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International Banking Regulations

Volume 482: debated on Tuesday 4 November 2008

Motion made, and Question proposed, That the sitting be now adjourned.—[Mr. Dave Watts.]

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 15 November. This is a timely opportunity to hold what I hope will be a constructive discussion about the issues that are on the table for that meeting of world leaders and all the work that will follow, and I hope to hear something about what the Government’s approach will be.

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.

I congratulate my hon. Friend on securing this debate on international banking regulations. He said that the structure is not transparent. Does he hope, as I do, that when our astute and highly regarded hon. Friend the Minister replies to the debate, she will refer to financial accounting standard No. 157, which was introduced in the US almost a year ago this week? It looked at the valuation of bank assets and put them on three levels, the third of which deals precisely with the collaterised debt obligations that brought to the surface the fact that sub-prime mortgages underpinned much of the American boom. That realisation triggered what we have seen during the year or so since. Perhaps we should be more open about the valuation systems that banks use which sometimes even they do not understand.

I am grateful to my hon. Friend for making that point. He is absolutely right. Of course accounting systems and procedures are very much part of the suite of issues that must now be examined. I shall touch on that subject again when I come to the Basel accords, as there is an overlap between the point that he made and the issues that arise in that context.

I was discussing the asset price inflation that drove all the recent occurrences, and the chain of causality that began to unravel. It is now well known that the problems were initially exposed by the downturn in the US housing market, which in turn exposed the sub-prime lending that had been going on. Those issues were rapidly transmitted through the international banking system and led to banking collapses in some instances, as well as the threat of collapses on a wider scale. That in turn led to a crisis of confidence in the banking system, which in turn sent LIBOR spiralling, thereby producing the current global slowdown in economic activity.

All those events almost brought the international banking system to the brink of a catastrophic collapse, which was averted only by the concerted and co-ordinated action of Governments around the world injecting £3 trillion of resources into the banks. It is worth recording the scale of the losses, as is it known, although those figures may change as time goes on. Government intervention at the moment is designed to cover potential known losses in the UK banking system alone of some £122 billion; in the euro area, the loss is estimated at $784 billion and in the United States it is $1.57 trillion.

To return to the UK, the Government recapitalisation that I just mentioned, which averted a complete catastrophe in the banking system, has lifted the capital ratios a bit, from an average of about 8.5 per cent. to about 10 per cent. However, we learn from the Bank of England’s financial stability report that even at these levels, UK banks would still need to shed about £1 trillion-worth of assets—almost equivalent to the size of the UK economy—to get their leveraging levels back to what they were in 2003. That is a striking illustration of the extent of the problem and the degree to which that overhang is still there and remains to be dealt with, even after the banking rescues have taken place. That will only be done either by a very long-term correction, which would mean correspondingly tight credit and slow growth for a long time, or, possibly, even more state support on top of what we have already seen.

We also have to address the moral hazard question that has come about as a result of the Government intervention. Put simply, banks now know that they will be bailed out. What has long been suspected has been confirmed; they are too big to fail. Does that raise a question—I am interested to know what the Minister thinks about this—about the incentives for banks to behave responsibly in future, knowing, as they now do, that they are too big to be allowed to fail? The Government intervention, which was clearly the right thing—I am not questioning that for a moment—has brought into existence the concept of shadow equity which, in effect, is behind every banking institution and is funded by every taxpayer.

The next question, as I mentioned at the outset, is what exactly happened on the regulatory side and what can we learn from it. It breaks down into three sub-questions. First, who are the key players in setting international banking regulation? Secondly, were the failures administrative or systemic? Thirdly, how can the failings be corrected? The first and most obvious key players are the International Monetary Fund and the World Bank, which were brought into existence in 1944 under the Bretton Woods agreement. Those institutions were established to step in where markets failed and to mitigate the anticipated excesses of global capitalism. They were also designed to prevent beggar-thy-neighbour policies, which everyone meeting at Bretton Woods believed had contributed to the economic and political catastrophes of the 1930s. I am sure that they were right in that conclusion, but it is interesting to look at the IMF’s remit, because it reflects what the debaters at Bretton Woods were trying to prevent from happening again—their perspective was the need to avoiding the problems of the inter-war years. The IMF’s remit focuses heavily on trade and trade regulation, as well as on exchange rates, but it says little about preserving financial stability.

Looking at the history of Bretton Woods, there was an interesting argument at the time between those who wanted to bring out of the conference global institutions, global rules, global financial governance and, possibly on the part of some, a global currency—an interesting echo of the debate around the table in Washington later this month—and those who argued for sovereign independence for states in their banking and trading systems, but with the means of co-ordination and general oversight and with the existence of reserve funds to give support to countries in trouble largely as a result of trade deficiencies. That is a different context from the one that we now face.

I think that people can see structural weaknesses in the IMF. I raise that point because if the discussion is going to be about the IMF as a key player in the restructuring of the regulation of international banking, other questions need to be addressed before reaching that conclusion. The first problem with the IMF as currently constituted is that it is seen around the world as the advocate of the Washington consensus. The US dominance of the IMF as an institution is undeniable. The US is the only member of the IMF with a 17 per cent. vote on the board, and that 17 per cent. is crucial, because most major decisions taken by the IMF require an 85 per cent. vote and the United States alone has the veto. In addition, US influence over the IMF has been ramped up over the years. Every time the IMF wants to renegotiate the quotas it has to gain US congressional approval to do so. Congress, not unreasonably, poses ever more conditions as a quid pro quo for supporting the revamping of the quota system, so it has its hands on the IMF’s policy stance, and that is recognised around the world.

