Wanted: dynamic intellectual to oversee £9 trillion of assets, decide the fortunes of 60m people and burnish the reputation of a 316-year-old institution. Applications to the Queen, care of Her Majesty’s Treasury, One Horse Guards Road.
Admittedly, when the Treasury’s advert for the next Governor of the Bank of England appeared in The Economist, it didn’t quite read like that. But it might as well have done.
Whoever succeeds Sir Mervyn King in June will become the most powerful unelected official in the UK. Only the Prime Minister and Chancellor will have more influence over Britain’s economic future.
The next Governor will be able to set not just interest rates but restrict mortgage or credit card lending, or reduce the size of the hedge fund industry, or starve a commercial property bubble of debt, or crack down on off-balance sheet borrowing.
They will have the power to fire bank bosses with a lash of their tongue, and quietly set rules on pay. Ultimately, the Governor will be responsible for supervising the entire City of London, Britain’s economic heartbeat and the world’s financial capital with trillions of pounds percolating through its markets every day.
And that just scratches the surface. Effectively, when it comes to the UK economy, everything but tax policy will be in the Governor’s hands. Never in its history will the Bank – or the Governor – have wielded so much power. And, for that, the Old Lady of Threadneedle Street can thank a relatively small retail bank called Northern Rock.
The run on the Newcastle-based former building society almost five years ago to the day – in September 2007 – changed everything. It was the first run on a UK bank in 141 years and a moment of national shame for a country that prided itself on financial services. The nation’s blushes were even more crimson given that Hank Paulson, the US Treasury Secretary, was in the UK to witness the disaster first-hand.
Within a week, the post-mortem had begun. Just six days after the queues had first snaked their way round Northern Rock branches, Sir Mervyn was called before the Treasury select committee (TSC) to answer how it had happened. There, in one historic exchange, MP Michael Fallon asked the simple question: “Who was in charge?”
“What do you mean by 'in charge’? Would you like to define that?” came Sir Mervyn’s reply.
His words have since become emblematic of the rudderless state of financial regulation in the UK, where a “tripartite” arrangement split supervision between the Financial Services Authority (FSA), the Treasury and the Bank – leaving no one in charge.
Labour had established the system in 1997 after giving the Bank independence to set interest rates. But, fearing it would create an uncontrollable giant, it decided to pass financial regulation to the newly-created FSA.
As Alistair Darling, an architect of the plan who later oversaw the financial crisis as Chancellor, recalled: “We did think at the time, should we put it all into the Bank? But the concern was you’d create this huge behemoth that was virtually ungovernable.”
Right from the start, the Bank had misgivings. The then Governor, Sir Eddie George, threatened to quit in protest at the reforms, which Sir Mervyn later said had neutered the Bank – leaving it capable of just “publishing reports and preaching sermons”.
“The Bank had been in charge of financial stability for 200 years, but that was sacrificed to make way for rates policy,” one central bank observer said. “The system lasted a boom, then fell apart at its first test.”
Sir Mervyn’s comments at the TSC exposed for all to see the lack of leadership on financial regulation. For some, though, it felt eerily familiar. Ten years earlier, and at the time new to the opposition benches, a number of Tory MPs had warned that the system was fatally flawed.
Andrew Tyrie, now chairman of the TSC, had told Parliament that the “memorandum of understanding between the FSA, the Bank, and the Treasury… is a pretty feeble document”.
Even more presciently, Peter Lilley, a short-lived shadow chancellor, cautioned in 1997: “With the removal of banking control to the FSA, it is difficult to see how and whether the Bank remains, as it surely must, responsible for ensuring the liquidity of the banking system and preventing systemic collapse.
“The process of setting up the FSA may cause regulators to take their eye off the ball, while spivs and crooks have a field day.”
Over at Tory HQ and in the wake of Northern Rock, Lilley and others explained to the new party leadership of David Cameron and George Osborne that UK financial regulation had a fundamental design flaw.
As the crisis gathered pace, culminating in the multi-billion pound taxpayer bail-outs for the Royal Bank of Scotland and Lloyds Banking Group the following October, it became clear that the status quo was no longer tolerable. More than that, politically, there suddenly appeared a huge opportunity in what would normally be a mind-numbingly arcane subject – reshaping Britain’s regulatory architecture.
