‘(1) The Treasury may by order make provision about the tier 1 leverage ratio applicable to a relevant body so as to require the relevant body to maintain a minimum tier 1 leverage ratio.

(2) The Treasury may by order make provision about the tier 1 leverage ratio applicable to a ring-fenced body so as to require the Financial Policy Committee to create differing minimum leverage ratios for different classes of ring-fenced bodies, based upon the risk profile of their balance sheet.’.—(Chris Leslie.)

Brought up, and read the First time.

I beg to move, That the Clause be read a Second time.

We now reach the Opposition new clauses, some of which were tabled on behalf of the Parliamentary Commission. As we said on Second Reading, the problem with the Bill is that it is very much a shell, which is to be populated with substantive measures. The Opposition are frustrated that the Government have not waited for the Parliamentary Commission to make full recommendations about the standards, culture and governance improvements that are needed in the banking sector.

New clause 1 would give the Treasury clear order-making powers in relation to leverage ratios in the banking sector. The Parliamentary Commission was certainly very forceful on this issue, but Sir John Vickers’s commission, which reported the year before, was even more concerned to impress the importance of the issue on policy makers. A bank’s leverage is the ratio of its assets to its equity capital. Its equity is equal to the value of its assets minus the value of its liabilities. Higher leverage rates magnify returns, because any growth in assets will be proportionately greater if the bank’s equity is thin. However, the corollary is that any losses are also magnified if leverage is greater. A bank’s equity can be wiped out by a smaller shock than would wipe out the equity of a less leveraged institution. Two banks with the same ratio of capital to risk-weighted assets, or RWAs, might easily have different leverage ratios.

The Government have said that they intend to provide the Financial Policy Committee of the Bank of England with a time-varying leverage ratio tool, but they do not want to do that before 2018. In the Opposition’s view, that is inadequate. The Government’s view would be subject to review in 2017, to assess progress internationally. Ministers say that they want to leave these things to other international institutions to determine, but Sir John Vickers’s commission made it clear in its report that it

“supports the use of leverage ratios as a backstop, and recommends that all UK-headquartered banks should be required to operate with a minimum Tier 1 leverage ratio of at least 3% (and would favour international agreement on a higher ratio). Further, all ring-fenced banks should meet this requirement on a solo basis.”

The commission went on to call for a tapering of the requirements

“when a bank crosses a size threshold…by increasing the minimum leverage ratio from 3% to 4.06% on a sliding scale as the RWAs-to-UK GDP ratio increases from 1% to 3%.”

Reforms are needed not only to leverage, but to the risk weighting of assets, as we have debated. In the aftermath of the crisis, regulators introduced the risk weighting of assets as an antidote to the high-risk, high-reward culture pervasive in the banks, but the risk-weighting process has been partial, and it has been self-defined by some of the banks. In the EU, the zero risk weighting attributed to some palpably risky sovereign debts has brought the system into disrepute.

Leverage ratio powers, on the other hand, need to be taken in the Bill and to be phased in ahead of the EU plans for the end of the decade. As I said, that was one of the main conclusions of the Vickers report. Not to legislate for leverage restraint would be a significant omission from the Bill, which the Chancellor, once upon a time, claimed would “reset” the banking system. As Ministers said on the Floor of the House last month, the Government have the power to introduce a leverage ratio in their understanding of the legislation, but that power is ill-defined. It is not clear that section 4 of the Financial Services Act 2012, which amends the Bank of England Act 1998, would ensure that such clear action was possible on a leverage ratio. The new clause would put that legal question beyond doubt.

Most importantly, Sir John Vickers said that a leverage cap of 33 to 1—that is the other way of expressing the leverage ratio of the over-extended nature of some banks— was

“too lax for systemically important banks, since it means that a loss of only 3% of such banks’ assets would wipe out their capital.”

He recommended a sturdier 25 to 1 ratio for systemically important banks—in other words, 4% of equity capital—but the Chancellor has dismissed that particular concern.