The IMF, in the present context, is seriously underfunded. Discussions are taking place, in which our Prime Minister is involved, to try to resolve its funding situation. However, even if the funding is sorted out, questions still have to be asked about the IMF as an institution and about its stance, because the Washington consensus is now damaged goods after the sub-prime catastrophe. One wonders whether the IMF will suffer reputational damage and whether that can be put right. It is not just about recapitalising the IMF; it is also about revising its role. People are calling for it to have an enhanced role in the supervision of international banking and to provide early warnings; to be a genuinely global supervisor and to have a strengthened brief on financial stability. All those things are needed—I do not think there is any question about that—but if any of that is to be achievable in a robust, sustainable way, there must be fundamental reform of the governance of the IMF. I am interested to hear what the Government think about that.

The second major institution that we have to consider is the Basel Committee on Banking Supervision, including the accords that have grown out of it, which was not set up by the G10 until the 1980s, long after the Bretton Woods discussion. The Basel accords eventually plugged the gap in the IMF’s remit, but they did so a long time afterwards. They have not come out of this saga very well either, yet a great deal of store is being set on their coming to the rescue of the international banking system. Basel I, the first set of accords, was long ago acknowledged as weak, which led to all the negotiations that ultimately resulted in Basel II, which is still advocated by many as the gold standard of financial supervision. However, the experiences of the past year show that Basel II, too, has fundamentally failed. Long negotiations led up to Basel II, throughout which the banks lobbied hard for a system based on two core principles: internal risk rating—the banks doing their own assessment of their exposure to risk—and low capital thresholds. In the negotiations that led to Basel II, the banks got both those things, so they really won again.

It is worth looking at some of the detail of Basel II, which allows banks with sophisticated risk-taking models—that is now most of them—to select their capital adequacy ratio from an à la carte menu of options provided by the Basel Committee. Basel II also means that banks can use their own measures to determine their exposure to risk. There is no independent, externally verified risk measurement. The banks measure their own exposure to risk.

Basel II also allows the banks to allocate their risk weighting to each of their assets, including off-balance sheet assets. To read what the banks said when Basel II was negotiated gives the impression that they thought that they were moving into a world with a huge regulatory hurdle, but Basel II was the guidance that told banks that it was fine to reduce capital charges on lower-risk lending—that is Basel II’s phrase, not mine—which was defined as retail loans and residential mortgages. It is extraordinary that it said that it was okay to have lower risk protection on those loans because they were safe.

I entirely agree with the hon. Gentleman’s sentiments about the weaknesses of Basel II, but if there were a revision, it might be worth keeping one of the benefits—releasing the banks from the obligation of relying on oligopolistic suppliers of credit ratings—and having some discretion, because of the great failings of those American rating agencies.

The hon. Gentleman makes an absolutely valid point. I am not trying to suggest that the whole Basel system should be dumped in the basket and forgotten. I am merely raising a suite of concerns about the content of Basel II, because I am worried that if world leaders, when they discuss re-engineering the architecture of banking regulation, assume that everything must proceed in the way that the accords previously proceeded, that will not be enough. That does not mean that there are not robust and important features in the Basel system, because there are, and they will want to retain them. I am pointing to the weaknesses, which will have to be addressed if we are all to have confidence in the new system, and if it is to be a permanent, not a temporary, fix.

I am running through some of the consequences of Basel II. Adam Applegarth cited Basel II compliance when he told the Treasury Committee last October that it was fine for Northern Rock to increase its dividend rather than to shore up its capital. He said that that decision was based on the regulations implied by Basel II. The accord’s weaknesses have also been identified by the Bank of England in its financial stability report, which points to the weak treatment under Basel II of trading book assets and risks relating to off-balance sheet exposure. Many analysts argue that if Basel II were fully implemented, it would lead to lower capital asset ratios—even lower than the average 8 per cent. that it envisages.

Despite that, the Basel system in general has many advocates, and many of its features are perfectly respectable, but important institutions around the world still address the current issues of banking regulation using Basel II as the platform on which to build everything. For example, the European Commission proudly cites Basel II as the foundation on which it is writing its capital requirements directive, which is currently being debated by MEPs. Further refinements are being made to Basel II, some of which were set out in documents published in September. They call for regular stress testing, ensuring the alignment of risk-taking with liquidity exposure, and maintaining a cushion of quality liquid assets as insurance. Those are welcome reforms, but they are based on the core principles of Basel II, some of which are now exposed as fatally weak. It is worth remembering that the Basel accords are not law; they are simply guidance. They have no direct enforcement mechanism, and are entirely dependent on the interpretation of each country’s central bank or regulatory authority. Nor is Basel II’s remit comprehensive enough to embrace all aspects of the toxic mixture of banking practices that have imploded.

That tour of the institutions is the main part of what I want to say. It is relatively easy to agree a list of weaknesses: inflated balance sheets, assets of uncertain value, complexity of new instruments, dangerously high levels of leverage, too much dependence on wholesale funding, dangerously low capital asset ratios, and insufficient understanding of the level of global interconnectivity between the different practices and instruments that banks have introduced.

Will my hon. Friend add to his list of problems the fact that all the banks that failed in the US, Britain and the EU had a clean bill of health from auditors who were dependent on those banks for their appointment, fees and other income? Should we not have a more independent process? For example, PricewaterhouseCoopers charged Northern Rock £2.4 million in 2007, of which £1 million was for consultancy. How can those auditors—other examples proliferate—be as objective as they need to be in the interests of depositors and the economy?

I anticipated that when I reached this stage of my speech other hon. Members would want to add to my list. I do not disagree with my hon. Friend, and I am happy to take on board the point that he made. Whatever is on the list and whatever anyone wants to add to it, it points in its sum to systemic failure on the part of regulators. In reply to my first question on whether the failure is administrative or systemic, the evidence points more to systemic failure.