“There was an argument that when you had a banking crisis on the scale we did, then saying the regulatory system shouldn’t change was an inadequate response,” Mark Hoban, the former financial secretary to the Treasury who was moved to employment minister in the recent reshuffle, said.
Cameron and Osborne set to work. In opposition, they had put together an economic policy advisory committee – a “wise men’s group”, one adviser called it – made up of business and City luminaries such as former Rolls-Royce chief executive Sir John Rose and Next boss Lord Wolfson.
In its ranks were two old-fashioned bankers, former Barclays chairman Sir Peter Middleton and former Lloyds chairman Sir Brian Pitman, who had been shocked by the regulatory failings. According to Tory advisers, Sir Brian, who died in March 2010, was particularly “astonished that there was no one doing prudential supervision”.
Osborne also put two of his top advisers, Rupert Harrison and Eleanor Shawcross, on the case. Together with Lord Sassoon, a former investment banker who would become commercial secretary to the Treasury, they stripped regulation conceptually back to basics.
Starting from the principle of “macroprudential supervision” – taking the big picture rather than firm specific view of financial stability – they concluded that regulation had to be put back in the Bank.
There was a remorseless logic to the plan. As Lilley had observed, the Bank was ultimately responsible for financial stability as the lender of last resort – a role it played with Northern Rock in 2007 and again with RBS and HBOS the following year.
And if it was to put taxpayer’s money at risk, it needed the authority and oversight over the bank’s books. Such a role would require a depth of knowledge provided only by being the supervisor of each individual bank as well.
What had got lost under Labour was a focus on financial stability. Again, the problem was in the design. As part of the government’s reforms in 1997, the nine self-regulatory bodies for banks and insurers were disbanded and responsibility for consumer protection was handed over to the FSA.
Following numerous scandals such as pensions mis-selling, Equitable Life, and endowment mortgages in the 1990s, the FSA’s focus inevitably shifted towards consumer protection.
“The media focus was on conduct issues. The TSC was also focused on conduct. The organisation was driven to think more about that. There was a design flaw,” Hoban said. In the “NICE” decade – so-called by Sir Mervyn for the years of non-inflationary continuous expansion - financial stability seemed an irrelevancy.
As consumer protection infected the regulatory mindset, a box-ticking approach to supervision took hold and the FSA lost its ability to use judgment to manage the banks. The Tories’ solution was to spin off consumer protection into a different regulator, to become the Financial Conduct Authority, leaving the Bank in sole charge of prudential supervision without any distractions – creating so-called “twin peaks” regulation.
In July 2009, the Conservatives published their White Paper, which remains the blueprint for the Bank’s overhaul today.
It put clear water between the Conservatives and Labour over regulatory reform. The Tories were arguing for the FSA to be disbanded, while Labour believed the tripartite system could be fixed by establishing an effective, overarching committee to co-ordinate policy. But there was still a lot of work to be done, let alone winning a general election.
Initially, the Tories encountered significant resistance to their proposal from regulatory bigwigs such as the former Bank deputy governor, Sir Andrew Large, former FSA chairman Sir Howard Davies, and inevitably Lord Turner, the current FSA chairman.
Even Sir Mervyn was initially reluctant, particularly about bringing together two such different cultures and taking responsibility for insurance – a job the Bank had never performed before.
According to Conservative sources, Sir Mervyn was eventually won over by the arguments of his central banking colleagues rather than any Tory voices. Stanley Fisher, then governor of the Bank of Israel and a former chief economist at the World Bank, and US Federal Reserve chairman Ben Bernanke, were particularly influential.
Addressing the subject in 2008, Fisher said: “Those who have not worked in bureaucracies might argue that all this can be achieved through better co-ordination.
“The world does not work that way. Information flows between organisations are simply less efficient than those within organisations. It is very likely that prudential supervision will return to central banks when the lessons of this crisis are drawn.”
Sir Mervyn’s conversion was a key moment. At the Mansion House in June 2009, he delivered a speech that Darling in his memoirs described as “a naked attempt to wrest powers away from the FSA”. “As such it was a direct challenge to government policy and therefore to me. The problem was that [it] was Conservative Party policy,” he said.
Sir Mervyn’s stance lent the Tories vital credibility, and he helped out again after the election when the Conservatives were forging their alliance with the Liberal Democrats. “The Lib Dems weren’t sure about disbanding the FSA. It’s not that they were against it, it’s just that they wanted to think it through,” a Tory source said.
