Brown’s ‘Churchill’ Moment Masks Failure of Regulator He Built
Nov. 26 (Bloomberg) -- Gordon Brownisn’t known for making quick decisions. He agonized for months over whether to call early elections after becoming U.K. prime minister in June 2007, before deciding against it.
When financial and commodity markets unraveled in early October, Brown had no time to dither. On Oct. 7, shares of HBOS Plc, Britain’s biggest mortgage lender, plunged 42 percent, while Royal Bank of Scotland Group Plc sank 39 percent.
Just a day later, Brown and Chancellor of the Exchequer Alistair Darlingannounced that the British government would spend up to 50 billion pounds ($75.6 billion) buying stakes in the country’s flagship banks to prevent a panic. The strategy would be copied around the world -- most notably by U.S. Treasury Secretary Henry Paulson, who announced on Oct. 14 that the government would spend up to $250 billion buying stakes in U.S. banks.
Brown was resurgent just weeks after lagging in opinion polls. French daily Le Figaro wrote that Brown’s calm, reasoned response in a time of crisis was worthy of Winston Churchill. Paul Krugman, the Nobel Prize-winning economist, pondered in his New York Times column: “Has Gordon Brown, the British prime minister, saved the world financial system?” Krugman said that would be an exaggeration, yet he praised Brown for his quick, clear-headed recapitalization.
The 57-year-old Scotsman, with a Ph.D. in history, is now leveraging his transformation as a financial fireman to push for new rules to govern capital. He took a leadership role at a mid- November meeting of world leaders in Washington designed to coordinate responses to the worst financial collapse in at least 80 years.
‘Principles-Based’
Brown finds himself defending his own handiwork: the U.K.’s financial regulator, the Financial Services Authority. He created the FSA, which oversaw banks during the meltdown, in his first year as chancellor of the exchequer, in 1997. The agency is a proponent of “principles-based” regulation, which means it oversees the financial system via a set of 11 broad-based principles rather than the thousands of specific rules enforced by the U.S. Securities and Exchange Commission.
Unlike the SEC, which regulates only the securities industry and mutual funds, the FSA is responsible for all financial institutions: insurance companies, mutual funds and commercial, mortgage and investment banks. It also regulates hedge fund managers.
For years, Brown held up principles-based regulation as a model. The first two principles are “a firm must conduct business with integrity” and “a firm must conduct its business with due skill, care and diligence.” One admirer was Paulson, who praised the British system.
‘Run on the Rock’
Then came Sept. 14, 2007, when thousands of depositors lined up at branches of Newcastle-based mortgage lender Northern Rock Plc demanding their money. It was the first run on a British bank in more than 140 years, and a subsequent Parliamentary probe blamed the FSA’s lack of oversight for the bank’s failure.
Limping under a mountain of debt, Northern Rock was taken over by the government in February. In the year after “the run on the Rock,” as it was called in the British press, HBOS, RBS and other British banks faced their own funding crises and agreed to a government bailout.
“The problem with Brown is that he’s an architect of a lot of this mess, so he has a certain credibility problem,” says David Green, who spent 30 years as a senior supervisor at the Bank of England and then six years heading international policy at the FSA.
“Gordon Brown himself may now be thinking it’s not great to be taking credit for being in a huge bloody hole,” says Howard Davies, who was chairman of the FSA from its creation in 1997 until 2003 and is now chairman of the London School of Economics. “Everyone was sinking, and he managed to bail out before everyone else.”
More Rules Needed
Adair Turner, the FSA’s new chairman, says that giving bankers a set of principles to abide by has clearly not worked. “We need as rapidly as possible to get to an international agreement about what the future rule book should be,” Turner, who took office on Sept. 20, told lawmakers in November. “That has to be a more effective rule book than there has been in the past.”
Turner is a former vice chairman of Merrill Lynch & Co. in Europe and from 2003 to 2006 chaired a U.K. commission that studied the country’s pension system.
As the world financial crisis unfolded, Paulson acknowledged that more, not less, regulation was needed and committed himself forcefully to the Brown solution. On Oct. 14, Paulson announced the Treasury would spend a big chunk of the $700 billion in emergency funds Congress authorized to buy stakes in banks and other financial institutions directly. Then, on Nov. 12, Paulson abandoned his original plan to buy up banks’ toxic debt.
New Bretton Woods
Brown blames the banks, not the FSA, for Britain’s crisis. “Financial institutions have fallen short, with irresponsible risk taking, incompetent risk management and inadequate due diligence,” he said at a Nov. 11 press conference in London.
Still, Brown says the lack of global regulatory oversight justifies convening a newBretton Woods, the 1944 conference near Mount Washington in New Hampshire that fixed exchange rates and created the International Monetary Fund and the World Bank.