Regulators did not, or could not, keep up with the pace, extent and technical nature of changes in financial markets. They did not have the right tools for the job. It is relatively easy with increasing hindsight to agree on what is needed. Hon. Members may want to add to this list, but I shall give my requirements: timely early-warning devices, higher levels of transparency across the system, more cross-border supervision, counter-cyclical instruments, and re-engineering of risk measurement and management. How that can be done is the hard question. The main tools in the box are the International Monetary Fund, the World Bank and the Basel accords, and beyond that the interpretations by a host of different regulatory systems of what those accords say. However, they could also be described as the major contributors to the 2008 financial disaster.

I said that aspects of the matter are urgent, and in seeking an urgent response, there is a tendency to grasp the tools to hand. Clearly, there is urgency about the agenda, but in seeking to bring about a new global regulatory framework, there is a necessity for a great deal of reflection and careful building because there is so much at stake, but that calls for time, so there is tension in the discussions between time to get this important matter right, and the urgent need to avoid further calamities. That is a key tension, and I am sure that it will be a feature of the discussions in Washington and the follow-up work.

It is not easy from our perspective to know how those tensions in the system will work out, but it is important that Parliament considers, and engages in, the issue. That is all I am trying to highlight today. I hope that it will give the Government an opportunity to say more about their thinking as they prepare for the Washington meeting. If it will help the Minister, I will collapse all that I have said into three basic questions. What is the Government’s analysis of what went wrong, and does it match mine? What are the key components of any new global regulatory architecture that is fit for purpose? Can they be securely based on existing institutions, or does a workable reform require us to conceive new institutions for global financial governance?

I have declared my interests in the Register, but we all have additional personal interests. I currently enjoy the pleasure of a NatWest overdraft and mortgage, and I hope that the credit crunch will not immediately impact on those. I am also prospectively a Royal Bank of Scotland pensioner.

I congratulate the hon. Member for Warwick and Leamington (Mr. Plaskitt) on securing the debate. His speech was an example of Parliament at its best—pre-scrutiny work on the challenges that the Government will face in upcoming meetings, during which how to deal with the medium-term implications of the current credit famine will be considered.

The hon. Gentleman emphasised particular issues that are worthy of consideration. He said that additional state support for the banking system might be necessary further down the line, and he rightly emphasised how we need to bear in mind that there are many national interests in the debate about the altered regulation that might be introduced. We must be aware of and cautious about the implications of change to regulation, because that will impact on our country’s interests.

I should declare an additional interest: the World Bank has been and is a client of mine, and I know people at that organisation. For those who have not been to Washington, it is notable that it is only a two-minute walk from the White House to the World Bank headquarters buildings on I street. The closeness of that institution to the Washington consensus is important. Crucially, the hon. Gentleman mentioned how there is a real debate about what the new regulatory regime will be like; will it be unipolar or will it be diverse? I wish to take this opportunity to caution strongly against the dangers of adopting one overall system of regulation.

Following the theme of globalisation in relation to regulation, we must recognise that one issue connected to the financial crisis is that of financial contagion. If one goes down the route of ensuring that there is similarity in terms of regulation across financial markets and the globe, that contagion is more likely to be enhanced in any future crisis. To some extent, the degree of semi-detachment of the Asian financial markets from the rest of the financial global system means that they benefit from having some protection from the current problems. I wish to press upon the Government that when they seek to protect our interests during international debates on regulation, they should be aware that there is an argument for what might be described as regionalised circuit breakers and that there is an advantage in having some difference.

We must also bear in mind that if there is complete similarity in terms of regulation, it is possible that, geographically, businesses will find it easy to move from one place to another within the international financial system. Clearly, we have an interest in defending the concerns of the City of London. That is particularly important because, in terms of employment in Greater London as a whole, the financial industry has become dominant in our capital city—almost to the extent that it is the cuckoo in the nest.

There is a danger in following one solution to rescue the international banking system. There is no doubt that the Government have shown real leadership—even just in terms of installing confidence in financial markets—by taking vigorous and rigorous action. They have created an economic value by ensuring that they are seen to take quick and speedy action. However, I have some doubts about the medium-term efficacy of the equity capitalisation that has taken place. Unfortunately, there is a great danger that such an approach is badly flawed. In my constituency, the south London economy is dominated by small businesses, which are being crushed by the credit famine. As Members of Parliament, we all complain and rail at Ministers from the Treasury and the Department for Business, Enterprise and Regulatory Reform about why the banks cannot deliver on providing 2007 levels of credit. However, it is quite unreasonable of us to complain in that way to Ministers. We are saying, “We own the banks; why can’t they deliver?” However, the reality is that the banks cannot do so because they are badly wounded institutions, as the hon. Gentleman has mentioned.

Prospectively, up to £1 trillion of additional damage and risk might have to be considered for coverage. I earnestly believe that in their desire to be seen to act as quickly and responsibly as possible, the Government have alighted on the wrong solution. We should have followed what happened in 1992 in Sweden in terms of trying to remove the bad debts that exist on bank balance sheets and transferring that into a bad bank. That is the same model recently employed by the Swiss National Bank regarding UBS. The crisis in Sweden in 1992 was especially severe. The overall private sector bank defaulted debts were the equivalent of 15 per cent. of gross domestic product. On the basis of the figures in the hon. Gentleman’s speech, our crisis could prospectively be even more significant. I cannot speak with the same clarity as him, but I shall try to bring the matter down to a simple comparison: the Government’s policy is like someone saying, “I will buy your house because you’re in trouble,” when in reality the patient is bleeding to death and needs to go to hospital.

In many ways, the current level of confidence in financial markets is dependent on the credibility of the Government’s actions. I fear that if the Government are driven to make a second round of bail-outs, their credibility will be greatly damaged and we will all suffer as a result. The Government made a good announcement yesterday about the creation of the new UK Financial Investments Ltd. That institution will be well positioned to form the new bad bank structure that has operated so successfully elsewhere—it was greatly successful in Sweden and proved to be profitable for the Swedish taxpayer.

