Iceland, the liabilities were in foreign currencies. By the time the bank went bust, the assets were all toxic. The state of Iceland did not have enough dollars, sterling or euros to be able to bail out its own banks.

Even if we had the most sophisticated supervisory system of the type the report recommends, the EU and its fiscal authority has no money. It does not have sufficient money to bail out a really serious big European bank. It would fall to individual European states to take bits and pieces of a large multinational, multibranch bank and rescue it. Although one example is cited in the report in which France and Belgium each rescued part of a bank that was operating in those countries, in a global banking system we would have to devise better rules about who finally pays for the rescue of a bank that is going bust. As I said, I would prefer not to rescue banks at all, but if we are going to rescue them, we need clear rules, especially in the context of the EU, when some are in the eurozone and others are in a different system.

To the extent that we can separate out the rabbits and the foxes to protect the rabbits and shoot the foxes, the hedge fund problem is not serious. People who subscribe to hedge funds are grown-up enough to know what risks they are taking. If they do not, they should not be there. We should leave the hedge funds alone and let them do whatever they do because that is a sector of professional high risk-takers who know what they are doing and are amply rewarded for the risks that they take. We should look after the small person, but more than that we must look out for the taxpayer.

I want to say something about all the structures that have been set up. Despite the FSA and the various other bodies that we have, what has actually worked—here I differ from the noble Lords, Lord Willoughby de Broke and Lord Trimble—is that the European Commissioner for Competition has the best policy about what to do with banks: break them up. Prudential supervision may not work, but if you can enforce rules of competition and see to it that no bank gets too big—whether a pure retail or a mixed bank—we may yet have some insurance against the likely failures and, if they do fail, the cost of rescuing them would be modest and not enormous.