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Professor Philip Booth is Editorial and Programme Director at the Institute of Economic Affairs, which is today publishing Central Banking in a Free Society, a pamphlet in which Tim Congdon argues that the Bank of England should be privatised. Professor Booth makes that case here.

Earlier in the week, David Cameron signalled that he believed that banking regulation should be returned to the Bank of England. However, there is a danger in thinking piecemeal about this problem. As is proposed by Tim Congdon, in Central Banking in a Free Society, it is vital that the Bank of England is privatised, has its capital significantly increased to around £15billion, and is allowed to use freely its lender of last resort function to support banks that are illiquid but solvent.

The emasculation of the Bank of England by Gordon Brown in 1997 is substantially responsible for the current mess. A system of maintaining banking stability that had been copied all round the world was destroyed and the Bank of England turned into a monetary policy research institute. When Northern Rock hit problems, the Bank did not know how to act. It had lost its day-to-day experience of the banking sector and there was uncertainty as to the roles of the FSA, the Bank of England and the Treasury. Instead of the Bank of England using its lender of last resort function generously and quickly, Northern Rock collapsed and confidence evaporated.

But, simply to transfer banking regulation back to the Bank of England, without privatising the Bank, will lead to the establishment of the FSA’s bureaucratic mentality at the Bank of England. The institutional understanding of the banking sector that existed at the Bank of England before 1997 has been destroyed and cannot easily be recreated whilst it remains nationalised.

There are other important reasons for privatising the Bank. It will provide strong incentives to provide better regulation. If the commercial banks provide most of the capital of the Bank of England, they will not want it put at risk by providing risky banks with liquidity. At the same time, a privately owned Bank of England will not want regulation to be too heavy handed as this would impose unnecessary costs on banks. The incentives that bank regulators currently have to expand their remit and load regulations on banks would be reduced and the right set of checks and balances would be created.

In short, banks would have to submit to the regulatory authority of the Bank of England in return for lender-of-last-resort facilities. They could chose not to be regulated by the Bank of England but then all their customers and counterparties would know that they would not have liquidity supplied by the Bank if they got into difficulties.

Is such a reform achievable? Without doubt, it is. The Bank of England was nationalised in 1946 as one of the first acts of the post-war Labour government. For the previous 250 years the Bank of England had been privately owned and was a success. The US Federal Reserve has private capital too. As Congdon points out, few of the problems in the US banking system have actually come from that part of the system that is regulated by the Fed – it is the investment banks regulated by the Securities and Exchange Commission as well as the separately regulated Fannie Mae and Freddie Mac, that are at the root of the problems in the US.

We have been through a very serious banking crisis despite ever-more onerous regulation coming from ever-more sources. The response of the regulators is predictable. They wish to expand their empire, expand regulation to those institutions that the crisis affected least (such as hedge funds, tax havens and private equity funds) and add yet more rules to the literally millions of paragraphs of regulation that currently envelop our financial system. It is not necessary to expand the regulators’ empire. All that is necessary is to have institutions with the right incentives and experiences to regulate incisively.

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