In terms of the proposals for a singular global regulation, I fear that we might unknowingly end up successfully proselytising the unfettered free market style of markets that has brought us into this mess. I know that I am well away from the political consensus when I say this, but there is always a danger that as politicians, we will try to cling on to one or two items of consensus in a storm. We have to recognise that the free market fashion of central bank independence has failed. Central banks have shown an incapacity to deal with the issues of asset price inflation, which the hon. Gentleman so rightly emphasised in his speech. The Bank of England’s performance has not exactly been stellar, so it amazes me that in the process of blaming the Financial Services Authority, people suggest that we should transfer powers to the Bank of England.

The hon. Gentleman rightly emphasised the issue of transparency. I am also worried about that to some extent.

I am very interested in the hon. Gentleman’s comments on Bank of England independence. Clearly, that is his view, but will he spend a couple of minutes explaining how he sees the system working instead? If he does not want the Bank of England to be independent, how does he see the regulatory system working?

I am grateful for the Minister’s intervention. A weakness in British politics is the way in which we, as politicians, have been happy to devolve many decision-making powers away from Parliament. My suggestion is that we should have confidence in our Ministers and politicians to make very good judgments themselves. I propose returning to the situation that existed pre-1997.

I was about to move on to transparency, which the hon. Member for Warwick and Leamington mentioned. I want to mention the issue of dark pools, which does not concern the swamp on the way to Mordor. It is the issue of off-stock exchange trading, whereby temporarily, for a few hours, information will not immediately be provided on large block trades that are going through exchanges. After the recent financial crisis, it would be wrong of us to continue to pursue that type of approach. The importance of transparency is a message that we clearly want to send to the financial sector, and it should be retained.

I am also concerned that the International Monetary Fund still shows a capacity to repeat the mistakes, in its obsession with free market solutions, that it made in 1998 as a consequence of the 1997 Asian financial crisis. That was seen yesterday in its determination to ensure that the 84,000 people of the Seychelles went through an immediate launch of their currency into free float at a time when the financial markets are absolutely crushing emerging markets. A country that already had a 175 per cent. debt to GDP ratio was yesterday forced to float its currency, and it saw that currency devalued in those markets by 43 per cent., so that the debt to GDP ratio today is 250 per cent. It cannot be right to expose those countries to that type of free market exposure, and that trend should not be pursued.

We must also recognise that in a unipolar financial market, those countries with very significant trade surpluses have been forced to invest those with just one choice of large liquid supply of US Government and US agency debt, and they have found themselves locked into a financial structure that is not necessarily to their advantage. The obvious Government policy as regards the US is to inflate and devalue their way out of the significant debt that they have secured. It must be a very strong argument, in terms of trying to recreate a structure for a new international financial system, to be able to provide an alternative large pool of investments for large trade surplus countries to be able to invest in.

One of the things most significantly to blame for the current financial crisis is the conduct of Japanese financial policy in the 1990s. That left us with the legacy of very low interest rates in Japan, which has meant that the carry trade has done so much damage in providing extra liquidity in the financial system internationally. Therefore, it is important that in any new structure that is created, there are responsibilities on Government in respect of the way in which that liquidity is provided.

I return to the point about there being an alternative large Government issuer. That large Government issuer of debt could well be the European Union. President Sarkozy is having a good war—perhaps a bit like our Prime Minister. His comments about the implications of the financial crisis are interesting:

“The eurozone cannot continue without a well defined economic Government.”

That hints at the logic that comes with the euro: ultimately, if people have a common currency, they need a concentration of common governmental powers. It is incumbent on us to help our European partners by saying that it is not in our interests to join that cause and to let them run ahead with their desire for a much more centralised system.

It is clear to me that many of our European partners are so angered by the damage that has been done by what they see in this financial crisis as a fault with the Anglo-Saxon nations that they will be determined, in their regulation, to stifle the Anglo-Saxon model of freewheeling financial markets, for good or for ill. We must ensure that in being determined to introduce heavy-handed regulation, they do not stifle the financial markets in the City.

This debate is timely and important, as others have said. I congratulate my hon. Friend the Member for Warwick and Leamington (Mr. Plaskitt) on securing it and on his speech. He is undoubtedly right on the scale of the challenge and the urgent need for action. He set out with characteristic thoughtfulness and clarity the key issues and options.

On the question of what went wrong, we have to ask, along with all the other questions, what executives, boards and auditors were doing signing off balance sheets loaded with financial instruments, many of which they evidently did not fully understand and whose value or lack thereof they clearly had not properly appraised. One issue that certainly has to be examined more closely is the penalties for those who fall short on that scrutiny, both internally and externally.

In the spectrum of options that my hon. Friend set out, from light-touch regulation to micro-management, we need to establish clear rules. I take the interesting point that the hon. Member for Croydon, Central (Mr. Pelling) made about regional circuit breakers. That is a valuable concept, but we need some clear, objective and enforceable rules on the issues that my hon. Friend went through, on capital thresholds, the integrity of balance sheets, exposure to risk and transparency, as well as the points about reform of the IMF that he mentioned.

My hon. Friend invited us to add to his list of things that were wanted, and I propose to do just that because I want to focus my remarks on another aspect of international banking regulation which has not received much mainstream attention but which is vital to many of the poorest people on our planet. My attention was drawn to it by an article in The Guardian on 7 October written by Paul Collier, who is director of the centre for the study of African economies at Oxford university. In it, after an amusing but telling analysis—I will not repeat it now, but I recommend it to others—of why crooks can more or less safely be left in charge of fish and chip shops but not banks, he homes in on the crucial issue of how well banks have done out of banking secrecy and how that aids and abets the looting of enormous sums of money from Africa and other poor areas.

