Our decisive central bank has been neutered by regulatory confusion

Howard Flight
THE TREASURY Select Committee has rightly questioned the arbitrary powers of regulators, particularly the Bank of England, over the boards and senior executives of private firms in the financial sector. Despite the mistakes of our cartelised banks, it’s unwise to assume that regulators can run businesses better than boards. Moreover, trends over the last 12 years have not produced regulators equipped to steer the banking industry away from the rocks.

What history and experience have taught me, however, is that the banking system needs a respected and adequately resourced central bank – both to supervise banking activities, steer the industry away from danger, and with enough power to act speedily and effectively in times of crisis.

In the difficult periods of the late 1920s and early 30s, the Bank of England, and its governor Montague Norman, were not given adequate credit for keeping the UK banking system afloat. His wise supervision was largely the product of good intelligence, shrewd observation, and clear perception of how banks manage their balance sheets. Internal Capital Adequacy Assessment Process (ICAAP) formulae are hardly an adequate or particularly effective alternative to actually knowing how and where banks are lending. Effective supervision is an art, requiring both experience and central bankers who have lived through bad times, as well as good.

When crisis hits, however, a central bank needs to have the authority to act speedily and in a relatively high-handed fashion. In 1974, the UK banking crisis was not as major as that of 2007 or 09, but had similar characteristics. Its main cause was a prior government policy of granting licences too easily to new banking operations. These new banks financed themselves in the wholesale money markets and built loan portfolios – largely lending against property, financed by wholesale deposits. As inflation started to accelerate – also caused by government policy – there was a speedy run on new banks. They found they could not roll over their wholesale deposits and thus became insolvent.

Arguably, the Bank of England was partly to blame for not spotting and heading off the dangers. But, it acted speedily and effectively to stem the crisis through the establishment of the “Life Boat”, to which I was briefly seconded. The “Life Boat” identified failing banks and instructed appropriate larger banks to take them over. Those that tried to resist were discreetly advised that they might find problems in renewing their banking licences. The Bank of England cleared up the crisis without cost to taxpayers.

As we also witnessed more recently, the run on banks in 1974 spread like wildfire when, by common understanding at the time, one of the major clearing banks found itself insolvent and was obliged to call on Bank of England lender of last resort support. At the time, the run also spread to building societies and local authorities, where the latter were major participants in the sterling wholesale money markets. There was broad acceptance that the central bank needed to act decisively in a crisis, including the exercise of arbitrary powers.

When the Financial Service and Markets Act of 2000 was being debated in Parliament, I was strongly opposed to the setting up of the tripartite committee and said so on the floor of the Commons. What concerned me was that, should another crisis like 1974 occur, it was unlikely that a committee would be able to act decisively.

As it turned out, ironically, it was the chancellor and the FSA who supported a speedy fire-sale of Northern Rock and the Bank of England that opposed this. So reduced was the Bank’s intelligence by 2007, it lacked the knowledge of what had been happening to balance sheets, and why the banking system was vulnerable to a major banking run. Rather, it relied on its econometric model, which did not have the parameters to identify the gestation of a major banking run.

It is reasonable for a central bank to approve banking licences and the appointments of individual bank directors. But it makes little sense for these powers to be duplicated by newly-devised regulatory bodies.

It is also reasonable and necessary for the central bank to have and to use arbitrary powers in times of crisis. But these should not be exercised on a regular, on-going basis.

Lord Flight is a former chairman of Investec Asset Management and a Conservative member of the House of Lords.