It is essential that ring-fenced banks be supported by tougher capital requirements, including a leverage ratio. Determining that leverage ratio is a complex and technical decision that is best informed by the regulator. The Financial Policy Committee cannot be expected to work with one hand tied behind its back, so it is important to put in place the leverage ratio at the earliest opportunity.

The Parliamentary Commission was not convinced by the Government’s decision to reject the Vickers recommendations to limit leverage that way. It stated that it

“considers it essential that the ring-fence should be supported by a higher leverage ratio, and would expect the leverage ratio to be set substantially higher than the 3 per cent minimum required under Basel III. Not to do so would reduce the effectiveness of the leverage ratio as a counter-weight to the weaknesses of risk weighting.”

Sir Mervyn King, the current Governor of the Bank of England, said that the leverage ratio turned out to be

“a far better predictor of the institutions that failed in the crisis” than measures of risk-weighted assets.

It is not good enough for the Government completely to leave the leverage ratio out of the Bill and to leave the regulators powerless. There are ways to overcome the impact that it would have on a minority of non-plc institutions—I know that some building societies have anxieties about it—and of developing a more sophisticated approach, and the best way would be to involve the regulator. We have suggested doing that in the new clause, which has different minimum leverage ratios for different classes of ring-fenced bodies, and our approach takes account of some of the concerns. In particular, building societies have a different equity structure, but that is no reason for not putting this safeguard in place. We feel strongly about it, as do the various commissions that have spent much time on the issues.

The hon. Gentleman began by reflecting that the Bill is just a shell, and that the powers and provisions will be implemented through secondary legislation. Of course, his new Clause conforms precisely to that description: all it would do is give a power to set leverage ratios. If he regards that as a problem—most observers seem to think that it is the appropriate structure for a Bill—the new clause does nothing to address it.

The question of leverage is clearly important. It is one of the very few areas on which the Government and the ICB have taken a different view, but there is some common ground. The Basel Committee and the Vickers commission have argued that risk-weighted capital ratios should be the primary capital constraint on banks, and that we should ensure a distinction between relatively  safe assets, such as gilts from the UK, and relatively risky assets, such as property investments in some other country.

What worries me is that risk-weighting of assets was used before and the wrong risks were given to assets, based on models that were too short-term and did not understand that domestic mortgages could have a high level of risk.

My hon. Friend is absolutely right, and I will come on to address the concern embodied in his Intervention.

However one defines or looks at them, some assets are palpably more risky than others. Whether in the past authorities had adequate arrangements to assess them, some assets can nevertheless be considered safer than others, which is the point of risk weighting. We must be sure to avoid the adverse consequences of institutions that have relatively low-risk assets on their balance sheet investing their capital in more risky assets but having an identical level of exposure in terms of the leverage ratio.

The primary safeguard—Vickers recommends this—should be through risk-weighted assets. Vickers suggested, through the ICB’s recommendations, that primary loss-absorbing capital should comprise 17% of systemically important ring-fenced banks and CRD IV provides the national flexibility to do that. As members of the Committee know, that dossier has been much debated in recent weeks, but one of the successes of our negotiations so far—scrutiny has not yet been completed in the EU institutions—is establishing the ability to implement the Vickers recommendations in that respect.

In response to the point made by my hon. Friend the Member for North East Somerset that risk weighting needs to reflect actual riskiness rather than a supposed view of the riskiness of assets, CRD III, which was introduced in 2011, significantly increased the risk weights on assets such as complex securitisations in particular to reflect the experience in the crisis that mortgage-based assets proved to be underweighted in terms of their riskiness, which contributed to many of the problems that we have seen.

