Bill Jamieson: The Bank of England governor's bid to rein in the financial sector has upstaged Brown and Darling

Published on Saturday 20 June 2009 14:46

IN AN explosive speech at the Mansion House dinner last week, the Bank of England governor Mervyn King not only upstaged the Chancellor but rolled a fizzing grenade under the government's approach to banking regulation. No mere off-message set of remarks was this, more an unmistakable grab for power.

Far from there being a policy consensus on financial sector regulation, the opposite appears to be the case. The pussycat King has turned tiger. In one of the most important speeches on the policy response to the financial crisis, he has set out differences in approach to that of the government and the case for more powers for the central bank. He has set out his separate approach on not one but three fronts.

The first and most challenging to Prime Minister Gordon Brown is a warning that without more powers granted – or more accurately given back – to the Bank of England, it will lack the resources required to deal with animal spirits in the banking sector.

"The Bank," he declared, "finds itself in a position rather like that of a church whose congregation attends weddings and burials but ignores the sermons in between… Experience suggests that attempts to encourage a better way of life through the power of voice is not enough. Warnings are unlikely to be effective when people are being asked to change behaviour which seems to them highly profitable. So it is not entirely clear how the Bank will be able to discharge its new statutory responsibility if we can do no more than issue sermons or organise burials."

The second challenge to the Treasury view – which has major implications for the future of banking institutions here in Scotland – is that the mega banks have got too big and need to be dismantled. If the banks are "too big to fail", he argued, then they are too big – full stop.

Our banks, he pointed out, not only entered the crisis with historically low levels of liquid assets but the financial sector here was also too big and too highly leveraged. The size of the banking system as a proportion of GDP was five times that in the United States and the risks to the UK taxpayer correspondingly greater. The process of de-leveraging is now doing great damage to the economy.

His speech carried a veiled endorsement of the argument for the separation of investment and retail banking if public confidence is to be restored. Banks, he said, should produce a plan for an orderly winding down of their affairs. In a passage that will have sounded like a death knell for those champions of economies of scale at Gogarburn and the Lloyds Banking Group headquarters on The Mound, he declared "making a will should be as much part of good housekeeping for banks as it is for the rest of us. And it would be sensible for the various authorities to work across national boundaries to identify detailed plans for how each large cross-border financial institution could be wound down."

The third challenge was to the government's prescribed role for the Bank in monetary policy. He warned that inflation targeting – the key raison d'tre of the Bank and its interest rate setting Monetary Policy Committee set out by Gordon Brown when he became Chancellor 12 years ago – has failed. "Setting Bank Rate to maintain price stability… did not prevent a recession induced by a financial crisis… Inflation targeting is a necessary but not sufficient condition for stability in the economy as a whole. Indeed, the overarching lesson from this crisis is that the authorities lacked sufficient policy instruments to take effective actions."

The speech – almost a sustained rebuke to the Chancellor, who was also speaking at the same dinner – was not just a staking out of the Bank's claim for a bigger role in the post-crash world but a radically different mindset and analysis to those prevailing at the Treasury.

The fact that the Bank governor has an independent view at all has already irked the Treasury and the Prime Minister no end. King's more guarded and sceptical view of the "green shoots" of recovery has greatly irritated the government, which has been at pains to talk up prospects in the hope that such talk itself would help ensure that Darling's prediction of a recovery setting in by the end of the year will become a self-fulfilling prophecy. King does not flatly disagree with the Chancellor's position. He just cannot see sufficient evidence yet.

The points of difference set out in last week's speech are of an altogether different nature and magnitude. What gives further impetus to King's critique is that it mirrors the approach to regulation set out in the US by President Obama last week. Central to the proposed changes are new powers for the US Federal Reserve – up to and including the authority to order banks to close. America's central bank is put right at the heart of the new regulatory order.

This was the position the Bank of England occupied from the time of Walter Bagehot's 1873 treatise that set out the responsibility of the Bank in addressing financial crises. All that changed with the arrival of Gordon Brown at the Treasury in 1997. To be sure, the Bank role as bank regulator was far from perfect. Oversights and scandals occurred. But there is absolutely no sign, particularly with the onset of the global financial crisis, that the Financial Services Authority has performed at all better. The advantage from the Prime Minister's view is that it is more amenable to government and Treasury control. But that may be its fundamental weakness.

Certainly the Bank of England itself has a case to answer. It may be a fine line between the Bank being relieved of its role in financial supervision and abdicating any responsibility for keeping a watch on financial market stability. But a line exists. The admission now that inflation targeting was not enough is as good as an admission of a regulatory weakness that the Bank should have flagged up earlier. Acquiescing in an inflation target which omitted any housing component was one such danger.

And if the Governor's case is to make the headway it deserves, it will be necessary at some stage to show it can undertake the responsibilities for bank supervision better than it did previously and that it can handle the huge logistical challenges such monitoring and supervision will now involve. The old system of rule by a twitch of the Governor's eyebrows may have worked in a more deferential age of stockbroker blue buttons, hierarchical management, shared values and "my word is my bond". But the world of Montagu Norman has long gone. And such a regime of nods and winks just doesn't work in a world dominated by global banks that have weak value systems and which now require as a result far more intrusive and detailed oversight, backed by sanctions.

That said, King's case on all three fronts is powerful and powerfully put. Unfortunately for the Governor, his case for more powers is up against the most centralising Prime Minister since 1945 and with a mindset so suspicious as to push control freakery to its absolute limits. And it also looks as if bodies such as the British Bankers Association have been browbeaten into acquiescing with an enlarged FSA.

As for breaking up the banks, here King has triggered what I hope will be serious debate – and certainly within Scotland. The mega banks simply cannot return to status quo ante and be allowed to grow on the premise that there will always be taxpayer bail-outs when crises strike. Carry on like this and they will be too big to rescue.

King may look like a pussycat. But his swipe has been that of a tiger's extended claw.