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Nadhim Zahawi portrait

Nadhim Zahawi is a member of the BIS Select Committee, the Party’s Policy Board and MP for Stratford on Avon.

Financial regulation is rarely invoked as a Conservative achievement. This is understandable, since stress tests and capital adequacy ratios and macroprudential frameworks are not exactly doorstep material. Yet I would argue we should be proud of what we’ve done to reform a system that so utterly failed the British people seven years ago.

The structure we inherited was designed by Gordon Brown and Ed Balls, who laboured under the belief that boom-bust cycles were a thing of the past. In 1997, the Bank of England was granted operational independence over monetary policy. Responsibility for banking supervision was then transferred from the Bank to the Financial Services Authority (FSA), which Brown told to adopt a ‘”light touch approach”.

This created an artificial split between the goals of monetary policy – keeping inflation on target – and financial policy – keeping the financial system solvent and safe. The Bank set interest rates without regard to the size of bank balance sheets, and the FSA supervised individual banks but lacked the clout and policy tools to manage the system as a whole. The result was that by 2007 the banks held debts worth six times UK GDP. Household debt was higher than any G7 country ever.

The debate about whether “too little” regulation caused the crash is simplistic. FSA regulation was “light-touch” only in a narrow technical sense. The prevailing philosophy was that rather than attempting to restrict the kind of risks that banks took, regulators should instead ensure that banks understood and controlled those risks themselves. This required a massive expansion in the size and complexity of the rulebook, with the number of pages in the FSA handbook increasing from 2,730 in 2001 to 9,283 in 2008. The thinking was that if banks could demonstrate in meticulous detail that they had complied with all the rules then this amounted to objective proof that they understood all the risks.

Yet this rules-based approach meant that big picture judgments about corporate culture, or the sustainability of a bank’s business model, were discounted as being too subjective. In 2004, the FSA identified Fred Goodwin’s management style as a risk for RBS but nothing was done. That same year he received his knighthood for “services to banking”. A narrow focus on process and box-ticking meant that banks stopped asking “is this right?” and started asking “is this legal?” – and from there it was a short journey to “what can we get away with?”, as we’ve seen with the rate-rigging scandals.

So when we came into office it was time for a radical rethink. We needed a system which would protect savers and the taxpayer without undermining the free markets on which Britain’s prosperity depends.
Our first step was to set up the Independent Commission on Banking, chaired by Sir John Vickers, to look at the structure of the banking industry. Vickers has proposed to ring-fence the retail side of banking from the high-stakes investment side, a recommendation which the Government fully accepts.

Under this system, the ring-fenced utility arm will be barred from lending or transferring capital to subsidise trading activities and will ensure that depositors are protected should a bank’s bets go wrong.
Second, we’ve brought monetary and financial policy back together under the same roof, recognising that both are intertwined.

The Bank of England’s Financial Policy Committee now sits alongside the MPC, tasked with monitoring the stability of the system as a whole. Unlike the FSA, it has the powers to lean against the next bubble. If it thinks the housing market is getting out of control, for example, it can direct banks to hold more capital against mortgages, while earlier this year it stepped in to reinforce banks’ underwriting standards.

It’s also clear that the FSA was trying to do too much in trying to regulate balance sheets and protect consumers at the same time. Alongside the collapse of the banks, the PPI and the rate-fixing scandals also happened on its watch. As a result, these macro and micro-level functions have now been split up into the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) respectively.

This is about moving from the failed approach of complex, prescriptive rules to one based on judgement. The FPC issues recommendations, but it’s up to the PRA and FCA how they get implemented. Unlike an ever-growing rulebook, this builds discretion into the system, giving regulators the flexibility they need to respond to changing economic circumstances.

Crucially, the new regulators have shown they have teeth. Last week the FCA levied a record fine for FX-fixing and brought in tough new standards on payday lending, including a cap on the total cost of credit. It’s under a Conservative government that the most unethical firms in this industry will be driven out of business.

Of course it’s impossible to design a perfect regulatory system. However competent the regulators, people are flawed and regulation will sometimes fail. That’s why leadership and culture are so important. If you get the culture right, people will regulate their own behaviour. Before the crash regulators weren’t interested in targeting culture – but this, too, has changed under this Government.

In particular, we’ve looked at the incentive structure underpinning individual behaviour. Banks are being expected to make greater use of bonus clawbacks if a pay award turns out to be undeserved, and to defer executive pay so management are encouraged to think long term. We’ve also legislated so that it is possible to prosecute and jail senior bankers for reckless misconduct – an idea that Matt Hancock and I first floated three years ago. This is about returning to the idea that bankers have a duty of care because they are stewards of other people’s money.

The left like to think of this issue as their natural territory, but we should be clear that financial reform is a Conservative agenda. It’s about restoring market discipline, strengthening competition by ensuring that no-one is too big to fail. There’s more to do, particularly on bringing new entrants into the market, but we should be proud of what we’ve achieved. Brown and Balls failed because they didn’t understand free markets. We on the other hand must never tire of making the case that it’s supporters of capitalism that are best placed to make it work.

16 comments for: Nadhim Zahawi MP: Labour’s bungled City regulation helped cause the Great Recession. Here’s how we’re putting it right.

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