It continues to be necessary to review that work. The Basel Committee and the European Banking Authority have begun separate reviews of risk weights and risk-weighting methods, with the Basel Committee due to report on those matters in 2014 and the EBA at the end of 2013. The methodology will never be perfect. These are approximations and attempts to glimpse something that is unknowable in an objective sense; it is an assessment made by others on the underlying assets. We are therefore supportive of a maximum leverage ratio for the reasons mentioned by both the hon. Member for Nottingham East and my hon. Friend the Member for North East Somerset. That maximum leverage ratio was, in fact, recommended in Basel III. Through the particular study of the experience of international banks during the last crisis, the Basel Committee established that 3% is the level of leverage ratio that would be consistent with providing the degree of protection that would have been appropriate if it had been applied in anticipation of the previous crisis. That should be implemented through European legislation, and CRD IV provides an ability to do that.

The hon. Member for Nottingham East thought that that should be introduced more quickly, and that has been mentioned by others, but he will be aware that the ICB recommends only that the leverage ratio that it recommends—the high one—should be introduced from 2019; it does not make a recommendation that that should come in earlier. That leads me to note two concerns about the provisions of the new Clause. The first is the question of timing.

The new clause seems to propose a provision—the hon. Gentleman confirmed this in his remarks—to introduce the higher leverage ratio now, or at least sooner than would otherwise be the case. Basel III called for mandatory leverage ratios to be introduced, but from 2018. To run ahead of that timetable would certainly create costs, and potentially uncertainty at a time when many of us are trying to encourage banks in the UK to lend more to home buyers and small businesses. Were we to introduce it precipitately, the measure could have material consequences for the real economy at a time when most people in the House would want to see an increase in the lending activity of those banks that we would expect to be ring-fenced.

Secondly, the new clause would imply a higher ratio than is proposed in Basel III. The hon. Gentleman alluded to the expectation, certainly in the building society movement, that the proposal would disproportionately hit institutions that focus on activities that in any reasonable assessment are relatively low risk at the moment, such as the activities practised by building societies. Their concern is that far from being the back-stop that the Government and the Independent Commission prefer, for some institutions it could be a front-stop; it could be the primary constraint. As I mentioned earlier, if those institutions were prevented from practising their current business model, it could drive them into more risky lending.

I am conscious that there is no counsel of perfection in these matters. To refer to what I said on Second Reading, we are seeking to find the best solution to this British dilemma of how we can have a prosperous, functioning, disproportionately important financial services sector, lending to businesses and home owners in this country and trading successfully around the world, while protecting the British economy and particularly the British taxpayer from the consequences and ramifications for the taxpayer and the system that failures would entail. The combination of measures we are taking, in terms of capital requirements and the ring-fencing provisions, leads us to conclude, knowing the particular institutions that we have—I am thinking in particular of building societies—that we are striking the appropriate balance by having exacting domestically specific standards, which are provided for in the European legislation, while taking a broadly international approach. It is worth pointing out that at the moment provision is not envisaged for national differences in the arrangements on leverage, so anything we introduce may have to be rescinded if it were not allowed at European level.

I would like to comment on a few features of the new clause before the debate is opened up. It is not entirely clear from subsection (2) whether the power to be given to the Financial Policy Committee would be a macro-prudential or a micro-prudential one. If it is a macro-prudential use, the Government have made a  commitment to give the FPC powers to have a time-varying leverage ratio; that would be introduced in 2018 subject to the review planned at European level in 2017, and we are pressing for the legislation to allow that at European level. In the meantime, of course, the Financial Policy Committee has other tools available, such as imposing sectional capital requirements on areas that it thinks contribute to excessive leverage. If the proposed power is more a question of micro-prudential regulation, the Financial Policy Committee is not the right body with regard to the prudence of particular institutions on their own terms.

The new clause talks about “risk profile;” it would be helpful to understand whether the risk profile of the balance sheet envisaged is a macro-prudential or micro-prudential concern. As I said, if it is macro-prudential, the proposed time-varying power would address that; if it is micro-prudential, it seems to be outwith the remit of the FPC.

Secondly, subsection (2) refers to requiring any

“relevant body to maintain a minimum tier 1 leverage ratio.”

