Brown's regulatory reforms contributed to the financial crisis
The report’s author, Professor Tim Congdon**, argues that Gordon Brown’s 1997 changes to the structure of financial regulation have been largely responsible for the catastrophe that has hit the British banking industry. The reversal of these changes, including the return of banking supervision and regulation to the Bank of England, is essential. Congdon argues that the Bank of England could do its job most effectively if it were privatised. Like the Federal Reserve in the USA, it should be owned by the main commercial banks, which are its principal stakeholders.
Professor Congdon said:
“The current financial crisis raises fundamental questions about the relationship between the commercial banks and the Bank of England. Before 1997 Britain had a system in which the Bank of England had an understood responsibility to act as lender of last resort to the banks and to help them if they had difficulty funding their assets. That system was a success, which was copied around the world. Unfortunately, it was undermined by Gordon Brown’s so-called ‘reforms’ at the start of his Chancellorship, leading to the worst financial crisis in this country since the South Sea Bubble.
“The Bank of England should be privately owned – as it was for more than two and a half centuries prior to 1946. Its capital should be provided by the commercial banks and it should have regulatory power over these banks in addition to providing a lender of last resort facility. These supervisory and lender-of-last-resort functions are inseparable.
“If we do not seize this opportunity to establish a sound and viable structure for British banking, we face the very real risk that we will lose a major proportion of our financial services industry to markets regulated by the European Central Bank or the Federal Reserve.”
The report also argues that:
- The lender of last resort facility should be extended liberally, but at a penalty rate, to banks which are illiquid (as was the case with Northern Rock), but not to banks which are insolvent.
- The Bank of England has been shown to lack the necessary expertise to deal with the current crisis, largely part due its dismemberment, and loss of staff and expertise, since 1997.
- The Bank of England has almost ceased to be “a bank”. Rather than behaving as a banker to the banking system, to which it must sometimes lend, it has increasingly resembled the economic research department of a university, with too narrow a focus on the control of inflation.
- A structure in which the central bank was owned, and its capital provided, by the commercial banks would set up a better pattern of incentives than the present arrangements. The member banks would resent having to incur losses on last-resort loans extended to one of their number if the deviant bank had been irresponsible in its lending. On the other hand, member banks would have a strong incentive to encourage the central bank to accept low cash and liquidity in the banking system, and an appropriate level of capital, since too high cash and capital ratios affect their profitability. The central bank would be subject to a benign set of checks and balances.
- Last-resort lending has been alleged – notably by the Governor of the Bank of England, Mervyn King – to encourage “moral hazard” (i.e., irresponsible risk-taking). But the historical record is clear, that the expanded deposit insurance arrangements favoured by King and others are a far more important and dangerous cause of irresponsible risk-taking by deposit-taking institutions than a lender-of-last-resort system.Professor Philip Booth, the IEA’s Editorial Director, said that the report was published at a time when no major political party in Britain seemed willing to contemplate a radical restructuring of regulation in response to the recent crisis.Professor Booth said:
“Too often, the response of opposition politicians to present events has been a claim that they wouldn’t have started from here. This is woefully inadequate in the context of the present crisis. Granting independence to the Bank of England in 1997 over monetary policy was widely and rightly praised. However, other key aspects of Gordon Brown’s reforms have either caused or exacerbated the difficulties afflicting the British financial system today. A privatised Bank of England – with appropriate regulatory powers and expertise – would provide a sound defence against the recent problems being repeated in future.”
“Regulators have failed in almost every respect in the current crisis and yet the FSA is now actively claiming still more discretionary powers. What we need is narrow but incisive regulation to deal with potential fragilities in the banking system. Opposition parties that support the market economy need to make the case for a new approach to regulation. Sadly, this is a debate in which British political parties have yet to engage. There is every sign of the political debate being dominated by the European Union, the FSA and the Treasury, each of which has almost unlimited desire to increase its regulatory powers yet further.”
*Central Banking in a Free Society by Tim Congdon, Hobart Paper 166, £12.50.
**Professor Tim Congdon is an economist and businessman. He was a member of the Treasury Panel of Independent Forecasters between 1992 and 1997. He has been a visiting professor at Cardiff Business School and City University Business School.