Independent Commission on Banking — Debate

Part of the debate – in the House of Lords at 2:53 pm on 15th September 2011.

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Photo of Lord Plant of Highfield Lord Plant of Highfield Labour 2:53 pm, 15th September 2011

My Lords, I thank my noble friend Lord Myners for initiating this timely debate. I shall concentrate my short remarks on issues to do with accountability and responsibility in the investment banking sector. These remarks are not the result of any specific expertise in the area. I am neither a banker nor an economist; I am an academic philosopher by trade. Nevertheless, these reflections, however naive, have led me in the direction of thinking that, at the very least, ring-fencing or complete separation of investment banking is the best that we should be looking to achieve, if it is politically feasible.

The character of the present banking system in the UK embodies the development of the liberalisation of financial markets pursued by both Conservative and then Labour Governments since the early 1980s. It is also the result of the growing globalisation of the economy, particularly of financial markets. As the noble Lord, Lord May, said, world financial markets are rather like an ecosystem in which a disturbance in one place can have major and unintended consequences elsewhere.

My argument is that the processes on which economic liberalism normally depends to constrain reckless behaviour have become less operative in the banking system. One of the major instruments for constraining reckless behaviour was the prospect of bankruptcy. People would make their investment decisions and their allocation of capital decisions in the light of the possible consequences in terms of bankruptcy. However, as we have seen in the past few years, this threat has become less and less plausible. This is partly because of the too-big-to-fail problem in which the bankruptcy of a major bank could have untold consequences for domestic economies and, indeed, for economies in other countries. The case of Lehman Brothers shows how unlikely it is for a large bank now to be allowed to fail. The situation has been exacerbated by globalisation. As banks are interlinked in this kind of financial ecosystem, the failure of one bank could have massive and wide-ranging consequences on the world financial system.

In addition, it seems to me that the internal controls exercised by banks on risk-taking behaviour have been eroded. By internal controls, I mean two things: the first is the role of the board of directors and its committees, and the second is the role of shareholders, which was mentioned by my noble friend Lord Myners. Why do I say that they have been eroded? The reason is that the products of the commercial or, if you like, disparagingly, the casino arms of banks have become extremely complex and, indeed, in the case of securitised assets, such as bundled-together mortgages, extremely difficult to understand. Often their worth is computed on the basis of mathematical models and the judgments of rating agencies, both of which are rather dubious in my view.

The economic liberalism that has allowed such assets to be created has drifted away from its original insight; namely, that economic and financial value is a product of individual preferences in a free-market context. Individuals making mortgage decisions are in that context when they initially take up a mortgage and buy a house, but as that mortgage becomes securitised, sliced up and bundled up with other people's mortgages, those other people are also choosing mortgages for individual properties and so forth, and you are getting further away from the idea of a market value. The only way of imputing value to these securitised assets is through a rating agency using extremely complex mathematical models. If products become more complex and understanding of them is confined to a limited number of people, it is not clear how boards can properly supervise risk-taking behaviour or, indeed, have a clear sense of the value of their securitised assets. The same point applies to shareholders. There is asymmetry of understanding and information between those who are managing the assets and those whose job it is to have oversight and to determine whether undue risks are being taken.

In addition, there is asymmetry of motivation between the traders and the board. The incentive or motive of a trader on a bonus is to preserve his or her positions and not to render them wholly accountable to supervisory inspection. That is much stronger than the motivation of the supervisor who does not have that sort of financial stake. This is a consequence of the bonus culture. There have been spectacular cases, not the least of which happened today at UBS, that show the truth of this point. The ability of a trader to evade proper scrutiny and accountability is partly the result of the bonus culture and partly the result of the complexity of the assets that are being created and traded. There is an asymmetry of information and motivation between traders and those who are supposed to be supervising them. This also applies to shareholders. I am not at all clear how this can be overcome, except by ring-fencing at the very least, or, as I would prefer, a separation of investment banking.

David Hume argued in the 18th century that when we think about public institutions like banks, we should assume that people are knaves and we should try to erect institutions that protect us from that kind of behaviour. It seems that the most appropriate way of trying to protect ourselves from the utility-maximising behaviour that we all engage in, but which can have particularly dire effects in banks, is through either ring-fencing or separation.

We should be very wary of blaming the banking crisis on a failure of regulation. The bankers caused that mess and it is the bankers' responsibility, by and large. To say otherwise is like blaming the police for criminal behaviour. Obviously regulation has to be improved and the Financial Services Authority did not cover itself in glory, but then neither did the Bank of England. We would be extremely naive to think that a new regulatory system is going to cure all the problems. It has to be a new regulatory system, plus separation of the investment banking sector.