Con SP: World Economic Forum on Financial Stability

[Samuel Gallagher]

 The Chancellor of the Exchequer spoke at the World Economic Forum on financial stability and the regulation of the financial sector.

Thank you. It is a pleasure to address this esteemed group today.

There can be no doubt that there is significant uncertainty, globally, regarding the state of the economy right now. Turbulence in financial markets has certainly slowed the growth of credit. The recent action taken with Northern Rock in the United Kingdom demonstrated the extent to which this turbulence can threaten overleveraged financial institutions with dubious balance sheets.

The root of this turbulence is, of course, the credit crunch.

The economics of the credit crunch are known to this audience, so I won’t give you an economics lecture. What I will say is that, in taming inflation, politicians forgot about credit. Claims of the “end of boom and bust” were wrong. They were predicated on the idea that, with inflation tamed, credit and debt could be allowed to build up and up and up, with no exit strategy in sight. Some of these beliefs on credit must be challenged with consumer protection rules - however, that is not the focus of this talk.

In the United Kingdom, this belief in unlimited credit manifested itself as growth that was fueled, essentially, by the financial sector and housing-associated debt provided by the financial sector. Lurking in the background were bubbles: liquidity, debt, and housing. Those bubbles were risks to growth, but they were often ignored.

Meanwhile, other segments of the economy, like manufacturing, were regulated to death. High street shops and businesses were regulated to death. The effects of this were, largely, ignored by the previous government because the financial sector fueled growth. The pervasive thought was that money was flowing into the Treasury, so nothing could be wrong. And that presented a regulatory imbalance across the economy and a regulatory conundrum regarding the financial sector.

For years, rightly, we criticised the rise of the regulatory state in the United Kingdom. It is a just criticism. It is just because, generally, the United Kingdom pursued a policy where the maximum regulation was implemented for the minimum public benefit. In many sectors, regulation became a deterrent to economic success and the public reaped little benefit from that regulation.

However, that was not true with the financial sector. Instead of over-regulation, the financial sector became subject to fragmented regulation. The formation of the Tripartite System and removal of major prudential responsibilities from the Bank of England, which we cautioned against in 1997 and again in 1999, created artificial barriers within the financial regulatory framework. In creating barriers, the system deferred responsibility as well. Nobody looks at the Tripartite today and knows who is responsible for what. That is a problem.

Of course, there were hints that there would be problems before Northern Rock. In 2004 and 2005, the Tripartite ran exercises on the ability of regulators to respond to distressed banks. The results of those exercises were clear: the Tripartite was not prepared to deal with a distressed bank. Sadly, it was not until Northern Rock that the results of these exercises, conducted years ago, were taken seriously. And in that moment the United Kingdom had to take dramatic action: the fragmented regulatory system failed and preventing a systemic failure required exercising new, extraordinary powers. Powers that weren’t even written into law at the time.

The fact that the laws were written during the heat of a crisis brings me to a reality we face. Free markets and free enterprise require rules. When confronting the financial market and financial stability, there is a justification for closer, more cautious regulation than in other sectors of the economy. The alternative - fragmented, “failed touch” regulation - threatens financial stability, becoming a liability, not an asset. That is because, at its core, stability is an asset. All financial institutions perform better in a stable environment.

Achieving that stable environment remains an elusive goal, at least in the United Kingdom. Elusive, but not impossible. Achieving it requires coordinated prudential regulation, regular stress testing, and legal authority to act during a crisis.

Central to these efforts, in our view, is the Bank of England. As I mentioned, prior to 1997, the Bank of England served as the preeminent financial regulator in the United Kingdom. We seek to return it to that role. In doing so, the Bank would gain explicit authority over macroprudential oversight: examining threats to financial stability as a whole. Given the close links between monetary stability and financial stability, a central bank is a sensible place for macroprudential regulation to be located.

Of course, that would not resolve the coordination issues that plagued the United Kingdom during the run up Northern Rock. For this purpose, it is worth more closely linking the prudential responsibilities of the FSA to the Bank. We will be putting forward proposals to achieve this.

