It is a pleasure to serve under your chairmanship, Mr. Benton. I am grateful to Mr. Speaker for giving me this opportunity to discuss Government policy on international banking regulations, not only because of the experiences that we have all just been through but because we look forward to the meeting of the G20 in Washington DC on
There is no doubting the scale of the challenge before the G20 as its members plan the meeting. Clearly, it is huge. There is even talk of a new Bretton Woods. If one thinks about the context in which that system came about—it was almost the aftermath of the second world war—one can understand the scale of the challenge that is before us. There is some urgency to it, because of the remaining weaknesses and faults in the international banking system. It is clear that huge stakes are involved, not least because the leaders will discuss the future stability of the world's financial system and, through that, the future prospects of virtually every nation on the planet. The rewards for getting a new regulatory structure, whatever it turns out to be, right are enormous, but, equally, the costs of getting it wrong are huge.
One thing at stake is what I call the regulatory culture. I do not think that there is now any question in anyone's mind about the fact that there was a massive regulatory failure in the run-up to the culminating events in October, but the issue is what failed within that regulation. There are already competing views on that, and competing camps will converge on the Washington meeting later this month. Three views are emerging. One group anticipates that reform will lead to some grand new global regulator: one regulator, one set of rules, one set of enforcement proceedings. At the other extreme is the group that wants to stick to the do-it-yourself approach to banking regulation, leaving nations to work out their own salvation. Finally, there is a group coalescing around the middle that wants multiple systems of regulation but with some measure of co-ordination between them to ensure consistency across the different platforms.
It is evident that some of the leaders who will go to Washington will talk up the idea of a new global and interventionist form of regulation of the banking systems in different member states—micro-management, if one likes—but that others who are preparing to travel there are anxious to defend the light-touch regulatory approach. I believe that the United Kingdom Government are in that camp. They would take the view that the light touch of the past has benefited the UK by producing growth in the financial sector and thus making a contribution to the economy, but set against that is the question of whether it contributed to some of the problems that have exploded before our eyes. There is not a straightforward bipolar choice between the two options. It is clear that a tension underlies the debate, and I have no doubt that it will surface in the Washington discussions.
The first question is what exactly went wrong, and with the advantage of hindsight, it is now relatively easy to answer that. It is worrying that the regulatory systems that were in force did not call time on what was going wrong, or, if they did, that they did not do it sufficiently loudly or with sufficient weight to bring certain practices to a halt. The sequence is now clear: there was a steady decline in banks' capital asset ratios. At the time of the Bretton Woods agreement that set up the broad framework that regulates the system, typical capital asset ratios were between 15 and 20 per cent. They have declined steadily since the 1940s and 1950s and are now down to about 8 per cent. That decline in itself need not have led to a catastrophic outcome, but it combined with other things that were happening to become a toxic mixture.
There were ever more complex financial instruments, many of them emerging from the application of new technologies to the markets; ever-increasing leveraging was used by the banks; more bank assets were packaged and distributed internationally; and, in many instances, the risk assessment attached to all of that was effectively outsourced to credit rating agencies that were remote from the actual world of banking. It is generally accepted that that combination led to the catastrophe in the banking system this year.
The extent of the leveraging was dramatic. The Bank of England's financial stability report published in October showed that UK customer lending by the banks was equivalent to customer deposits in those banks as recently as 2001. By 2008, UK bank lending to customers exceeded deposits by £700 billion—about one half the size of the UK economy. That was a dramatic shift in just seven years, with most of the extra lending offered by UK banks to UK customers sourced from overseas money washing around the international banking system.
With the integrity of much of that funding uncertain, and the fact that its structure was not transparent, we can now see that the whole thing rested to a large extent on asset price inflation, which everyone surely knew could not continue uninterrupted for ever. I suppose that there was an intellectual realisation that that was the case, but it seems that nearly everyone in the banking system was carried away by the exuberance of asset inflation that apparently would not end.