“While the founders of Bretton Woods devised rules for a world of limited capital flows, we must devise rules for a world of global capital flows,” Brown said in an Oct. 13 speech.
Brown proposes the creation of a panel of regulators to oversee the world’s 30 biggest banks, to harmonize global accounting standards, to supervise rating companies and to impose rules on the trading of credit derivatives.
The Group of 20 leaders in Washington endorsed the goals and instructed their finance ministers to come up with a plan for implementing them by the end of March, ahead of a planned summit in April.
‘Dead on Arrival’
The idea of a global superregulator is unworkable, says George Magnus, an economist at Zurich-based UBS AG. “It’s dead on arrival,” he says. “An American president and American Congress will never agree to it.”
At home, Brown and Darling on Nov. 24 announced a 25.6 billion pound economic stimulus package that will include tax cuts and government spending increases over two years to try to pull Britain out of recession. The plan will reduce the country’s sales tax 2.5 percent to 15 percent, cut levies on small businesses, and encourage mortgage lending by guaranteeing securities backed by home loans. It will swell the U.K.’s budget deficit to 8 percent of gross domestic product, the highest since 1970.
Brown’s command performance in the financial crisis has improved his ruling Labour Party’s dismal showing in national opinion polls. Before the crisis hit, the Conservatives commanded a double-digit lead and even Labour members were attacking Brown.
“Tony Blair was like champagne and caviar; Brown is more like porridge,” Meghnad Desai, a prominent Labour member of the House of Lords and emeritus professor at the London School of Economics, told the BBC in April.
London Tops New York
Brown’s bailout and globe-trotting have helped him claw back some support, and even Desai has praised him. Conservatives now have the backing of 40 percent of likely voters, while Labour supporters increased to 37 percent, according to an Ipsos MORI poll conducted Nov. 14-16.
The regulatory mistakes of the FSA raise questions about London’s rise as a financial center. “Just over a year ago, the feeling was that London had stolen a march on the States in having a sensible approach to regulation, and that’s why businesses were coming to London,” says Harvey Knight, a regulatory specialist at London-based law firm Bevan Brittan LLP and a former FSA attorney.
In 2005, London surpassed the U.S. as the No. 1 choice for stock listings by foreign companies, especially those from emerging markets such as India and Russia. In 2007, a record year for initial public offerings, foreign companies sold twice as much stock on the London Stock Exchange -- $22.1 billion -- as they did in the U.S.
Paulson Blueprint
Paulson, chief executive officer of Goldman Sachs Group Inc. from 1999 to 2006, sang the praises of the British model soon after he took over as Treasury secretary in June 2006. “The advantage of a principles-based system is that it is flexible and sensible in dealing with new or special situations,” Paulson said in a speech to the Economic Club of New York.
Paulson also embraced the use of principles-based regulation as part of his March 2008 Blueprint for a Modernized Financial Regulatory Structure. He proposed putting the SEC under the same roof as the Commodity Futures Trading Commission, the regulator that oversees the Chicago Mercantile Exchange and that governs with far fewer rules than the SEC.
McKinsey Study
Paulson’s main target was the Sarbanes-Oxley Act of 2002, which imposed tough accounting standards on U.S. firms in the wake of the collapse of Enron Corp., WorldCom Inc. and other companies. A 2007 McKinsey & Co. study for New York Mayor Michael Bloomberg and U.S. Senator Charles Schumer of New York found that Sarbanes- Oxley requirements were one reason the global stock underwriting business was migrating to London.
(Bloomberg is the founder and majority owner of Bloomberg LP, the parent of Bloomberg News.)
Brown created the FSA in 1997 to consolidate financial regulation, pulling together nine different agencies. The most significant change: Supervision of banks was taken away from the Bank of England. The BOE, now headed by Governor Mervyn King, gained its independence to set interest rates and kept responsibility for the stability of the financial system as a whole.
“It has always been true in the U.K. that things got done with a raise of the governor of the Bank of England’s eyebrows,” says Michael Fallon, a Conservative member of Parliament and the deputy chairman of its Treasury Select Committee. “I think the top 10 or 12 banks should remain under the supervision of the Bank of England because they have the authority and the knowledge.”
BCCI, Barings
The government created the FSA partly as a reaction to two banking scandals: the BCCI and Barings affairs. The London- and Luxembourg-based Bank of Commerce & Credit International SA collapsed in 1991 amid allegations of widespread fraud. Barings Plc came close to bankruptcy and was sold to ING Groep NV in 1995 after rogue trader Nick Leeson lost 862 million pounds on futures contracts.
“BCCI and Barings led to the discrediting of the Bank of England’s approach,” says Green, the former FSA and BOE official. “There was a suggestion the Bank of England was too close to the people it dealt with, that it wasn’t distant enough to ask the right questions.”