To buy time, the Coalition agreement stated ambiguously: “We will bring forward proposals to give the Bank control of macro-prudential regulation and oversight of micro-prudential regulation.”
“We basically fudged it,” the source said. “There were then a lot of discussions between Mervyn King, the Deputy Prime Minister, and the Prime Minister. It was very important getting Mervyn King convinced. That was vital to getting Vince Cable [the Lib Dem Business Secretary] on side. Cable has a lot of respect for the Governor.”
In Tyrie’s opinion, as well as many others, what the Government is now pushing through is nothing less than “the most important overhaul of regulation ever undertaken in this country”.
Under the new legislation, which is expected to gain Royal Assent before the end of the year, the Bank will retain its responsibility for setting interest rates and will also obtain a host of new powers for financial supervision – its macroprudential “toolkit”.
The “tools” have yet to be decided but are likely to centre on capital – the buffer of cash banks hold to protect against losses.
The Bank will be able to force up requirements on mortgage lending if it believes a housing boom is brewing, for example. Technical as it sounds, the effects could be dramatic. As a result, mortgage borrowing would become more expensive, or banks might even withdraw credit altogether – all at the whim of the Bank.
The “toolkit” will also be ever-expanding to respond to innovations in the industry.
To ensure lenders comply with policy, the Bank will have the power of direction over a few key “tools”. That power will be embedded in legislation approved by Parliament. For the rest of the “toolkit”, the Bank will be able to make recommendations that lenders will either have to comply with, or explain why they refuse to do so.
To administer the tools, a new structure has been created at the Bank. At the top will sit the Financial Policy Committee (FPC), a group of experts from inside and outside the Bank who decide whether financial stability is under threat – for example, by a new debt bubble.
If the FPC decides stability is at risk, it will use its tools “to take away the punchbowl before the party gets going”, to use central bank jargon, and instruct the Prudential Regulatory Authority (PRA) to act.
The PRA, a subsidiary of the Bank that will supervise individual lenders, will then make sure each bank or building society implements the new rule. To ensure all the committees are joined up, the Governor will chair the FPC and the PRA, as well as the interest rate-setting Monetary Policy Committee (MPC).
The argument is that had the Bank had its new powers in the last decade, things might have been very different. Specifically, taxpayers might not have had to shell out £133bn in cash to bail out the industry and provide a further £1 trillion of state guarantees, according to National Audit Office calculations.
One credible alternative version of events might have run as follows. In 2001, assuming the new powers had been in place, the Bank would have made a big noise about the rapid emergence of the credit derivatives market. The fact is, it did warn in June that year about a potential “systemic issue… for the future” over credit derivatives, and suggested “authorities need to track the scale and direction of this risk redistribution”.
As the market continued to explode in 2002, the Bank would have required all over-the-counter trading to be moved to central clearing parties, slowing the pace of the market’s expansion and providing regulators a better view of banks’ exposures.
With a closer eye on banks’ balance sheets, the scale of their growing US sub-prime mortgage exposures would have become apparent by 2005 or 2006. In response, the Bank would have triggered another of its tools – forcing lenders to hold much more capital against structured credit products. Doing so would have made sub-prime debt more expensive, so acting as a deterrent as well as increasing the buffer the banks had to absorb losses.
At the same time, the FPC would have asked the PRA to make sure each of the UK banks were safe. Free from the FSA’s box-ticking approach, the PRA would have taken a qualitative look at balance sheets, and probably instructed at least two of the most aggressive banks – RBS and HBOS – to reduce their exposures.
With concerns about RBS’s capital strength to the fore, the PRA – empowered to use its judgment to overrule any objections – would then have barred the chief executive, Fred Goodwin, from bidding for ABN Amro in 2007. Even if it had allowed an approach, RBS would have been instructed to pull out after the run on Northern Rock in September.
In reality, the new tools would probably only have reduced the scale of the crisis rather than prevented it entirely. But other measures in the Financial Services Bill would have further protected taxpayers.
Instead of state bail-outs, banks would have been made to impose losses on their bondholders as well as shareholders.
Although the Bank would have had to provide emergency liquidity support, the scale of taxpayer intervention – which peaked at £1.16 trillion – would have been far, far smaller.