On the face of it, it is not clear to what the “relevant body” refers. Is it intended to be limited to all banks, or is it, as the Independent Commission on Banking recommended, to be applied to a subset of banks, particularly ring-fenced bodies of systemic importance?

We understand that the matter is important. It has exercised both the Commission and the Parliamentary Commission, and I am sure that we will continue to debate it throughout the House. I hope that I have given a reasonable account of the Government’s view as to why the new clause is not necessary and could have consequences, however unintentional, that damage the prosperity of the country.

Capital is at the heart of all the financial crises that we have had, and the solution to them. It is relatively simple, and there is a great tendency to over-complicate banking. If bank capital ratios were put right, most of the other problems would fall away. There would be less need to worry about ring-fencing and protecting depositors. Bank capital really is at the absolute heart of what we are trying to do now to put things right. It is worth bearing in mind that the Royal Bank of Scotland had only just over 1% capital; it was more than 90% geared at the point at which the crisis hit.

The question is, what is bank capital all about? It has a number of functions. It is there to absorb losses when banks run into difficulties. If we consider that a reasonably run bank will probably have to write off between 0.5% and 1.5% of its outstanding loans and assets every year, that gives us some idea of the minimum level of capital that is needed. In a bad year, in which the bank loses slightly more than that, it knows the order of magnitude with which it is dealing.

The other reason why bank capital is important is that when depositors turn up at the bank and say they want their money, the bank must be able to provide it; that is the classic run on a bank. The issue that banks have when there is a run is not that they are short of assets but that they are short of liquidity, which is where the definition of assets that are going to be counted towards capital is so crucial. The assets have not only to be of low risk, but to be liquid. When we consider what  happened to Northern Rock, there was no shortage of assets, but there was a shortage of liquid assets with which to meet the demands of depositors.

Interestingly, the Bank of England decided not to follow the suggestion of Bagehot that the central bank should be willing to lend when there is a liquidity issue but not when there is a fundamental solvency issue. The Bank of England decided that there was a moral hazard over Northern Rock and that if it came to its rescue, it would leave the wrong impression for all of the banking community. Therefore, the Bank of England decided not to help with the liquidity issue, underlying the point that the capital assets of a bank, the capitalisation ratios, need to be liquid as well as solid assets.

What is it that can be liquid and is a solid asset? They are extraordinarily limited assets. They are the notes and short-dated bonds issued by the currency in which the bank has the Majority of its liabilities, or indeed any of its liabilities. If it is a multinational bank, it is conceivable that it will have a run on its deposits in dollars and therefore it will need to have assets in dollars against that. If it is a UK bank, it is simpler just to deal with sterling. It needs to have notes and coins issued by the Bank of England and short-dated Government debt.

Anything that is long-dated immediately loses liquidity. In this context, it is worth bearing in mind what happened to Long-Term Capital Management. LTCM had a simple financial model. It dealt in enormous amounts of money to make a tiny margin on the difference between the benchmark bond and the bond that had just ceased to be the benchmark bond. The bond that has just ceased to be the benchmark bond yields a little more than the benchmark bond, because the benchmark bond has a number of buyers who need it for regulatory or index purposes. It will be in index funds, and so on. Therefore, against the normal trend of the yield curve, the slightly shorter-dated ex-benchmark bond had a slightly higher yield. LTCM piled into those bonds with billions and billons of dollars, and was able to earn a consistent return year in, year out. It was a very successful model, but it catastrophically exploded when liquidity in the ex-benchmark bonds suddenly disappeared. LTCM found that its model no longer worked, and it was left with many billions of dollars exposed in an unwinding market.

Even longer-dated Government bonds, because of the variability and unpredictability of liquidity, are not zero-risk assets. This comes back to the core of the argument: how are assets defined? The hon. Member for Nottingham East said that the Europeans have included some extraordinarily insecure sovereign bonds. Sovereign bonds are not automatically good risk. Anyone who does not believe that just needs to think of the Argentinean bonds that they might have held over the years, or the Chinese bonds that were issued in the 1920s that are used as elegant wallpaper, or imperial Russian bonds, and so on.