Brown hailed his new agency at its 1997 launch as “a unique, 21st-century, one-stop center, a single supervisor for all providers of financial services.”
The job of the FSA, which today has a staff of 2,500 and a budget of 302 million pounds, was complicated by the fact that it had to implement rules from the European Union and from the global Basel Capital Accords.
The Basel rules, among other things, set a floor on the amount of capital banks have to hold to protect themselves against loan defaults.
8,500 Pages of Rules
One result of the FSA’s myriad responsibilities is that it isn’t nearly so principles based as it’s cracked up to be. In a speech to business leaders in 2007, Callum McCarthy, the FSA’s former chairman, noted that the agency is charged with enforcing 8,500 pages of specific regulations. Before the financial crisis broke out, the FSA had been trying to pare that number.
The decade after the FSA’s creation was a time of rapid growth in the U.K. banking industry -- and in the risk it was willing to take on. From 2001 to 2007, U.K. bank balance sheets exploded, with assets tripling to 6 trillion pounds. In 2001, customer deposits in U.K. banks broadly matched customer loans pound for pound. By 2008, U.K. banks were lending 700 billion more pounds than they held in deposits, according to the BOE’s October 2008 Financial Stability Report.
Overseas Debacle
The report says the banks raised a significant portion of that money by packaging and reselling securities overseas.
The FSA never had the resources it needed to supervise the banking system properly, especially when the system was growing so fast, says Kenneth Clarke, the Conservative member of Parliament who served as chancellor of the exchequer from 1993 to 1997. “The new FSA had such an enormous amount of new responsibilities that it never really developed the close familiarity with the banking world that was required,” Clarke says.
In the wake of the bank failures, Chancellor Darling wants to hand authority to manage bank bailouts to the BOE instead of the FSA.
Green says that under a principles-based system, an FSA supervisor has to confront bank executives he or she thinks are taking too much risk and force them to pull back. “That’s what you do as a supervisor,” says Green, who’s now an adviser at the London-based Financial Reporting Council. “It’s a major shortcoming; they lost sight of their core business.”
‘Lessons to Learn’
Hector Sants, the FSA’s CEO, says that principles-based regulation isn’t to blame for the regulatory lapses; it was the people charged with administering it. “The FSA has been very clear that it has lessons to learn,” Sants said in e-mailed answers to questions. “Supervisory mistakes were made.”
Sants, 52, became the FSA’s CEO in July 2007, just two months before the run on Northern Rock. A former Credit Suisse Group AG executive who headed the FSA’s oversight of investment banks and markets for three years, Sants took over from John Tiner, who ran the agency from 2003 to 2007. Tiner declined to be interviewed.
Sants says that the FSA’s problem was that its supervisors didn’t probe deeply enough to see the risk for highly leveraged banks should the U.K. economy go into a tailspin.
“When I look at some of our mistakes, it’s because we didn’t follow through on principles-based regulation,” Sants said in an October speech in Edinburgh. “People weren’t thinking about outcomes.”
Crumbling Rock
Brown, Sants and company were forced to think about outcomes when Northern Rock began to crumble. The bank grew under CEO Adam Applegarth, who was appointed in 2001, from a small mortgage provider in the north of England to the third-biggest lender in the U.K., with more than 100 billion pounds in assets by the end of 2006. It expanded by packaging mortgages into securities that it sold in credit markets from New York to Sydney.
In August 2007, Northern Rock was caught in the first credit freeze and found itself unable to borrow. On Sept. 14, when lines formed at Northern Rock branches, the BOE agreed to an emergency loan to keep it afloat.
After a five-month search for a buyer, the British Treasury took over Northern Rock. An internal FSA probe and a report by Parliament’s Treasury Select Committee found a series of failures. The FSA audit said there was a high turnover of supervisors, as bank inspectors are called. Until June 2006, the FSA team overseeing Northern Rock was primarily in charge of regulating insurance companies, the FSA audit found.
FSA Lapses
The Treasury Committee report was more scathing. It said the FSA should have monitored Northern Rock’s rapid expansion more closely and acted when the bank’s share price began tanking in February 2007. It also admonished the FSA for granting Northern Rock a waiver from Basel accord requirements in June 2007 and allowing it to use more of its own estimates on probable loan defaults.
One result: Northern Rock increased its dividend in July 2007, weakening its balance sheet less than two months before the run on the bank.
The Treasury Committee also found the FSA didn’t keep close enough track of bank liquidity. “It would have looked very flawed on the liquidity side,” BOE Governor King told lawmakers.
Bradford & Bingley Plc presented the next hurdle for the FSA. The company had grown into Britain’s biggest lender to landlords, with a loan book almost double the size of its deposit base, making it dependent on markets to finance operations.
