Barings begs questions about Bank regulation

ECONOMIC VIEW; Not to spot that something was going wrong is, at best, bewildering
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The Independent Online
The Barings report comes out today. There will be two obvious elements of interest in it: the criticism of the Bank of England as Barings' regulator; and the forensic detail as to how the actions of one person in a branch office in Singapore could bankrupt a sizeable London merchant bank.

That it will criticise the Bank of England's performance as supervisor is not in question, for already an official on that side of the Bank has resigned, but the level and tone of the criticism will be significant. The forensic detail will be fascinating for it still puzzles other bankers that Barings could have got itself into this position without people further up the hierarchy being aware of the dangers.

But there will be a third element of interest, not so much in the detail of report itself but rather in its implications. For it may well mark a turning point in banking regulation: the moment when it became clear that it is on balance better to hive off the regulatory function from the Bank and have it carried out in a separate entity.

Such a split has been mooted for some time and been resisted by the Bank. This report will in all probability change the nature of the argument.

A little history will explain why. Most people think of the Bank of England as the supervisor of the banking system as the normal state of affairs, but it is a recently acquired function. It has been a formal regulator in the sense of administering a legal banking code only since 1979; before that small UK deposit-takers were administered by the DTI, while the Bank used exchange control legislation to buttress its powers of influence over the main body of banks in the City.

Before exchange control, the Bank exerted its authority over the banking system purely by influence. Such was its power of patronage that, within the core City institutions at least, this system worked reasonably well. There was an implicit Bank guarantee behind core City institutions, the clearing banks, the accepting houses (the top merchant banks), and the discount houses. It was only implicit because there was no requirement on the Bank to organise support for anything, but experience had taught it that it was better to support failing institutions than let them go. The Bank was (and of course still is) lender of last resort to the banking system. It was this need to provide liquidity that gradually drew the Bank into regulation.

Thus the failure of the Bank to support the largest discount house, Overend Gurney and Co, which went under in 1866, had led to such a run on the system that in the Baring crisis of 1890, it immediately organised the rescue. In return for this guarantee, City institutions did what the Bank told them.

This did not work outside the City, as the early 1970s fringe-bank crisis demonstrated. These institutions were not proper banks in the sense that they offered a full banking service, but they did take deposits. The DTI proved unable to regulate them effectively and the Bank felt it had to organise the rescue - bullying the core City institutions to recycle their deposits in what became known as the lifeboat. This appreciation that the DTI was an inappropriate body to be a regulator led to the 1979 Banking Act, which brought the whole system under the Bank.

There is one further wrinkle worth noting. That first Banking Act proved inadequate, for the Bank felt it gave it insufficient powers to prevent the collapse of Johnson Matthey Bankers, and a toughened version was brought out in 1987. Once again, though, either the powers seem to have been insufficient, or the administration of them inadequate.

Given this history, it is easy to see the significance of the collapse of Barings now. We have had more than a century of concentration of regulatory responsibility into the Bank of England - responsibility the Bank has resisted but has had imposed on it. But we have ended up with a system that is not only unable to spot a looming catastrophe in a core City institution but which, having saved a series of piddling fringe financial institutions, is unable or unwilling to use its influence to support what most had assumed was of impeccable quality.

The result is pressure on the Bank from two quite different sources. Outside the City, the common sense (but not unfriendly) line of attack goes like this. You could excuse the Bank for the fringe-bank crisis, for it was not the regulator. You could excuse it JMB because that was a slightly odd animal. You could excuse it BCCI because that genuinely was a very difficult job to control. But not to spot that something was going wrong in Barings is at best bewildering, at worst hopeless.

Inside the City the emphasis is both more sympathetic and more hostile. It is more sympathetic in the sense that everyone feels to some extent "there but for the grace of God..." It is more hostile in that the failure of the Bank to organise a support group (as opposed to the failure to spot the problem) is seen as a symbol of its decline in competence and standing.

This is really serious. I was told by the head of a top-flight City institution the other day that he had changed his mind on regulation. Until Barings (which, incidentally, he believed would have been rescued if the Governor has been around on the Saturday instead of being on holiday and getting back into the office only on the Sunday) he thought the Bank should retain the regulatory function. Now he believed it would be better hived off into a separate institution.

If people at the top of the City think that, then the game is up. Obviously the Bank will remain lender of last resort, so it will continue to have a say in regulation. It will need to make judgements whether a bank failure might be deemed "systemic" - that such a failure would lead to a run on the banking system as a whole.

But the day-to-day regulation would be elsewhere. Instead the Bank would devote itself to monetary policy, arguably an even more important function.

And the new regulatory body? Well, the interesting issue here is whether we should combine banking and securities regulation. The movement of banks into securities business and the explosive growth of futures markets certainly makes the distinction a bit of a nonsense. But that is in the future.

First, the Bank has to see that it is in its self-interest to dump banking regulation on someone else.

Key dates in UK banking regulation

1866 Failure of Overend, Gurney and Co

1890 Rescue of Baring Brothers

1939 Exchange Control Act

1973/4 Fringe banking crisis

1979 Banking Act (and repeal of exchange control)

1984 Failure of Johnson Matthey Bankers

1987 Banking Act

1991 Failure of Bank of Credit and Commerce International

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