New-fangled financial regulation does not come without risk, though. The Bank will become an enormous institution, with staff numbers rising from 1,800 to 3,100 and a Governor presiding over it all like a 17th century monarch.
“What the Government seems to have done is to create a byzantine structure of committees of which the only common part is the Governor,” Darling said. “What you end up with, is this very large complex organisation responsible for critical decisions that will affect people’s standards of living as well as the financial health of our system [and] basically it all comes back to a Governor.
“I think a structure that is reminiscent of Louis XIV’s court of the Sun King is wholly inappropriate for the 21st century. My worry about the new arrangement is that it’s just too big.”
Darling does not want to scrap the Tory plans – “It’s done now,” he says – but he believes the Bank needs to be properly modernised to keep the Governor in check.
“The Governor is just that. A Governor, in the old colonial style,” he said. “The entire Bank is embodied in the figure of the Governor and there are no checks and balances. It is fairly despotic. Of course, you can have benign despots, and you can have other sorts.”
Darling is not alone. Like the former chancellor, Tyrie has been campaigning for better corporate governance.
“The proposals we have made would provide the Bank with something more akin to the corporate governance structures we would expect in any modern institution,” he said.
“Anyone reading the Financial Services Bill would conclude that the Government had neglected to consider governance – or that it was an afterthought. Some say the post of Governor in the legislation creates a new single point of systemic risk.”
Tyrie is pushing for the TSC to be given the power to recommend that Parliament vetoes the appointment of a new Governor. Subjecting the Governor to democratic process would “buttress their legitimacy”, Tyrie said. Others counter it is one political land-grab too far for the influential TSC.
The main point of contention, though, is with the Court of the Bank, the oversight body which has in the past been little more than a sinecure for the City’s aristocracy. “We can’t carry on with the legacy of a semi-reformed 17th century Court,” Tyrie said.
As far as Darling is concerned, “the Court is an adornment”. Darling tried to reform it in 2009 “to make it into the equivalent to a board of directors”, but “the Governor [King] did not want to go down that line”.
To be fair, the Governor will be just one voice on the Bank’s three committees making the critical judgments – the FPC, the rate-setting MPC, and the board of the PRA.
There have also been changes since the Financial Services Bill was first published. There will now be an oversight committee of the Court, which will exclude the “executive” (the Governor and his deputies). It will be able to commission internal and external reviews of the way the Bank has handled decisions, whether they be setting interest rates, launching quantitative easing or restricting mortgage lending.
“If we had set up a committee that did not report to anybody and did not order internal investigations, it would be a legitimate question,” Hoban said. “But the Court can hold the Governor to account, and rightly so.”
The only power the oversight committee will not have is to review policy decisions. “To have a second committee that substitutes its policy judgments for the policymakers’ just won’t work,” one reformer said.
Sir Mervyn’s reluctance to accept any root-and-branch change to the Court might also be tied up in the Bank’s venerable history.
Originally, the Bank was established as a commercial entity with one pretty important customer – the Government. It was founded in 1694 after a group of City merchants offered to give the Government a £1.2m loan to help pay for the rebuilding of the navy, in the process laying the seed capital for British imperial expansion.
The loan was never to be repaid, but in return the merchants received 8pc in annual interest in perpetuity and became sole banker to the Government.
By virtue of its lock on government business, the Bank of England gradually grew into the bankers’ bank. And with its new status, the Court was created. Members would be picked from the City establishment and often serve for life. But it remained, at heart, a commercial operation.
As Liaquat Ahmed wrote in Lords of Finance: “Though the directors were charged with governing the supply of credit in Britain, they did not pretend to know very much about economics, central banking or monetary policy.”
It was only under Montagu Norman, Governor from 1920 to 1944, that its transformation into a real central bank began – and that was largely as a result of the financing requirements of the First World War, which more or less turned it into an arm of the Treasury.
In 1946, that status was formalised when the Bank was nationalised, not to be given back its independence until Gordon Brown took over as Chancellor in 1997. In all that time, though, the Court remained.
The question now is – who will be the new Governor? Sir Mervyn still has eight months to serve of his second five-year term as Governor, but thoughts long ago turned to who will be his successor.