The article states:

“The loot-seeking elites that control parts of Africa illicitly send capital out of the region to the tune of $20 to $28bn per year.”

Paul Collier bases that on a new study undertaken by Raymond Baker of the non-governmental organisation Global Financial Integrity. He then points out that a capital flow of that size is more or less equivalent to the total overseas aid to the region, so if it could be closed off, that would give rise to a similar amount of money as the doubling of overseas aid. Obviously, one would have to get the money out of the hands of the corrupt elites and use it for the benefit of the people, but it is an essential step in getting that enormous resource back where it belongs.

It is clear that current rules on banking transparency and supervision are unequal to the task of keeping track of, exposing and returning money taken from Africa and shifted around the global banking system and in and out of offshore accounts. The world has started to address the need for better scrutiny and accountability in the wake of 9/11, when the need to combat the financing of international terrorism became evident. However, as the article points out, some banks resisted even that. It is right to ask whether the same scrutiny should not now be extended to the salting away of the products of corruption, bribery and extortion from poor countries—and those countries that ought not to be so poor—that are governed by corrupt political and business elites.

The banks, not only here but around the world, now need Governments to use their citizens’ money effectively to give retrospective guarantees, bailing them out in respect of practices that, as we have heard, should never have been allowed to grow in the first place. In return, should we not insist that the global financial system stops facilitating the exploitation of poor people in Africa and elsewhere? Now that the banks are over a barrel, is it not time to force greater transparency upon them?

I therefore ask my hon. Friend the Minister to say first whether she agrees that that is a serious and pressing issue. Secondly, will she undertake to look further into that aspect of international financial regulation? Thirdly, will she let me know what the Government are doing to put it on the international agenda, at the forthcoming G20 meeting and more generally? We cannot allow banking secrecy to collude in the looting of wealth from the world’s poorest, and I very much hope that the Government will do something about it.

I add my congratulations to the hon. Member for Warwick and Leamington (Mr. Plaskitt), not only on securing the debate but on giving us such an excellent resumé on its context. I also congratulate the hon. Member for Croydon, Central (Mr. Pelling) on his interesting comments. I entirely agree with the right hon. Member for Oxford, East (Mr. Smith) that it is timely to consider the fact that banks have clearly facilitated corrupt Governments and businesses putting money beyond the people that they should serve. That aspect is just as urgent as the others, and it should not be lost in the mix.

We all agree that urgent regulatory reform is necessary. It is salutary to realise that the tightening of rules usually follows a failure. I remember all too well the BCCI scandal. The question is why we do not seem to be able to get ahead of the curve. Why do we have to go through failures, large and small, before getting a grip on what needs to happen? Then, of course, circumstances change, the whole situation goes full circle—and again we find ourselves seeking to regulate something that has already happened.

There is a lively debate between Europe and America over rules-based and principles-based regulation. I doubt whether there will be much meeting of minds. We believe that principles-based regulation seems to be the way forward, although it may have contributed somewhat to the problems. However, the Americans clearly want to insist on a rules-based system, although in many respects that does not seem to have worked well either.

Everybody is blaming everyone else, but it seems that there has been a collective group think between regulators, banks and auditors and that they are standing behind each, or beside each other, supporting each other in saying that everything is okay and that no one has been shouting out that the emperor has no clothes. It seems that no one has been waving a flag, saying that something is wrong that needs to be dealt with quickly. A combination of complex instruments, probably faulty accounting standards, a reliance on credit ratings agencies, substantial leveraging, off-balance-sheet items and internationalisation—the way in which banks now straddle the globe and therefore straddle individual regulatory authorities—has given rise to the problems that we are seeing today.

However, even after yesterday’s Treasury Committee, with the Chancellor, the Governor of the Bank of England and the Chairman of the Financial Services Authority giving evidence, we cannot say that there were no warning signals. Although everyone could see them in hindsight—that is easy—I believe that the signals were clear.

Those signals should have been picked up by those charged with the responsibility. Initially, that was the banks themselves—and not only the boards of the banks but the risk committees. Then there are the internal auditors. The external auditors rely significantly on internal auditing. I suspect that some internal auditors had been waving the flag, but they were drowned out by the need to push on—partly because of the structures that rewarded people and partly because of the share prices and the fact that everything was looking well. None the less, I suspect that there were some who should have been listened to. I do not believe no one was flagging up the problem.

The current situation is indeed dire. Getting back to prudent levels of capital ratios will be extremely painful. If we are not careful, the so-called nice decade will be followed by a very nasty decade, and heading it off will be difficult. Although international regulation is clearly important, domestic regulation is vital. I suspect that it may be much more difficult to get international agreement, but each country ought to be clear that it is important to get its own regulations in place. The Banking Bill now being debated in Committee is a good attempt to get some of these changes on board, but I do not believe that it is necessarily the final solution. As I said, the warning signals were there in Northern Rock, Bradford and Bingley, Lloyds TSB, and HBOS and RBS. However, they were not heeded, not picked up, not acted upon.

There seems to be a sort of paralysis, with each country doing its own thing domestically unless it fits in with some international regulation. I fear that if we wait for some sort of international consensus we will not be able to put our as much of own house in order as we should. Delay is dangerous. Although international co-operation and regulation are important in harmonising our efforts, we should not divert our attention from putting our own regulatory structures in place.

Urgency is the key, and the forthcoming meeting in Washington will be extremely important. Examination of the roles of the International Monetary Fund and the World Bank will put the system under pressure. There appears to be a need for fundamental change. I will be interested to discover what approach the Government are taking and what their solutions may be, as they join those discussions.