However, as we learned, the issue is not just coordination, but authority. During Northern Rock, it was unclear who had what powers. We needed a new law to create powers to deal with a failing bank - and I think we can all agree Northern Rock was on the path to failing. Moving forward, we will implement clear rules for a bank resolution regime led by the Bank of England.

The Bank, during Northern Rock, had the capability to provide liquidity support. It had the capability, eventually, to see the systemic risk that was posed. What it lacked was the authority act. That must change. And it will.

Finally, there is the question of stress testing. Some argue that regulators should have seen the issues with Northern Rock years ago. There is a compelling case for that. Regulators, based on the 2005 exercise, knew that mortgage books, if improperly managed, could become a threat to a bank’s financial health. But Northern Rock ticked all the boxes and the regulatory checklist. So there was no action.

That is insufficient. We need to establish a regulatory system where regulators work with financial institutions to stress test their systems. Banks should be put through exercises that prove the capability to survive turbulence in financial markets. Vigilance and preparation must become cornerstones of the banking system.

Building this system at home will help prevent financial instability in the future. However, it will mean little absent global efforts to secure the global financial system.

It’s not unreasonable to think that, when the analysis is done, we’ll find that the seeds of the current market turbulence were planted during the economic boom of the past decade. Northern Rock’s lending policies and growth strategy are proof of that. There was an addiction to debt. And economic officials, not just banks, enjoyed that addiction and the growth that it fueled. That is problematic.

But there was a deeper problem: the rules governing financial stability rewarded that debt. Financial institutions had no incentive or requirement to slow down. Credit agencies that judge risk had incentives to encourage more debt. Macroprudential regulation, generally, is not a part of the system.

That can change. Reform of the Basel accords should include discussions on innovations like countercyclical capital requirements - encouraging banks to build a buffer during “booms”, such that they are prepared for future tightening of financial markets. Reforming credit agencies to reduce procyclicality is crucial - certain debts, such as subprime mortgage debt, are bad no matter when in the credit cycle they are issued. They should be treated as such.

These are simple benchmarks for reforming international governance. I must thank my colleagues, Mme. Legarde of France and Herr Steinbrück of Germany, for joining me in a commitment to rethinking the global rules that govern global financial stability.

Our discussions regarding financial stability have made one thing absolutely clear: far from making a case against capitalism, the credit crunch makes the case for stronger global markets and greater cooperation between nations.

That is at the core of the statement recently released by myself, Mme. Legarde, and Herr Steinbrück. We believe that there is a necessity to coordinate our actions in response to the credit crunch. And we are doing so.

We recognise that working together is better for everyone. The single market as we know it today - a Conservative construct built during Margaret Thatcher’s premiership - is responsible for promoting growth and improving living standards across the whole of Europe. That is perhaps the greatest example of economic coordination and integration in world history. That is a model we should look to.

Improving communication and coordination between regulators can provide an early warning of systemic financial risks. That is an achievable goal in the short term. Coordinated stimulatory measures can lift economies threatened by a slow down in credit. That is an achievable goal. Coordinated action to encourage capital buffers and bank security can contribute to financial stability. That is an achievable goal.

Long term goals, such as building the European Union’s single market for capital, will require future discussions. But they are absolutely things we should commit to.

The challenges we face today are different from the challenges of the last decade. But they are challenges that we can prepare for. A resilient global community can limit the risks we face from the credit crunch. And it starts with improving how we work at home and how we work together.

In the United Kingdom, we’ve championed the idea of a Big Society. It is the idea that free enterprise and social solidarity can coexist and complement each other. Sound financial institutions and stable markets are a cornerstone of that. And today, more than ever, it is clear that a global big society - an embrace of stronger markets and cooperation to protect those markets - must be a concept that we work towards. But it will require cooperation.

I am committed to driving that cooperation forward. I hope that I am joined by many here today in doing so.

Thank you.