Three flaws in the Financial Services Bill

Under the heading, Osborne looks to limit damage of ‘credit busts’, the FT gives a neat summary of the Chancellor’s plans. In particular:

He said the FPC would also look out for dangerous linkages in the financial system and identify exotic new instruments that might undermine stability. It would be charged with containing credit booms as well as limiting the damage of “credit busts”.

Which this morning caused me to regret that I was not given time in the Commons at the second reading of the Financial Services Bill to quote from the 1932 preface Hayek’s Monetary Theory and the Trade Cycle:

There can, of course, be little doubt that, at the present time, a deflationary process is going on and that an indefinite continuation of that deflation would do inestimable harm. But this does not, by any means, necessarily mean that the deflation is the original cause of our difficulties or that we could overcome these difficulties by compensating for the deflationary tendencies, at present operative in our economic system, by forcing more money into circulation. There is no reason to assume that the crisis was started by a deliberate deflationary action on the part of the monetary authorities, or that the deflation itself is anything but a secondary phenomenon, a process induced by the maladjustments of industry left over from the boom. If, however, the deflation is not a cause but an effect of the unprofitableness of industry, then it is surely vain to hope that by reversing the deflationary process, we can regain lasting prosperity. Far from following a deflationary policy, central banks, particularly in the efforts than have ever been undertaken before to combat the depression by a policy of credit expansion—with the result that the depression has lasted longer and has become more severe than any preceding one.

In debate on Monday, after a number of interventions about the futile search for stability and the breach of the rule of law inherent in the proposals, I indicated three flaws in the Bill, three “elephants in the room” as Peter Lilley had put it,

I very much welcome the Bill, which I hope and believe will prove to be the zenith of contemporary thought on bank reform. With due deference to my right hon. Friend the Member for Hitchin and Harpenden (Mr Lilley), I wish to talk about three potential elephants in the room. First, I wish to make some remarks about accounting, then I wish to discuss the conduct of individuals and liability, and finally I wish to talk about financial stability.

I know that the Minister has heard my views on the international financial reporting standard, but I draw his attention to a letter in yesterday’s Financial Times by Lord Lawson, under the headline “Forget Fred and focus on the real banking scandal”. He stated:

“The auditing of banks’ accounts, however, is fundamentally flawed in itself. The IFRS accounting system itself has proved to be damagingly pro-cyclical, and the ability to pay genuine (and genuinely large) bonuses out of purely paper profits, which are never subsequently realised, is at the heart of both the bonuses that cause such public and political outrage, and the reason why bank management consistently does so well when bank shareholders do so badly.”

Andy Haldane, the executive director for financial stability at the Bank of England, gave a speech in December. I shall not read out all the remarks that I meant to cover, but he concluded by saying that

“if we are to restore investor faith in banking sector balance sheets, nothing less than a radical rethink may be required.”

He was referring, entirely, to accounting standards. I therefore refer the Government to my private Member’s Bill introduced on 13 May 2011, which seeks to introduce parallel prudent accounting for banks. It is a couple of pages long and I hope that it can be added to this Bill.

I also refer the Government to “The Law of Opposites”, a paper produced by the Adam Smith Institute and written by my colleague Gordon Kerr, who has spent 25 years “gaming accounting rules”, as he would perhaps say, in order to make a profit. The banking system is in a far worse state than is generally believed. I do not see how either the Financial Policy Committee or the prudential regulation authority can operate without a true and fair view of the state of financial institutions, and I do not believe for a moment that the international financial reporting standards give that to us.

On the conduct of individuals, we fail too often to think about the pattern of regulation in which we have engaged. It seems that the first thing that legislation does is to damage the incentives and disciplines of the market. Having thereby created moral hazard, regulators come along to try to mitigate the consequences of that moral hazard. A banking licence today is a licence to lend money into existence, at interest, with the risk socialised. When we look at central banking, deposit insurance and limited liability, we find that moral hazard is absolutely rife in the banking industry, even before we consider investment banking. I suggest to the Government that it is time to increase the liability of banks’ directors. There should be strict liability for them, and bonuses should be held in a pool and treated as capital for at least five years. I will introduce a private Member’s Bill to that effect on 29 February.

We have talked about financial stability and the difficulty of defining it. There has been a sense that there is some kind of equilibrium economy—an evenly rotating one—in which there could be a sustainable and stable quantity of credit. Indeed, on pages 14 to 16 of the Joint Committee’s report there is an interesting discussion about the need to regulate credit.

To leave time for my hon. Friend the Member for North East Somerset (Jacob Rees-Mogg), I will just say that if we were talking about any other commodity and were discussing adding to a failed regime of price control a regime of quantity control, we would certainly reject the idea out of hand. In Lord George’s testimony to the Treasury Committee before the crisis, he made it absolutely clear that the Bank of England had created a credit bubble to avoid falling into recession, yet we are going to give the Bank even more powers, more tools, [resulting in] more risk of ruin and more big-player effects and distortions of economic expectations.

I congratulate the Government on introducing the Bill, and I sincerely hope that it represents the absolute zenith of contemporary thinking on interventionist bank reform.

In the following video, my remarks begin at 21:31:

I should think society will learn, in the next few years, some important lessons about the use of arbitrary power by monetary and financial authorities. Hold tight.

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