It cannot be Government bonds. It cannot be mortgages. Even packaged and resold mortgages ought not to count as the base capital of a bank because of their inherent risk. Again, if there is any doubt about that, look at the ratings given by Standard & Poor’s to packaged mortgages of sub-prime debt. When that debt was packaged together, it gave the highest tiers triple A  ratings. What happened to those triple A ratings? They disappeared in a puff of smoke when the underlying mortgages turned out not to be sound. So the ratings agencies cannot be a guide. I have very strong views about the general ability of ratings agencies to predict anything other than what has already happened. It comes back to the simple base capital of short-dated domestic Government bonds, cash and—dare I say it—gold, which always counts as a bank’s capital.

Then the Government need to decide what the right ratio is. My hon. Friend the Member for Wycombe (Steve Baker) thinks it should be 100%. I do not go as far as my hon. Friend, but I think it should be at about the 4% level—higher than is currently suggested by the Bank for International Settlements. We have to be careful about the BIS and Basel, because Basel is deeply political. There was a point when we were arguing at Basel that mortgages should count towards bank capital—this was prior to the Government being in office—because politically that was helpful in this country; it allowed banks to approve more mortgages. As I understand it, the Germans were arguing that loans to small business should count as bank capital because of the structure of German banking. So the BIS and the Basel accords are not independent, Olympian figures that calculate risk outside any political context. They are subject to all the normal political horse trading that international bodies suffer from.

I do not think it will be easy for the Government to get this right, and I certainly want them to take their time. We are emerging from the depths of a crisis, and banks still have many billions of pounds of bad debts on their balance sheets. To tighten bank capital now would be a mistake. It needs to be eased in so that banks can recover and restore their balance sheets first. When it is done, if we want to have a long-term, sustainable banking system, it has to be based on real, solid capital that is liquid and is not dependent on complex financial models, which should be treated with suspicion bordering on contempt.

The Committee is grateful to my hon. Friend for his perceptive and elegant summation of the issues that we face. All of us would accept his advice that the science of risk weighting does not merit the name. Even bodies that aspire to augustness, such as the Basel Committee, tend not to be populated by Olympians but by ordinary mortals who are subject to the same frailties as others.

My hon. Friend is absolutely right in reflecting that there should be a separate means of assessing the resilience of the institutions that do not rely on risk rating alone. Whether the appropriate ratio is 3% or higher is a separate question. As he rightly said, the question of when that should apply from is also a separate matter. Our view is that we should have the backstop ratio that is there. We have been persuaded by the Basel agreement. It reflects a study of the consequences of the past few years and the response to the crisis. But the provision that we have in mind is for a variable ratio that is scrutinised and enacted by the FPC and able to respond to the changing conditions. The circumstances in which this leverage ratio would apply will vary. Most people would accept that there are times, such as the  time that my hon. Friend alluded to, when people are intoxicated by the availability of credit and the opportunity to make returns from that. That was just the point when a more precautionary approach and a higher leverage ratio should have been instituted.

It is important to have regard not just to a single ratio but to the possibility of a variable one. So the Government’s view that we should introduce in 2018 a power for the FPC to be able to set a variable leverage ratio goes precisely to the point that my hon. Friend was making: that it is in the hands of another group of people—a group of expert people, no doubt subject to the same frailties as the supervisors in the Basel Committee, but nevertheless people charged with having a clear-sighted view on the consequences for financial stability of the way that the system is going from time to time—to look in particular at the leverage ratio and what can be done about it.

My hon. Friend is absolutely right; it is the liquidity, not simply the maintenance of levers of capital, that is important. The Vickers Commission is clear about the importance of that. Paragraph 3.20 of its interim report states:

“In light of the advances made by the FSA and the Bank of England, the Commission will not make recommendations directly on liquidity regulations, but will take due account of them in its work. The reforms contemplated…aim to support the liquidity of banks by ensuring that they remain solvent during times of stress.”