I believe that two major issues must be tackled—those things that have changed so significantly in recent years. The first is the international operation of banks generally; their enormous size enables them to straddle all sorts of markets, and we need to regulate them effectively across the globe. The second is the variety of activities that those global institutions now undertake, of which banking is only a part. For instance, they deal in insurance and have all sorts of financial departments and sections. In a way, it is that combination of relatively recent factors that have exposed the current regulatory system to failure.

We have not grasped the significance of the increased internationalisation of banks, and we have not grasped the importance of their expansion into all sorts of new areas and the creation of all sorts of instruments. Things have reached the point where we are floundering around trying to find a way to regulate and supervise the system. That prompts the question—and this is the other side of the coin—about whether the regulators should try to grab hold of the banks’ coat tails as they move out into new areas of financial instruments and global operations, or whether we require the banks to reorganise themselves so that they can be more effectively regulated.

We recognise that banks are not the same as any other sort of commercial operation; they are clearly important for the world economy and we require them to act in a certain way. However, if they have constructed themselves into entities that are almost impossible to regulate and supervise, should we not seek ways in which they can be de-aggregated or split apart rather than centralised, so that we can look more clearly at the differing requirements of their individual activities?

Basic banking on the high street is significantly different from the derivatives market in capital terms. However, 99 per cent. of people in this country who require an ordinary, basic banking service from their high street bank, perhaps with a mortgage attached, have great difficulty in securing a new mortgage or obtaining loans for a small business. That is purely because of the activities in another part of that large bank, which have caused these failures. Is it time to look at such mega-institutions and realise that effective supervision, control and regulation is simply not possible under their current construction?

If the international community is going to be the lender of last resort with the bail-out provided by the taxpayer, it should require banks to change the way that they operate and de-aggregate some of their activities. We need a fundamental reassessment of the way that current banking operations work internationally. If we look at the current size of enormous banks and their range of activities across many different countries and regulatory systems, I severely doubt that we can be sure that we will not encounter a similar situation in around a decade’s time. It is time for a new approach.

I am grateful to the hon. Gentleman for taking an intervention, as he is coming to the end of his remarks. Does he agree that there is a certain historical circularity about this? There was a time when banks were legally obliged to operate in separate spheres. I think particularly of the legislation that was passed in the United States after the great depression, and the Glass-Steagall Act that prevented banks from crossing the line that the hon. Gentleman mentioned, and doing retail banking as well as other things. Do present circumstances suggest that perhaps it is time to revisit the issues and the debate that took place when that legislation was repealed, and see whether something similar needs to be introduced and whether that would in fact be possible?

I thank the hon. Gentleman for his intervention. That is exactly what I was suggesting. What we have allowed to happen so quickly and over such a range of different issues means that our somewhat shaky regulation is now totally out of place. I wonder whether we should be looking at some of the older models.

The financial services compensation scheme was never designed to bail out a huge high street bank. It was intended for smaller operations that might fail due to poor lending decisions or a structural problem—the big banks would put their hands in their collective pocket and bail such operations out, as they did not want a systemic failure. Can we consider a financial compensation scheme that will require pre-funding for the sort of potential problems that might occur with another RBS? It is almost unthinkable. Investment banks have been allowed to leverage up to such an enormous extent that it has put under pressure their normal banking business, which affects so many of us. The irony is that those who have supported their local bank with their business are the very people who have to put their hands in their pockets through their taxes and bail out the other part of the bank. It is untenable, and we must revisit the idea of separation rather than continuing with the current aggregation.

I would like to start by congratulating the hon. Member for Warwick and Leamington (Mr. Plaskitt) on securing this vital and timely debate. As has been mentioned, his contribution was thoughtful and articulate, and I thank him for giving us the opportunity to debate the issue. He was right to focus on his hypothesis about what went wrong, which largely centred on the banks but included the regulators and the regulatory framework.

A further aspect that I will mention before moving on to the substance of my remarks, concerns those Governments who, with the amount of credit that was being pumped into the economy, saw the short-term benefits from greater spending and apparent economic growth. It was difficult for Governments to call time on that, which perhaps challenges the point raised by the hon. Member for Croydon, Central (Mr. Pelling) on where the responsibility should lie.

There is no doubt that underlying all of this is the importance of the financial services sector, particularly to our country, but also broadly across the world. Britain is no different from any other country in that the financial services sector is the financial heart that keeps the economy going. Over the last year and a half since the credit crunch first hit, we have experienced a form of financial heart attack that is now having painful effects on the broader economy. When the capital adequacy rules, which were meant to ensure that banks, credit institutions and investment firms had a minimum capital base in order to protect them against such risks, were stress tested, they failed the test. The crisis that we are debating has shown up our flaws not only at home but internationally.

Let us look at our home economy and at what has happened and gone wrong. The Opposition are working with the Government on the Banking Bill, which should address some of the issues that have come out of our own experience. The reforms in that Bill, which will enable banks and regulators to act sooner through the special resolution scheme, will be important. It will be easier for authorities to rescue banks that have got into trouble by using the bank insolvency procedure. That will enable an orderly wind up and will be of benefit. Behind that is the issue of the tripartite approach. When the hon. Member for Warwick and Leamington was speaking, it struck me that in a sense, the question we face in Britain is the same as that faced the world over, although at a different level.

In Britain, one institution, Northern Rock, was challenged and essentially went down. It had been looked after by the Financial Services Authority as a single bank, but it ultimately posed a systemic risk. The problem with the tripartite scheme was that that broader systemic risk was not picked up and addressed rapidly enough by the Bank of England. At the international level, if there are stresses in one country—Iceland, for example, or the United States where the problems started—it impacts across the world. A similar challenge is understanding how one localised problem, whether a bank within an economy, or a particular economy within a global system, will impact overall and what difficulties will occur.

