Darling vs King: Blood on the tablecloth

At the Mansion House dinner in London, the Governor took careful aim; more power to the Bank of England, he cried. But what of the Chancellor? He wants a strengthened FSA. Richard Northedge untangles the Gordian Knot of banking reform

As the Cabinet was reshuffled at the start of the month, Alistair Darling was not even sure he would be delivering Mansion House speech to the City's bankers on Wednesday. Many suspect he will not be addressing them there next year, leaving him little time to fulfil his goal of imposing a new regulatory regime on the Square Mile.

Mervyn King, the Governor of the Bank of England, is confident of his own future, however. He was re-appointed for another five years just last year and he is happy to play a long game. At that dinner with Darling, the nature of that game and his difference with the Chancellor over regulation were revealed before an audience of the great and good of the financial services industry.

King made it clear he thinks the Bank should lead the reform of the City and that the Treasury should not rush into plans that strengthen the third member of the existing tripartite regulatory system, the Financial Services Authority.

Repeatedly, King called for delay. "We must learn lessons," he conceded. But "they cannot be final conclusions because the present crisis has some way to run". We need to reflect more deeply, he added later, while discussing reform, then he warned Darling: "It must not be put together in a hurry. We are a long way from identifying precise regulatory interventions."

Having already given his own speech, Darling – separated from King only by the Lord Mayor – had no right of reply. And in case the Chancellor had missed the message, King drummed it home: "We need to think carefully to get this right." Yet, less than two years after the credit crunch turned world finance upside down, the bandwagon for change is rolling quickly.

FSA chairman Lord Turner produced his proposed reforms in March and the consultation period closed on Thursday. King just beat the deadline by delivering his response at the dinner. Darling will produce a White Paper next week giving the Treasury's response to Turner and it will favour strengthening the FSA, not the Bank.

The manifesto King outlined in his bid for power exposes a long-standing tension between the Treasury and the Bank. Threadneedle Street still smarts from the loss of banking supervision when Darling was chief secretary at the Treasury under the then chancellor, Gordon Brown, after Labour came to office in 1997.

The credit crunch increased the stress as the three authorities sought to blame each other, and the Bank initially resisted attempts to rescue Northern Rock and inject liquidity into markets. Brown was accused of dithering in reappointing King, and Darling opposed the Governor's wish to promote economist Charles Bean to become his deputy but, on both occasions, the Bank men got the jobs.

Now, by proposing solutions fundamentally different to Turner's, King has put the Bank into conflict with the FSA too. Unlike Turner – in Japan last week and absent from the highly charged dinner – King believes that investment banking and retail deposit-taking are incompatible within one organisation that the state is expected to bail out. And the Governor argues that banks that are too big to fail are simply too big to continue.

Forcing banks to shrink or split could change the shape of finance houses and result in demergers that could create new banking institutions. But it would mean a big change in ownerships just as the Treasury tries to offload huge stakes in Royal Bank of Scotland and Lloyds. And the implication is that those stakes could not be bought by a rival if it made that competitor too big to fail.

The Bank retained responsibility for financial stability in the 1997 reforms even though the FSA supervised individual banks. Threadneedle Street monitored the bubble inflating in debt markets but – it is claimed – the Bank muted its warnings to avoid treading on the new regulator's territory. But this year's Banking Act has made that responsibility a statutory requirement and King fears that if another bubble bursts, the Bank will get the blame. He thus wants powers to prevent future collapses.

He argues that not only are interest rates insufficient to ensure stability, they should be used only for controlling inflation, not for restraining the banking system. He thus told Darling: "We need instruments to prevent size, leverage, fragility and the risk of the financial system becoming too great."

King calls those instruments his toolkit. And it would be his toolkit, not the FSA's, bringing the balance of power back from the regulator to the Bank even though Darling prefers to strengthen Turner's powers instead. The Governor points out that not only is he now legally responsible for maintaining stability, it is the Bank – not the regulator – that has the money to support banks by injecting liquidity.

The Bank's bid to lead reform was boosted last week in the US when President Barack Obama proposed a package that would give new powers to its central bank, the Federal Reserve, at the expense of the Securities and Exchange Commission, America's FSA. Mr Obama wants the Fed to monitor all companies big enough to threaten the financial system – not merely banks – and to have powers to take control and close down businesses in danger of collapse. That parallels what King wants for Britain and he sees such international moves as strengthening his hand.

On that principle at least, he agrees with Darling. "Regulators cannot only look at their own backyard and hope to understand what's happening," according to the Chancellor. But the distance between City and Westminster will be emphasised again at the end of the month when Darling produces his White Paper and the Bank its half-yearly financial stability report.

Darling's paper is expected to endorse Turner's argument for a stronger FSA rather than returning power to the Bank. The Chancellor says the solution must be based on better corporate governance, greater transparency, internationally agreed frameworks, a better system for dealing with bank failures and greater focus on system-wide risks. He is not talking about downsizing banks or dividing them up.

The Bank's report is likely to focus on policy rather than on whether the financial system has stabilised and why recovery will be slow. It is expected to discuss the need for macro-prudential and pro-cyclical regulation, the jobs for which King is demanding his toolkit.

He also opened another front last week, saying that, as Britain emerges from recession, fiscal policy has to change. That is driving the Bank's tanks directly on to the Chancellor's lawn: the Governor looks after monetary policy but taxation and spending are Treasury matters. King rubbed it in, saying that in five years, national debt as a proportion of national income will be double pre-crunch level, and warning that there must be a clear plan to cut deficits during the next parliament to reduce that ratio.

With a general election due within 12 months, that is a foray into politics. King was too polite to wonder who will be chancellor in that next parliament, but sitting with the Governor on the top table at the Mansion House dinner, a few places to his left, was George Osborne – the man who might be making next year's speech.

King may not court the Tory shadow Chancellor's support, but he has it. Osborne believes in fewer big banks and a stronger Bank of England. If the Governor can delay the debate on regulatory reform until we have a new chancellor, he may well get what he wants.