In other words, the provisions for enhanced liquidity—through Basel and other means—are regarded as being complementary to the recommendations.

It is a matter of judgment. It is important that the Committee understands that the Government have no objection whatsoever to a leverage ratio being in place. More than that, we think that the leverage ratio should be an important tool for macro-prudential regulation and that it should be possible to increase it above the 3% level that Basel implies. That should be vested in the way that is proposed in the Financial Policy Committee, so that it strengthens the armoury that that institution has for regulating the sector.

I think I heard the Minister say that he supported a leverage ratio that had the potential to go above the Basel minimum recommendation and that may be a slight departure from my understanding of the Treasury’s recommendations hitherto. Setting that to one side, however, I still think that the importance of getting some progress on this issue requires us to address it now in the Bill in some shape or form. I accept the point of phasing in the arrangements and allowing time, particularly in the economic circumstances, to ensure there are no adverse consequences. Nevertheless, over the medium to longer term, putting our banks on a safer and sturdier footing is incredibly important, as all the weight of the evidence of the Vickers Commission and the Parliamentary Commission suggests.

I commend the helpful comments of the hon. Member for North East Somerset. He is insightful about the nature of bank capital and, in particular, issues of liquidity—in general confirming my view that this is not a left versus right wing question. It is not an issue where some on the left think that we need to constrain the banks and others do not. There are some, such as Lord Lawson and others on the Parliamentary Commission,  who have taken a very firm view about the need for reform of the structures and the balance sheet arrangements of the banking sector.

The hon. Member for North East Somerset talked about a 4% leverage ratio. That was a really important comment. I understand that in the United States in some circumstances that could be nearly 5%, ironically, although they have the Fannie Mae and Freddie Mac arrangements that tend to distort international comparators of leverage ratio arrangements for some of the banks. Nevertheless, the hon. Gentleman was correct to talk about the need to be wary of going for the lowest common denominator through some of those international institutions, particularly given the importance of the banking sector in the UK economic make-up. It is systemically important for banks in particular, not just worldwide but for our economy, that we apply that extra degree of care and attention to these leverage questions.

It is important to put it on the record that the comparison with the US, as the hon. Gentleman implied, is not strictly fairly made, in the sense that there are different elements included and different ratios from place to place. The Governor designate of the Bank of England, when giving evidence to the Parliamentary Commission, said that apples and pears were being compared in those matters. I do not think it right for the Committee to think there is a higher comparable ratio in the US.

My point still stands. I certainly agree that, as I was saying, in some ways the level of state Intervention in the capitalist entity that is the United States of America is quite high, which ironically makes direct comparisons quite difficult. Nevertheless, I think it is important to recognise that, as the hon. Member for North East Somerset set out, some of the circumstances at RBS and others were quite shocking. We should take the opportunity to learn lessons and ensure that we have put ourselves on the right course.

We have not specified the leverage ratio in new Clause 1, because we want it to be variable across different classes of ring-fenced bodies. Systemically important banks are very different from building societies, and that is something on which we ought to take the regulator’s lead. Including new clause 1 would, however, put down an important marker that we consider the leverage ratio to be a crucial component of the safety and security of the banking system. We cannot simply rely on ring-fencing, because this is a bigger story than structural constraints.

For those reasons, rather than simply treating the Committee stage as something that we have to get through and saying that the matter will be dealt with at a later date, we must ask ourselves: if not now, when will we do this? We have to take a stand and sort it out, which is why I would like to put new clause 1 to the vote.

Question put, That the clause be read a Second time.

The Committee divided: Ayes 8, Noes 10.

Question accordingly negatived.

Ordered, That further consideration be now adjourned.— (Greg Hands.)

Adjourned till Tuesday 16 April at ten minutes past Nine o’clock.