Mervyn King: administrator, bureaucrat...and Governor

The Bank of England is getting bigger, taking over the FSA. But is it, and the governor, big enough to handle its new job? Richard Northedge reports

At the Mansion House bankers' dinner 12 months ago, the Governor of the Bank of England, Mervyn King, shocked the then Chancellor by demanding to take over City supervision from the Financial Services Authority. Last week, the new Chancellor used the same dinner to serve King what he wanted.

But while the Bank will get bigger, is it – never mind is the Governor? – big enough to handle the new job?

The Chancellor, George Osborne, proposes not only to give the Bank back the powers it lost in 1997 when the new Labour government created the FSA, but he is also making it the regulator for corners of the City that have never been within the bank's remit. Insurance companies, stockbroking, building societies, hedge funds and much more look set to come under King's control, as well as high-street lenders and savings groups.

And he will remain head of the committee setting Britain's interest rates and retain responsibility for the currency and money markets. With the extra duties being added by Osborne, King will become the world's most powerful central banker, but by expanding the role of the Bank of England, the Chancellor may find he has changed for ever the nature of the governor's role.

The Bank will need more than an intellectual monetarist with an instinct for setting interest rates: it will require an administrator capable of processing the piles of paperwork that pass through the FSA, plus a manager able to handle an army of bureaucrats and a budget much bigger than the bank's traditional spending. The FSA is a very different organisation with a very different culture from the Bank of England.

King heads an organisation whose three centuries of history still influence its workings. The Bank of England is run by a court rather than a board. Top-hatted waiters greet – or deter – visitors to its ornate halls in the neo-classical building at the centre of the City of London, while the 13-year-old FSA has a reception desk in a foyer decorated with Bob Dylan lyrics at the foot of its tower block in Docklands. If the Bank looks like a think tank or Oxbridge college, the FSA more resembles an invoice-processing centre.

Is running such a bureaucracy really what King was demanding last year? Lord Turner, who became head of the FSA at the start of the credit crunch, has a background in management consultancy and can cope with an organisation employing 3,000 staff and spending more than £400m a year. The Bank's headcount is far lower and its core budget just £122m.

King says he will build on improvements instigated by the FSA since the crash, but states: "The Bank will bring its own central banking culture." His solution seems to be to cut the FSA's red tape when he takes over its duties. "We shall aim to avoid an overly legalistic culture with its associated compliance-driven style of regulation," he says. "We must reverse the seemingly inexorable trend towards more regulation and more regulators. That did not work in the past and is not the right response now."

Yet one lesson of the crisis is that regulators must monitor banks more closely. King's own background at the Bank of England is as an economist, not a regulator, but when it last supervised the banking system, the City comprised discount houses, merchant banks and accepting houses. That quaint world has been replaced by proprietary trading desks selling collateralised debt obligations to hedge funds and mortgage-backed securities being sliced and diced between traders and investors. A raising of the Governor's legendary eyebrow over tea in a banking parlour no longer constitutes regulation.

And even then, the Bank's regulatory processes were not foolproof. The bank collapses involving Johnson Matthey Bankers, BCCI and Barings happened on the Bank's watch. Nor, before it takes on a new role, has the Bank proved it can consistently achieve its current objective of controlling inflation: the 3.4 per cent rate contrasts with a target of 2 per cent.

Osborne has been determined, however, to rip up Labour's tripartite agreement that split responsibility for the financial system between the Bank, FSA and Treasury. Last week, he outlined plans for a new Prudential Regulatory Authority within the Bank to supervise financial firms and a new Financial Policy Committee, chaired by King, to act if it fears a future bubble could cause a new financial crisis.

The FSA's role as public watchdog will be incorporated into a new Consumer Protection and Markets Authority that will monitor every financial firm, even though that overlaps with the Bank's prudential regulator. A further new agency will consolidate the investigation of serious economic crime.

But if dividing regulation between the tripartite authorities allowed some troubled banks to slip through the gaps, the fear is that dividing supervision between these new bodies closes those cracks but also creates new crevices – and that the transition from one system to another allows further opportunities for problems to be overlooked and companies compliance costs to escalate.

Osborne is aware of the danger, saying: "We will handle the transition carefully, consult widely and get this right." The Chancellor wants the new system running by 2012, but he pulled off two coups last week that should help him. Lord Turner is to remain at the FSA until the transition is complete and his chief executive, Hector Sants, who had already announced his intention to quit this summer, is instead to stay and become the Bank's new prudential regulator.

Sants is a popular ex-banker credited with much of the FSA's refocusing following the financial crisis. He will become a deputy Governor and his own deputy will be Andrew Bailey, a former private secretary to the Governor, who is officially the chief cashier with responsibility for issuing banknotes but who has headed dealings with the troubled banks since the crisis, especially on loans to problem companies.

"Together, Hector and Andrew form the perfect partnership to make the transition work and create the new organisation," says King.

Osborne echoes the Governor's words, saying: "This is a strong team to ensure a smooth transition."

Keeping Sants was just part of a busy 10 days for the Chancellor, who also set up a commission on the banking industry that will consider whether the big finance houses should separate their retail operations from "casino banks" – making the them less risky and easier to supervise. King favours a split and must be hoping for support from the commission's chairman, Sir John Vickers – a former chief economist with King at the Bank.

Osborne last week also received his first report from the new independent Office of Budget Responsibility, downgrading the forecasts for economic growth. On Tuesday he will present his first Budget to Parliament, setting out his plan to reduce the country's deficit, and any necessary tax rises, as well as providing the limits for the autumn spending review.

But the Chancellor is expected to return to the banking sector in his Budget speech, announcing plans for a levy on the banks as well as reiterating his demands for restraint on pay and bonuses.

Sants, 54, is already seen as a possible successor to King, whose second five-year term as Governor ends in 2013, when he will be 65. Expanding the Bank so significantly will mean that future governors must be administrators as well as economists or bankers. By making the Bank bigger, the Chancellor is making it a bureaucratic business, too.