Paul Tucker, Sir Mervyn’s financial services deputy, is the favourite, with Lord Turner, the FSA chairman, hot on his heels. Both were burnt by the Barclays Libor-rigging scandal, when critics said they should have been more alive to the issues, but Government sources said it is unlikely to have damaged their prospects.
“If you look for someone who’s never come near controversy, you’ve got someone with no experience,” one Government source said.
Others in the running include Lord O’Donnell, the former Cabinet Secretary, and Lord Green, the trade minister and former HSBC chairman. Sir John Vickers, a former chief economist at the Bank, may be rewarded for leading the Chancellor’s Independent Commission on Banking. Rachel Lomax, a former deputy governor, is the leading female candidate. Jim O’Neill, the head of Goldman Sachs Asset Management, is said to be keen to apply “if they want someone like me” (a straight-talking Mancunian who has made his name with an American investment giant).
One thing is for sure, though, with the ideal applicant needing to demonstrate mastery of finance, regulation and economic policy the talent pool is fairly small, which is why Darling is keen for the Government to look outside the UK.
“It would be a huge mistake not to look for an international candidate,” he said. “Given that you can’t understate the importance of the job, we have to get the best Governor that we can.
Mark Carney, the governor of Canada’s central bank and a star of international financial regulation, was a real possibility until he ruled himself out last month.
One thing the next Governor will have to be, however, is both consensual and bold. Sir Mervyn provided an early insight into future regulation when he forcibly ejected Barclays chief executive Bob Diamond earlier this year despite him having no direct powers to do so.
“Barclays was top of the class in terms of box-ticking, it had all the right systems in place, but the culture from the top was all wrong,” Tyrie said. Another Tory MP added that the handling of Diamond’s exit was designed to send a very clear signal.
“Bank bosses should be looking over their shoulder from now on,” he said. “The Bank has got the authority to do it again. There is precedent.” In future, such decisions will be taken by the PRA board, on which the Governor sits. But, although the process will be improved, the outcomes may well be the same.
Whoever is successful, Sir Mervyn’s legacy will loom large over his successor, who is expected to be named before the end of the year and will serve a single eight-year term under the new arrangements.
Bankers and financiers hope the next Governor will be able to work more co-operatively with the City after Sir Mervyn’s somewhat finger-wagging lectures on moral hazard, unconcealed contempt for bankers, and his slow response at the start of the crisis. But, for all his failings, Sir Mervyn will go down as possibly the most important Governor the Bank has ever had.
Once the new legislation is through, the Bank will have a vast array of “tools” to manage the economy and fight bubbles. Since 1997, the Bank has had just one – interest rates. And, historically, its economic powers were less explicit and largely wielded through the influence it had on the currency as well as monetary policy.
No one could have predicted Sir Mervyn would have played such a role. Ironically, he was appointed by Brown in 2003 because of his background as an economist – reflecting the change in the Bank’s focus. Under his tenure, the financial stability arm of the Bank was starved of investment. And yet, it is for the rebirth of the Bank’s historic financial stability function that he will be remembered.
“When the dust settles and the history books are written, my personal view is the Governor’s tenure will get a good write-up. He faced unprecedented challenges and addressed them with a good deal of courage and huge intellectual integrity,” Tyrie said.
It is probably no coincidence that in his BBC Today programme lecture, King quoted liberally from Montagu Norman. Setting aside Norman’s suspected Nazi sympathies, there are clear parallels. Norman did more than any other Governor to modernise the Bank for the 20th century. King has overhauled it for the 21st.
In the running
Lord Turner The FSA chairman is a fearsome intellect and shrewd political operator. His Turner Review in 2009 was a key document of regulatory reform. But the City is not a fan since he described much of what bankers do “socially useless”.
Paul Tucker The Deputy governor for financial stability at the Bank, is the front runner. Liked by the City – vital if the new structure is to be effective – and he has been at the forefront of reforms since the crisis. But he has been damaged by the Libor crisis.
Lord O’Donnell He stepped down last year as Cabinet Secretary. He has a strong economic background – Treasury, IMF, World Bank and head of the Government Economic Service, but some Tories think him too closely linked to Labour’s failed economic strategy.
Lord Green The trade minister was HSBC chairman until he got the call from David Cameron. As a lay priest he has unimpeachable ethics. His problem is his Tory allegiance, as a minister he could be seen as a political appointment as Governor.