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Queen’s Speech

My Lords, I will confine my remarks to questions about bank regulation and supervision because the financial crisis has undercut in a very severe way conventional wisdom about accountability and responsibility in banks. There were two strands to that conventional wisdom. The first was that competition coupled with the threat of bankruptcy would pressure banks into serving the needs of their customers. Otherwise, they would be likely to go bankrupt because customers would migrate elsewhere and the prospect of bankruptcy would require them to behave responsibly. The second strand was that the role of shareholders was key to making the boards of banks responsible. If boards could be made responsible, those boards in turn would have a strong incentive to make their managers responsible. However, the crisis has drastically undermined both of those strands of conventional wisdom. In terms of bankruptcy, we have had to face the "too big to fail" syndrome rather graphically illustrated by the loan revealed yesterday. First, if banks are too big to fail, the bankruptcy constraint is weakened as one of the market-based forms of discipline. Secondly, and perhaps even more importantly, the global trade in securities has implicated one bank deeply in the affairs of another so that the effects of the bankruptcy of one bank cannot be insulated and detached from its effects around the system in the other banks with which it has dealings and relations in terms of trading in securities and so forth. Banks at dire risk of bankruptcy have a ripple effect on the others, as Lehman Brothers showed last year. The competition/bankruptcy constraint has been weakened by the financial crisis. It could be argued that the second strand then comes in as the way of making banks more responsible—namely, the role of shareholders. The shareholders should, as my noble friend Lord Myners has been arguing—and I applaud him for that—exercise more power over the boards of banks. They should be more assertive and take their responsibilities as owners more seriously. I agree with all of that. Nevertheless, there are limitations and those limitations have been exacerbated by the current crisis. First, there is an asymmetry of motivation between the shareholders and the board of a bank. The board of a bank and indeed the managers within a bank have a much stronger incentive to want not to be regulated and not to be made responsible than the shareholders have to make them responsible. That is the asymmetry of motivation, which is a difficult thing to overcome. There is a strong incentive for the board and managers to evade accountability. There is no such strong incentive for shareholders to assert the need for accountability. That needs to be changed and no doubt there are ways in which it could be changed. There is also an asymmetry of information, which has become important in the light of the financial crisis. It is clear that the boards of banks, never mind the shareholders, usually had a hazy idea of what their managers were getting up to. They did not understand many of the financial products that the bank owned and was investing in. If the boards of banks have an insecure grasp of the products that the banks own and do not understand what they are doing, how are shareholders to exercise their power of making the banks accountable? The financial crisis has revealed the problem involved in asserting some kind of accountability over institutions that have exotic assets. That has to be tackled, too. My noble friend Lord Myners made a point in the past few days that the difficulty of emphasising the role of shareholders has become exacerbated by the fact that shareholding can take place for a very short period of time—seconds, apparently, on the basis of what he was saying last week. You can be in and out of shareholding in a firm in the space of just a few seconds. If that trading becomes more generalised, how can shareholders be expected to exercise some form or control of banks? My noble friend Lord Haskel raised the issue of utility versus casino banking, and I am rather sympathetic to that. The week before last, the noble Lord, Lord Skidelsky, dropped a hint in the New Statesman about the need to distinguish between risk and uncertainty. Not being an economist, I am not sure how economists draw that distinction, but in philosophy, which is my subject, a risk is something that you can give some kind of numerical value to. It has some kind of root in a market and so forth. You can calculate and model risk. You cannot do that with uncertainty. If banks are trading not only in risks but in uncertainty in the casino side of what they do, the rational response to uncertainty as opposed to risk is to rank outcomes by the worst possible, and choose the best of the worst outcomes. If you followed that through in terms of institutional design, you would end up separating casino banking from utility banking, because it would protect the best worst outcome in a way that the mixture of the two banks cannot. What we must not do as a result of all this is expect any change in attitude on the part of bankers. Bankers, like the rest of us, tend to pursue their own rational self-interest. Some kind of exhortation to bankers to be more virtuous may work in the short term, but will not work in the long term. We need to re-read David Hume and treat everyone as a potential knave in business and devise subtle institutions to avoid the consequences of that.