B&B Collapse
When the bank’s finances began to falter, the FSA took a hands-on approach and demanded daily reports on the bank’s liquidity, Rod Kent, B&B’s former chairman, told lawmakers in November.
It was too late. In September, after Bradford & Bingley’s shares had fallen 92 percent from the start of the year, the FSA pulled the trigger and advised the government to take it over.
Other banks faced similar challenges. HBOS struggled to finance itself in 2008 as it wrote down assets in the wake of the housing market meltdown. In September, the government helped broker the takeover of HBOS by Lloyds TSB Group Plc.
That Gordon Brown should play a role in resolving the global banking mess is consistent with his history as a critic of unfettered capitalism. He was born in Glasgow and grew up in Kirkcaldy, birthplace of Adam Smith, who was famous for his groundbreaking 1776 book “Wealth of Nations,” which advocated minimal government interference in the economy.
Brown was already a Labour Party activist when he entered the University of Edinburgh at the age of 15. His Ph.D. thesis was on the history of the Scottish Labour Party.
Brown Attacks Thatcher
After stints as a college lecturer and as a producer for Scottish Television, he was elected to Parliament in 1983. In 1989, Brown penned a book, “Where There Was Greed,” a scathing attack on the policies of Conservative Prime Minister Margaret Thatcher, who had cut taxes, deregulated financial services and privatized the mining, rail and utilities industries.
In the book, he railed against the “extraordinary transfer of resources from poor to rich” under Thatcher and the “huge concentrations of private, unaccountable power.”
As an MP, Brown gradually moderated his views. He was a disciple of Labour leaderNeil Kinnock, who tried to move the party away from the hard left during his tenure from 1983 to ’92. After Labour’s fourth election defeat in a row in 1992, John Smith took over as Labour leader, promising continued change with Brown at his side. After Smith died in 1994, Brown was defeated by Tony Blair in the race to succeed him.
Brown’s consolation was Britain’s second-most-powerful post, chancellor of the exchequer. Blair and Brown devised a New Labour Manifesto and tore up Labour’s controversial Clause IV, which advocated “common ownership of the means of production.” The moves paved the way for Labour’s 1997 election victory.
Free Trade Supporter
As chancellor, Brown argued that Britain needed to take measures to remain competitive in an era of globalization. Brown became a staunch supporter of free trade and advocated pro- business policies such as public-private partnerships.
“He’s a pro-market, center-left politician, but he doesn’t think whoever governs least governs best,” says Sunder Katwala, general secretary of the Fabian Society, a think tank close to Labour.
Some Labour MPs are saying Brown is now too pro-business and isn’t extracting tough enough conditions from the banks in exchange for government funding. The government has pledged to invest up to 50 billion pounds to recapitalize British banks. It’s also guaranteeing about 250 billion pounds of loans, while the BOE has made 200 billion pounds available for bank borrowing.
RBS and Lloyds-HBOS will issue new shares underwritten by the Treasury that could give the government a 60 percent stake in RBS and more than 40 percent of Lloyds-HBOS.
Cancelling Bonuses
All board members at banks that receive government funds must forgo bonuses for 2008, and they must halt dividend payments until the banks redeem the preferred shares the government bought in the bailout, Paul Myners says. He is a former money manager and financial journalist who in October joined the U.K. Treasury as City minister, the government’s liaison with British banks.
A newly vigilant FSA is also imposing more stringent rules. The banks participating in the government’s bailout will hold Tier 1 capital of more than 9 percent of assets, according to an FSA statement. Before the crisis, 6 percent was considered healthy. Tier 1 capital consists of a bank’s equity capital plus preferred shares.
Beyond these conditions, the government has pledged to act like any other commercial investor. “We will not be seeking to control the banks on a day-by-day basis,” Myners says.
‘Model’ Regulator?
Even after all the carnage, Brown has not disowned his creation, the FSA. “The FSA is generally recognized to be a model financial services regulator around the world,” he said at a Nov. 15 press conference during the meeting of global leaders.
Confident in his own agency, Brown is overflowing with ideas for remaking global regulation. He wants a beefed-up IMF to act more like a multinational central bank. He advocates giving the Financial Stability Forum, a Basel-based organization of finance ministers and central bankers he helped establish in 1999, more authority to regulate banks.
Of the two Gordon Browns striding the globe, one was lauded by former U.S. Treasury Secretary Robert Rubin in New York on Nov. 14 for his “sound, sensible, courageous” program to pull the world financial system out of crisis. The other has to confront those at home who say the prime minister and his FSA bear some of the responsibility for the trauma British banking is going through.
To contact the reporters on this story: Stephanie Baker in London atstebaker@bloomberg.net; Caroline Binham in London at 3517 orcbinham@bloomberg.net; Elisa Martinuzzi in Milan at +39-emartinuzzi@bloomberg.net.
Last Updated: November 25, 2008 19:10 EST
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