One measure that we have proposed, which would address one of hypotheses raised by the hon. Member for Warwick and Leamington about the inflation of banks’ balance sheets, is for the Bank of England to have oversight on debt and credit levels in the overall economy. In terms of responsibility for flagging up problems or having an early warning system, as the hon. Member for South-East Cornwall (Mr. Breed) has suggested, there is no doubt that giving the Bank of England a remit to look at overall levels of debt and credit flowing around the economy would be a welcome change. The Bank could make regular reports to the FSA, which could look at how that overall risk might impact on individual institutions. Obviously, some of those issues were addressed, as the hon. Member for Warwick and Leamington has said, by the Bank of England’s financial stability report last month.

Even so, setting aside some of the more domestic difficulties that we have faced, reforms clearly need to take place at the global level. As the hon. Gentleman has said, we have relied on the Basel accord and the Basel II reforms when it comes to capital adequacy rules. However, in practice, that has caused problems—we can see that simply by looking at what happened. We can look at the theory and have an intellectual debate, but the adequacy rules have demonstrably not provided a sufficient guarantee against banks failing.

I should like to touch on some key aspects of that—I know that the hon. Gentleman wants to listen to the Minister’s response to his questions—the first of which is the fact that liquidity risk was possibly ignored too much. Therefore, banks that had very low liquidity, such as Northern Rock, were still able, as the hon. Gentleman has said, to stay within the rules. That is clearly a problem. We need also to look at how the existing rules can lead to what seem to be sub-optimal or dysfunctional asset allocation, for example, because of zero-weighting of AAA-rated assets.

The hon. Member for South-East Cornwall has mentioned forcing banks to compartmentalise their operations. I understand why he takes that view, but I wonder whether it would not be jumping to a solution too quickly. Banks could be compartmentalised into retail and investment banking for example, but, actually, the genesis of the problem was ultimately in retail banking and mortgages. When we look at the problem, we see that there was a bad understanding of risk—we keep coming back to that. It is therefore about understanding the reality of risks faced by, and capital structures of, the banks concerned.

Was not the real problem the avarice of banks, which determinedly pushed out securitised obligations that were not properly checked? Many of the tranches were given automatic AAA-ratings, so senior management and investors did not really look at the detail of the real risks that they were taking.

The hon. Gentleman is, of course, right. I have set out some aspects of the problem, but a range of things went wrong collectively to lead us to today’s situation including, of course, the ability of the credit rating agencies and the way in which they rated some of the debt when it was being packaged and sold on. It seems that because of the way in which the credit rating agencies are incentivised and how their businesses run, they signed off more debt, which is part of the problem that we are dealing with. That, combined with—I am sure that banks would challenge this—an excessive reliance on the risk ratings given by agencies, as has been said, may appear as the sub-contracting of risk assessment to outside agencies. If such ratings are done as an independent check, and if ratings simply validate an internal assessment of risk, they can be of benefit. However, there is no benefit if there is no internal initial assessment of risk.

Overall, market risk was not effectively measured. We had backward-looking models that looked at what had happened. Clearly, nobody is ever more sure about a trend than the prevailing market wisdom the day before the trend stops. There was a growing certainty about the continuation of asset price inflation. That raises the question of introducing rules that are more counter-cyclical when it comes to credit and capital adequacy, rather than the pro-cyclical environment in which we found ourselves.

Transparency was part of the problem. Consumers will, in the coming years, be far more willing to ask whether a bank is a sound financial institution. The big thing that we have not talked about today is how the public will view banks—they may be far keener to see financial information on banks with which they plan to make debt, mortgage or savings transactions. That could be one of the more fundamental—and helpful—changes. A critical consumer eye could now come into the equation, alongside any regulatory reforms that might be introduced.

A final caveat is that we must be careful that we do not use a regulatory-reform blunderbuss to tackle the problems. There are several problems, and we therefore need a more sophisticated approach than saying simply, “Let’s have more regulation.” Rather, we need smart regulation. If we look at the recent US experience of the Sarbanes-Oxley legislation in response to Enron, we can see that inappropriate, heavy-handed regulation often does not achieve its objective. We need to be careful that we do not go down that route, and it is especially important for us to be watchful.

Obviously, there will be a new US President this week, and we must carefully ensure that we work at an international level. The Prime Minister has pointed out that we will need leadership from the US to navigate us through these challenging times. Up to now, we have had a vibrant financial sector in the UK, which is important to our economy in terms of jobs as well as providing its lifeblood. We need to ensure that any reforms do not unnecessarily hinder competitiveness without providing more financial stability. We do not want to jeopardise our financial sector’s future success and growth, and we have to get it right first time.

We need to find a blend between international co-operation and domestic reform. There is no doubt that a one-size-fits-all regulator would be an excessively constraining and over-the-top response. We need something a little more sensitive than that—something that results more from co-operation. It is clearly in the common interest to achieve co-operation in new reforms, rather imposing something on countries. We need to get this right. As the hon. Member for Warwick and Leamington has pointed out, the challenge is momentous and immediate, and we need to rise to it. Clearly, over the coming months, we will focus on it and, hopefully, get it right first time.

I should like first of all to congratulate my hon. Friend the Member for Warwick and Leamington (Mr. Plaskitt) on his great foresight and timing in managing to get a debate on this crucially important topic. We have had a fascinating glimpse in the debate of the complexities of the issues with which we are dealing. That gives a great deal of credit to my hon. Friend and to everyone who has contributed.

Current international financial conditions are unprecedented. In addition to the work that the Government are doing domestically to restore faith in the banking system, there must be a global response to what is a global economic crisis. My hon. Friend mentioned Bretton Woods and Basel, and I will deal with both, but he was right to bring them to the attention of the Chamber. The Bretton Woods framework of 1944 reflected the determination of leaders and economists such as J. M. Keynes to avoid the disastrous economic nationalism that led to the great depression and which helped lay the groundwork for the rise of fascism and ultimately the calamity of the second world war. In the decades since, the Bretton Woods institutions have been a key element both in supporting international co-operation and countries that have been hit by negative shocks, and in providing the long-term financing and assistance necessary for sustainable growth. At the same time, the way in which the institutions work has certain drawbacks. As my hon. Friend pointed out, they are anachronistic in many ways and reflect a different world. If I have time, I will outline how the Government intend to approach the reform of such institutions.

Over the years, we have added to the Bretton Woods framework. In the mid-1970s, the Basel Committee on Banking Supervision was created to set common standards for financial regulation around the world. Following the Asian financial crisis, we created what is now known as the G20 to bring together emerging markets and developed countries to address the serious economic problems of the time. In the late 1990s, we created the Financial Stability Forum, which has improved the quality of banking regulation and promoted a more international approach to financial market developments. Nevertheless, recent events have confirmed that the world economy has changed irrevocably. The Bretton Woods framework was created for a world of 50 relatively sheltered states. We must now consider whether it is time for another wave of reform—I think that the case for that is overwhelming—to create a global financial system that is fit for a modern and more interconnected, globalised, IT-driven world. We must do so while we continue to address the immediate effects of the ongoing financial crisis at home and abroad. Effectively we need to do both things in parallel, and that approach has been reflected in all of the comments in our debate.

The turbulence in international financial markets has the potential to affect every country around the world, so a co-ordinated international response is required. We need national action, but that will not solve the problem on its own. National systems of supervision are simply not in an adequate position to respond to the huge cross-continental flows of capital in this different, more open, more globally interdependent world. The first step has been taken to stabilise market conditions. The British Government, as part of a co-ordinated international effort, have taken rapid and well-targeted action to recapitalise the banking system. The Bank of England has doubled the amount of liquidity that it provides to banks, and we have guaranteed new lending between the banks so that we can get lending working again. That action has strengthened confidence in the banking system, put financial institutions on a firmer footing and provided support for the real economy.

Britain’s fast action has been widely applauded, and many other countries have followed our lead and taken similar action. The G7 action plan, which took a lead from the UK plan, has provided a framework for effective co-ordinated international action, which has resulted in more than £300 billion being approved from public funds to recapitalise banks worldwide. We remain committed to taking all action necessary to restore confidence and stability in the financial system. International co-ordination is a central part of the Government’s response and we will continue to work with international partners going forward. My hon. Friend is right to say that international financial institutions, too, have a role to play—I am not just referring to stabilisation, but I do not wish to talk too much about that in the time that I have left.

I want to move on to the points that my hon. Friend made about how we can reform the system so that it is more fit for purpose. After initial stabilisation, the next step is to achieve a global financial system that is fit to meet the challenges of the future. As many hon. Members have said, the financial crisis has revealed problems at the heart of the international financial and regulatory system that we must rectify. That means addressing not only reforms to the supervision and regulation of financial markets but global governance arrangements. The Prime Minister has stated that the reforms must be guided by five principles: transparency, integrity, responsibility, sound banking practice and global governance with co-ordination across borders.

Strengthening of the supervision and regulation of the banking sector is essential. Significant steps have been taken that build on the recommendations of the FSF and that are in line with the road map agreed with European Union partners. For example, the FSF recommended strengthening Basel II capital requirements for banks using off-balance sheet vehicles. We should move forward with that proposal as it represents an important step towards restoring faith in the banking system. Beyond those immediate challenges, more progress is needed to establish globally applied standards of financial regulation and supervision for the future.

We have made a number of proposals to international partners, including improving incentives in financial institutions to manage risk; improving transparency in financial markets; ensuring appropriate regulation of all financial institutions and markets; and ensuring that the financial system supports economic stability. Better supervision and regulation need to be coupled with better global governance. Events have shown that global financial markets present challenges that no one nation can solve in isolation. We have to strengthen global co-operation and build a new global financial architecture for the years ahead. The new global governance should deliver a global early warning system so that future risk to global economic and financial stability is identified and mitigating action is taken early. There should be effective cross-border supervision of global firms, including through international colleges of supervisors, globally accepted standards of supervision and regulation applied consistently across countries, and mechanisms for co-operation and concerted action in a crisis through international cross-border stability.

I know that the debate is drawing to a close, but does the Minister agree that action must be taken to deal with the proceeds of corruption and exploitation and the collusion of the international banking system? If she does not have time to address the matter now, will she write to me and tell me what the Government will do to put it on the international agenda?

I agree that it is a vital issue and my right hon. Friend has done us all a service by raising it. I am happy to write to him, but we have strongly supported international efforts, both against money laundering and terrorist finance and to enhance the transparency of the banking system.

A number of positive steps have already been taken in recognition of the global change that we need. For example, the IMF recently established a new macro-financial surveillance unit, and reviewed its global financial stability report. We believe that more needs to be done to strengthen its role. The IMF’s statement of surveillance priorities agreed by Ministers at the annual meeting sets out a clear strategic focus for IMF surveillance. We believe that the IMF must work more closely with the FSF to provide a clear warning of risks to global macro-economic and financial stability.

While the Minister is on the subject of the IMF, do the Government think that it is time to consider the governance structure of the IMF and the issue of US dominance, especially as the Prime Minister is now leading efforts to bring in funding from states that are not appropriately represented on the structure of the board?

The UK has been at the forefront of the debate to try to get some kind of reform of the voting structures and architecture of international institutions, including the IMF and the World Bank. However, achieving such reform is almost as challenging as getting things agreed at the European Union when vetoes are used. It is clearly an important matter and we will continue to take forward our ambitions in that area.

We have entered a new era for the global economy. We need a new international system that is fit for purpose, both to deal with the many different and evolving challenges of the system of global banking, finance and economics and to stabilise the current situation. The Government are determined to make important progress in both areas and have been leading those efforts both at home and abroad.